Alarming errors in “lessons” from the 1930s

Angel Gurría explained this morning that protectionism is the real and present danger facing the world economy, citing the 1930s as an object lesson. This view no doubt enjoys considerable support. It is practically a ‘stylised fact’ in our historiography of the Great Depression (was the Smoot-Hawley tariff not in your high school textbook?). It is presumably uncontroversial among policymakers, since Gurría heads the official talking-shop of the world’s advanced economies. That makes it all the more alarming, because it profoundly misunderstands the dynamics of global depression.

Here is an authoritative contemporary review of the interwar problem (Lary 1943). On page 182 begins the subsection, “Summary of Experience, 1930-33”:

The principal conclusion that may be drawn from the foregoing survey of the international transactions of the United States during the great depression is simple and obvious: Whatever may have been the other factors contributing to the breakdown of the world economy, an orderly and integrated international society could not be expected to survive a contraction [in US GDP] on the scale that occurred after 1929.

… It was inevitable that many foreign countries should have ceased to depend on internal contraction as a means of adjustment to external pressure … and embarked on programs of domestic expansion.  And it was also inevitable that most of them should have resorted to additional and more direct measures of curtailing imports and that these measures should have fallen with particular severity on imports from the United States in order to redress the balance. Under these conditions many approaches to the problem aimed at immediate restoration of the international gold standard and removal of trade restrictions and discrimination were more concerned with the outward manifestations than with the basic causes of disorder. (emphasis added)

For “international gold standard” substitute “Economic and Monetary Union” i.e. the euro-area. For “trade restrictions” substitute “the danger of trade restrictions” — viz the Gurría warning.

Were France and Germany’s illiberal trade policies a cause of the Great Depression or a consequence? Nurkse (1944), writing the League of Nations’ post-mortem on the interwar economy, is unequivocal:

In practice, apart from its inherent disadvantages, income deflation and unemployment as a means of adjusting the balances of payments is liable to encounter insuperable social resistances. in these circumstances the only remaining alternative to exchange adjustment in cases of chronic overvaluation is a policy of import restrictions. Here the interest of outside countries in a revision of exchange rates is equally plain; thus in 1935, for example, the outside world would have generally welcomed a certain measure of devaluation in France and Germany in preference to the alternative policies of deflation and import quotas in France and drastic exchange controls in Germany.

We actually don’t need to cite contemporary sources. The modern literature is equally clear on the underlying dynamics of the Great Depression. Illiberal trade policies were a refuge from the Depression, not a cause. It was the dogged pursuit of fundamentally flawed policy which fomented and transmitted that depression. Here’s Eichengreen (1992, 290):

The failure of economic activity to stabilize reflected not the rise of trade barriers but the tendency of supplies of money and credit to fall more rapidly in gold standard countries than they rose in countries with depreciated currencies.

The proximate cause of the Great Depression’s policy flaw is so unfamiliar today that its relationship with current events is veiled to too many, not least to some of the principal authors of the modern literature. The ‘proximate cause’ was the gold standard. The fundamental cause can be seen on at least two levels, both with parallels today. To do so, one needs to appreciate that the “gold standard” was both a national currency regime and, when practiced widely, an international monetary system. The significance will become clearer as we go along.

As a national currency regime the gold standard necessitated fidelity to monetary and fiscal austerity. These were necessary to keep the currency’s link to gold and this link was seen as the only defence against an inevitable outbreak of inflation. The widespread fear of inflation in the depth of the Great Depression occurred even as deflation was both a reality and a threat to these economies. There is no gold linkage to defend today, but the champions of austerity point to this same inevitability of inflation as a consequence of fiscal and monetary stimuli. As then, the reality is quite different.

As an international monetary system, the gold standard dictated the exchange-rate relationships between countries. Whatever else its importance, a country’s exchange rate determines how its economy will adjust to crises, whether of foreign or domestic origin. The EU’s decision to view euro-area integrity as a Maginot Line dictates that Greece’s exchange rate will play no role in its adjustment to the present crisis. (“But Greece has no exchange rate”, you reply. Well, yes it does. It’s just harder to recognise because it shares a common currency with a group of otherwise heterogeneous and equally sovereign neighbours. That exchange rate is classified by the International Monetary Fund as “no separate legal tender”.)  As in the Great Depression, this means that the burden of adjustment for Greece falls on domestic prices and incomes, meaning both deflation and unemployment.

The alarming thing about Gurría’s comment is that by fighting the wrong wars we are making refuge in illiberal policy all the more likely. The true “existential threat” to Europe is not disintegration of the euro-area; it is the advocacy of policies which not only can’t succeed but will push domestic political strains to breaking point. More broadly, the threat to global prosperity is not the use of too much stimulus but too little. If we one day find ourselves in a more protectionist world, it won’t be a result of ignoring Gurría’s warning. It will be because we forgot our own history.