A beginner’s guide to the Great Depression and the link to today

At the time of the Great Depression, the prevailing wisdom held that no currency was trustworthy unless it was “pegged” to other currencies. I’ll explain this in a minute. The point here is that this arrangement means that the government is forced to keep its budget in order. If it spends more than it taxes, the extra money it spends finds its way to the foreign exchange market (simply, the market where supply and demand for foreign currency meet). Normally, just about as much foreign money is arriving at the fx market seeking local money, as local money is seeking foreign money; supply and demand are balanced and the exchange rate is steady. (The central bank can fine-tune the market to ensure that supply and demand exactly balance — thus “pegging” the exchange rate. It does this by buying foreign currency when too much is offered and selling it when  too little is offered.) When the government overspends, there’s too much money arriving at the fx market. Unless all the other governments are spending this wildly, there’s no reason to expect their monies to show up at the fx market in these greater amounts. Hence, the ‘home’ government has created an excess demand for foreign currency (synonym: foreign exchange) in the fx market.

Here’s the rub: even when the government is completely virtuous (no fiscal deficits), a gap in the fx market can still materialize. The government next door might run a fiscal surplus (collecting more tax than it spends — maybe it’s worried about inflation). A smaller amount of its money will show up at the fx market, while the same amount of your money shows up, meaning there is an excess demand for foreign currency in the fx market. Although your central bank can fine-tune these discrepancies in the market, it cannot indefinitely supply the excess foreign currency demanded, because its reserves of foreign money are not unlimited. So, in order to keep supply and demand balanced (in the fx market), your government is going to have to cut its spending and/or raise taxes to generate a surplus. It will have to do this even if the economy already has a high unemployment rate and spending cuts will throw even more people out of work. The prevailing wisdom demands it! That is the essence of the story, and for the connection to the euro-area today, just skip to the bottom.

Before lowering this conceptual framework onto the Great Depression, some admin. The government budget is a policy tool in the previous example. Another, more immediate tool, though ultimately beholden to the budget (pdf), is the central bank’s interest rate. It has the power to affect demand and supply in the fx market immediately (except in acute circumstances — on which more later). By raising the interest rate offered on deposits in the domestic money, the central bank increases the demand for domestic money (both among local residents and foreigners). Voilà, the fx market gap is filled. So we have two policy tools. Now, when the fx market yawns, you’ve got to deploy these tools if you intend to keep the currency stable, or “pegged”. And you do intend to do so, because it’s the prevailing wisdom. You can see how these tools can be painful (and politically difficult). Imagine your own government jacking up taxes and your central bank sharply raising interest rates in the midst of today’s recession.

The final ‘admin’ is to discuss the various causes of such drains in the fx market. We’ve seen they can result from your own fiscal deficit (in the absence of fiscal deficits among the neighbours), and from your neighbour’s fiscal surplus (in the absence of your own fiscal surplus). Think of any source of demand or supply for foreign exchange, and you’ve identified a source of fx gap. (Another is implied in the previous paragraph: a hike in your neighbour’s central bank interest rate.) In the Great Depression, several sources of fx drain hit the world economy in quick succession. Each necessitated a counter-response: a tightening in fiscal or monetary policy or both. The essence of the Great Depression is that each tightening required another tightening, and so forth. It’s worth detailing these causes, as they happened, because they are no mere relics but alive and present. We’ve either seen them already in today’s cycle or may soon. For the chronology I draw heavily on Eichengreen, Golden Fetters (Oxford, 1992).

Commodity collapse. The first round of the Great Depression was underway before the US stock market crashed in October 1929. This round touched the economies which were exporters of primary commodities. A late-1920s decline in the prices of their exports resulted in lower export earnings. Yet their imports, which contained a large proportion of manufactured goods, were not getting cheaper. This generated gaps in their fx markets which drove them to a variety of policy responses: not only fiscal and monetary austerity, but re-doubling their quantity of commodities exported in order to raise more earnings. This itself only exacerbated the decline in commodity prices. In mid-1929, the bottom fell out:

… the precipitous drop in commodity prices after the summer of 1929 rendered even the most heroic adjustments inadequate. Resistance to policies of austerity, which were blamed for worsening the economic crisis or shifting the burden onto the working class, was mounting throughout Central Europe and Latin America. (p. 231). 

Capital retreat. As the US stock market bubble inflated in 1928 and 1929, it lured US capital back from abroad, as well as attracting foreign capital to the United States. Moreover, the Fed was raising the interest rate to fight the bubble, making US deposits more attractive. This was particularly damaging to Europe, because US citizens had been important providers of short-term capital there in the form of bank deposits.

Foreign bust. If a major trade partner suffers recession, it will affect your fx market in two ways. First, the depressed state of the economy reduces the demand for your exports — hence fewer export earnings. Second, if that economy starts deflating, then its prices are falling below yours, so that your economy is uncompetitive against it — again reducing your exports. The US economy had a big enough trade presence globally in 1929 to inflict such stress widely. Its downturn in 1929, starting in August, compounded the strains already besetting commodity exporters and central European debtors. By the end of 1929 “recession was almost universally evident. Only France, Sweden and a few of their economic satellites were spared.” (p. 246)

Debt. Commodity exporters were also international debtors. Though their export earnings were falling (due to falling world commodity prices), their international debt obligations were fixed. They had to service and re-pay the same amount of debt out of a declining income stream. This exact dynamic also strangulated indebted households and businesses, no matter where located. The US price level was already deflating before 1929; when prices began falling sharply from 1929, debt burdens ballooned. As firms and households subsequently became insolvent, their insolvency undermined the financial position of the lender (typically, a regional bank). Aware of the declining health of the lender, depositors withdrew money, triggering bank runs. Irving Fisher in 1933 called this the “Debt-Deflation Theory of Great Depressions.” Note his use of the plural here.

1931. Till this point there had been no major sovereign debt default. Souring loans among the commodity exporters killed the appetite for foreign lending, and this “transformed the Central European financial situation” (p.261). The banking system there had grown heavily dependent upon foreign funds. As those vanished, there was little left to liquidate domestic depositors who wanted out. In May 1931, a lot of them did: the financial status of Austria’s biggest bank was revealed: “deteriorating loan performance had completely wiped out” its capital, in a bank whose balance sheet was as large as the government’s total budget (p. 265). The ensuing bank crisis was enough to bring down the Austrian currency and turn the spotlight on troubles in Hungary and Germany, bringing down their currencies too. Recall the household debt-deflation sequence above: the consequence of insolvencies is to question the financial health of the creditor. On an international scale, the equivalent of the local bank run is a run on the currency. Britain was a major creditor to central Europe, and the loss of those assets seriously undermined the already faltering confidence in sterling. By September 21, Britain’s own currency had been brought down. There was little the Bank of England could do: in an acute phase of flight from the domestic currency, no level of central bank interest rate will prove attractive.

“Brought down” in this context means violating the prevailing wisdom: either losing the peg to the foreign currency, or departing the open world financial and trade system (in order to keep the currency ostensibly pegged; after all, if you can control trade and financial flows, you can control the supply and demand for foreign exchange). Both routes enabled recovery. The country could conduct expansionary policy (i.e. budget deficit and monetary expansion), possibly generating demand for the rest of the world as well. Indeed it is now an accepted conclusion that the first countries to leave the gold standard in the great depression were the first to recover. Those who could afford to, like France, stayed on the gold standard. France and its friends kept to it until 1935-36, calling themselves the ‘gold bloc’. The USA kept to it until 1933. In retrospect, the USA decision to devalue in 1933 was crucial: it turned the tide of the Great Depression in the United States. It also provided a liquidity boom for the world economy. By contrast, the gold bloc endured years of depression and deflation because they were hampered by uncompetitive exchange rates: all around them, trading partners had devalued.

Why did the gold bloc adhere to the pegged exchange rates? Because of the prevailing wisdom. The prevailing wisdom was so strong that it compelled everyone to go to great lengths to stay on gold. Those who stuck it out were simply those who could afford to (with the exception being the USA). Defence of currency pegs was a cardinal principle of the gold standard, and the defence of the gold standard was likened to defending civilisation itself. “It would be difficult to devise a measure that would give a greater shock to the world’s trade and credit than departure of Britain from the Gold Standard,” pronounced a British Cabinet memo on September 3, 1931. “And the world is in no condition to stand shocks to-day.” Such fears proved unfounded, which makes their unqualified assertion an example of dogma.

Which brings us to 2010. The crisis in the euro-area features sovereign debt of the weaker members of Economic and Monetary Union (EMU, the formal name for the euro-area). Sovereign debt is the debt borrowed by a government. US Treasury bonds are US sovereign debt. British “gilts” are British sovereign debt. Focusing on Greece for simplicity, Greek sovereign debt is not repayable. Yet it is owed to the banking system at the core of the EU. Hence, the EU has arranged a 750 billion euro package of loans to “help” Greece repay its debt (and to help Greece’s neighbours repay their debts). This does not address the underlying problem. Greek prices and wages are uncompetitive within the euro-zone and within the global economy. It needs both a debt restructuring and an independent currency. The reason for the latter is that this is the only realistic way of bringing Greek prices into line with the rest of the world. I could quote the IMF’s own projections to support the contention that programme fulfilment under the current plan is exceedingly optimistic, but this stuff is all over the internet.

The EU’s leadership is hamstrung by a prevailing wisdom which is taking on the quality of dogma. The EU itself is said to face an “existential” crisis if Greece defaults and/or withdraws from the euro (Angela Merkel’s words). What support does this statement have? The danger is that it traps policymakers into the absurd and the capricious, in the same way that gold standard dogma motivated such folly between the wars. Essentially, the EU is telling Greece (and its neighbours) to “take the pain” for an indefinite period, with severe austerity and certainly deflation and unemployment. All in the name of EMU. If the worry is the EU’s private banks, convert the 750 bn euro rescue package into a re-capitalisation fund for the banks, and let Greece default on its debt and re-issue its own currency (the drachma). I have sketched the key elements in a 5-part plan elsewhere. There should be no illusion that the consequences will be limited to Greece or the European banks. Whatever they profess now, Greece’s trading partners will be better off with a sharply expanding post-default, post-devaluation Greek economy than an interminably depressed one. Yet it is clear, too, that these trading partners will also need to depreciate, and that the loss of the euro as a reserve asset suggests an unpalatable strengthening in the US dollar. The next link in this story is undoubtedly the US-China nexus, which has interesting antecedents in the UK-US nexus in the various parts of the early 20th century.

But that is another story.