The 1930′s Forgotten Economic Lessons
Contents
The 1930′s Forgotten Economic Lessons
Three mistakes world leaders learned from the Great Depression, and forgot.
Originally Published | Arbitrage MagazineBy: Ellie Chan
The eurozone debt crisis is Europe’s first financial crunch since the introduction of the Euro. EU leaders are stupefied by a crisis they have no experience in dealing with, just as central bankers and political leaders were stunned by the first market crash in 1929. It is alarming to see that the world leaders are marching in the footsteps of their predecessors, who made all the wrong decisions that led to the Great Depression.
1. THE GREAT IMBALANCE
One of the greatest global imbalances in modern history was after the First World War. To financethe war, Europe borrowed heavily from the US government. Under the rules of the gold standard, Europeans had to take gold bullions out from the reserve vaults and ship them to the US Federal Reserve Banks. The Allies borrowed so much debt from the United States that, after the war ended, the Fed accumulated $4.5 billion out of $6 billion of circulated gold. That is 75 percent of all circulated money in the four major economic powers in the world (Britain, Germany, France, and United States).
The gross imbalance in gold distribution blocked the smooth machination of the gold standard. The lack of gold in Europe exacerbated the post-war economic turmoil. A fight for gold between Britain, France, and Germany soured their relationship. Since the United States possessed the largest gold collection, Britain lost its status as the world’s financial city, and never regained the position since. France attracted foreign money due to an undervalued franc, and hoarded its bullions while its European counterparts were starving for gold. Paul Einzig, author of the Lombard Street column for the Financial News, wrote that it was “the French gold hoarding policy which brought about the slump in commodity prices, which in turn was the main cause of the economic depression; that it is the unwillingness of France to cooperate with other nations which has aggravated the depression into a violent crisis.” Germany, faced with empty reserve vaults, war reparations, a nation under reconstruction, and economic slump, was in trouble. It had no other choice but to maniacally print money that resulted in the tragic period of hyperinflation.
The Great Crash on Wall Street in 1929 was the tipping point. It sent shockwaves across the Atlantic Ocean, and Europe plummeted into the Great Depression. The global imbalance in the post-war world formed a backdrop for a great financial disaster. Today, our world is reaching a concerning point of imbalance: nations being either big savers, or big spenders. China and Germany both have enormous account surpluses – the world’s first and second, respectively. China alone accumulated a foreign reserve totalling $3.2 trillion. China and Germany have become the biggest money savers of the world, and are now expected to be the saviours of the world, too.
The rest of the world (the peripheral eurozone countries, France, the United States) is trillion dollars in debt. They spent more money than they could raise through taxes, and they borrowed more from other countries than they could repay. The consequences are slow to show, but they are surfacing after a generation’s time. On one side of the globe, the economy is sucked into a hopeless cycle of contraction and austerity, which in turn leads to more contraction. There are outbursts of public unrest and political instability. More people are losing the lifestyle they once knew. On the other side, the economy is booming, investment money is pouring in, and many more are rising to a favourable living standard. A world this much out of balance is dangerous for everyone, including the seemingly prosperous countries.
2. STUBBORNNESS
Up until the Second World War, global financiers were devoted to the gold standard in bringing long-term price stability and strict control on inflation. At the outbreak of World War I, Britain, Germany, France, and the United States all abandoned the gold standard to finance the war. Everyone saw it as a temporary policy, and central bankers were adamant to take the world back on gold.
However, the post-war world was very different from the one before. All gold has fled Europe to the United States; Europe’s vaults were nearly empty. But Britain, always a strong advocate of the gold standard, returned to gold in 1925 at an unrealistically high exchange rate. British goods suddenly became very expensive. Exports dropped, factories closed down, unemployment spiked, and the entire nation spiralled into recession. Montagu Norman, the central banker at the time, was stubborn on bringing prestige back to the sterling and did not understand that the overvalued pound was staggering the British economy.
In the midst of the Great Depression, in 1931, Norman finally took the pound sterling off the gold standard. The currency was no longer pegged to gold, allowing the central bank to lower interest rate to free up money and stimulate the economy. Though economists initially condemned the decision, they could not deny the benefits Britain gained from being off gold. The devalued pound cheapened British exports again. Manufacturing revived, people returned to work, and Britain was, in fact, the first country to emerge from the Great Depression.
Liaquat Ahamed, Pulitzer Prize winner of his book “Lords of Finance”, blames Norman and other central bankers in the 1930′s for pushing the world into the Great Depression: “[M]ore than anyone else they were responsible for the … fundamental error of economic policy … to take the world back onto the gold standard.” The stubbornness of one central banker prolonged Britain’s misery for six years. In the current crisis, Angela Merkel’s stubbornness is similarly prolonging European woes. It seems the German Chancellor rejected many possible solutions. She refused for many months for contributing more capital into the European Financial Stability Facility (EFSF), the eurozone rescue fund. She ruled out European Central Bank (ECB) funding in the EFSF. She also opposes to the idea of eurobonds, which are eurozone government debt with joint liability. Merkel was hesitant for good reasons. She wanted to utilise market pressure to discipline the troubled economies, instead of handing them free money and giving them a pass out of this mess. But we saw the contagion reaching the German Bund market, with a disappointing bond auction in November. S&P credit agency also put Germany on negative credit watch that threatens its triple A standing.
Unable to contain the growing crisis spreading into her country, Merkel is clearly desperate to win back market confidence. She aggressively announced, on December 14, of EU’s long-term progression to become a fiscal union. But at this stage, the crisis already consumed Europe. Such a decision would have had the “bazooka effect” on markets at the beginning of the year, but now the stakes are higher, and investors remain sceptics.
3. A MISSING BACKBONE
What escalated into the Great Depression was a US banking crisis triggered by the collapse of a private bank called Bank of United States (BUS). Despite its official-sounding name, it had no relationship with the US government. As the bank became insolvent, the Fed believed they could build a strong enough firewall around its collapse. They decided not to bail it out.
The failure of BUS, a high-profile bank, changed public sentiment very quickly. Depositors lost confidence as they could no longer tell whether a bank was healthy or not, so they indiscriminately started pulling their money out of all banks. What resulted was a scramble for credit across the system.
The Fed could control the credit crunch by injecting cash into the banking system, but the governors refused to act. Only half of the banks in the country joined the Federal Reserve system, and the governors did not think it was their responsibility to safeguard these non-member banks; although collectively, these banks had a large impact on the credit system. In 1931, one out of every ten banks in the country closed down. Confidence vanished, and thus marked the beginning of the unstoppable bank runs that swept across the nation between 1931 and 1932.
Legislation finally passed in 1932 to allow the Fed to inject $1 billion of cash into banks – the Fed was finally pumping money into the system on a required scale. But it was too late, by then, the United States, like the rest of the world, had entered the darkest year in the Depression.
The lack of funding support from the central bank is a mistake policymakers are repeating today. The ECB refuses to pour money into the EFSF (it is also unlikely to contribute to the European Stability Mechanism), or commit to large-scale bond buying, or act as the lender of last resort. Similar to the Fed’s narrow criteria of its responsibilities, the ECB devotes to a narrow definition of central banking. Its sole purpose is to control price stability within the eurozone, which means keeping inflation low. Jens Weidmann, President of the Bundesbank, said the ECB’s mandate prevents it from embarking on unlimited bond purchases and past experience showed this would inevitably lead to inflation. With the crisis at this stage, economic outlook for 2012 is bleak. Many economists are predicting recession: Financial Times reported 72% believe Europe will enter a recession in the next 12 months. The ECB should instead worry about deflation, and if it is to fulfil its objective to stabilize prices, which prevents prices from falling, then quantitative easing (buying of government bonds) is necessary.
STEPPING FORWARD
The eurozone debt crisis is nowhere near the magnitude of the Great Depression. The 1930′s tragedy remains a far outlier of the sufferings mankind experienced in modern history. It is the largest sequence of errors made, and from which decision makers still draw lessons to ensure it does not happen again. But contrary to stepping forward, we see once again that the world is unwilling to rebalance itself, that leaders are unreasonably stubborn about their own standpoint, and that the central bank is so narrow-sighted that it becomes passive during a great calamity. All three things are within our power to change, though some will take longer than others. But if we do not take a different course, and quickly, history may repeat itself.
ARB Team
Arbitrage Magazine
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