Economic Consequences of Peace: Interwar Instability & Depression
Economic Consequences of the Peace
End of 1st Globalization: International economic disintegration (capitals, commodities & labor). End of EU hegemony (GB). Social and civil conflicts. Development of Fascism & Communism.
EU Post-WW1
After the peace treaties: Germany had to compensate the winners with reparations and the regions of Alsace & Lorraine. No more empire = Weimar Republic. War debt from the US because of the loans provided to allies. Unemployment due to the return of the soldiers. Inflation. Economic contraction; contraction in the US had a negative effect on the EU recovery (sharp import contraction and curb to foreign loans). Hyperinflation: German hyperinflation (1923 – 1$ = 4.2 billion marks), American loans to Germany (inter-allied debt problems). Solution to hyperinflation = creation of a new German mark (attached to gold) they went back to gold standards — Dawes Plan, 1924 and establishment of the Young Plan in 1928 which was a new system for the payment of German reparations.
Growth and Stability During the 1920s
Gold Standard
- Gold Exchange Standard adopted in Genoa in 1922 is the return to the Gold Standard and one of the major sources of instability.
- GB returned to the Gold Standard in 1925, FR in 1928 and the same for the majority of the countries.
Sources of Instability of the Interwar Gold Standard:
- The US (major creditor in the world) was deeply protectionist VS GB free trade policies adopted in 1914. In 1922, the US is going to establish a very high tariff.
- Fall in world prices (particularly in raw materials and food). The Eastern EU and Latin countries, agrarian countries, were highly indebted having a BoP deficit.
- No willingness to trade off domestic growth for a balanced external sector (many governments did not follow the rules).
- No flexibility on prices and wages.
- Absence of a financial centre such as London before the war: The British economy is in decline and this will affect the trust and confidence in the sterling pound; The currency & monetary policies that should have been taking the lead such as the US are not going to have the skills and willingness to manage the international Monetary market.
There was not a clear centre, nobody knew if the important currency was the pound or the dollar.
Trade Market
Causes of deflation: EU is no longer the centre of international trade and the international exchange mechanism broke down (EU countries exported manufactured goods in exchange of raw materials and food from the Rest of the World). Intense import-substitution process during the war in the non-belligerent countries (if I cannot import, I am going to produce it myself) — tariffs are going to be key to this process.
Protectionism
In the world economy there is a significant increase in the production of primary goods (excess supply).
Spain
Growth & Instability
- 20s = acceleration and 30s = stagnation.
- High growth in the 20s in: leading role in the industrial sector (iron, cement) and among traditional industries; The industrial sector structure became more diversified and complex because the capital goods industry increased its share while consumer goods industry decreased. Electrical sector: hydraulic energy (overcome the lack of coal). Financial sector: mixed banking system with the predominance of Spanish capital which received a boost from the repatriation of investment in Cuba.
- Despite the economic growth, until 1914 there’s a divergent period between Spain and the rest of EU.
- Disaster of 1898 = Capital repatriation & investment boom; Fiscal reform & birth of modern large corporation in Spain. It was the loss of the last Spanish colonies in Cuba, Puerto Rico & Philippines.
- Structural change in 20s = less than 30% of population was employed in agriculture by 1930.
- Improvement of literacy and education rates.
- Demographic transition = decreased mortality; increased life expectancy.
- 1930 = Primo de Rivera: not only tariffs but more intense administrative intervention and regulation. Protection & intervention jeopardized economic growth = the industrial sector had high production costs (energy) and population really low wages (higher food prices). Increased public spending = public works program during dictatorship: railways (network improvement), highways & hydraulic public works. Huge intervention of the government in the economy.
Gold Standard
- Capital repatriation from Cuba & investment boom brought the Fiscal Reform.
- 1900 – Fdz Villaverde = taxes on civil servant wages, public debt interest, business profits & new indirect taxes on electricity & natural gas. Increase in tax pressure = short run public budget surplus.
- After WW1, Spain accumulated gold (profits from its neutrality), that was not used to restore the Gold Standard and created systematic deficits in the external sector.
Economy During Great Depression
- The global crisis did not have a high impact on Spanish economy: decrease 40% exports on raw materials and food and 6% yearly decrease on investment.
- Spain remained isolated from the international crisis due to its weak links with the international financial market & had large reserves (isolation is one of the reasons why Spain is less affected).
- Modest GDP drop (0.6% year) = stagnation = agricultural economy and isolation from the international economy, not as industrialized as other EU countries and prevented Spain from a big crisis suffering.
- Private investment falls sharply due to domestic political tension.
New Political Regime: The 2nd Republic
- The republic economic policy maintained the status quo & the fiscal policy was orthodox: just 1 new tax for very high income levels / public spending remained at high levels compensating the drop in private investment.
- Restrictive monetary policy to maintain the exchange rate (currency): the increase in interest rates to attract international capital was useless because of the international markets disintegration.
- Collapse of prices of primary goods in the international market: impact on agricultural exports and mining, however the economy was closed. This was the main transmission channel of the depression to Spanish economy.
- Coincidence of political changes and economies: Opposition to the Republic by entrepreneurs, bankers and large landowners. Labor policy = workers support = increase in wages with no link to production but labor cost increase for firms and increase in industrial sector employment.
The Great Depression (1929-39)
Originated in the US; it had European focus and several warning signals (most important = decrease in Prices). It was a global crisis, therefore it affected every country in the world. Outcome = WW2. What explains the severity of the depression? Contractionary monetary policy, fall in investment and deflation (Keynes). The contractionary monetary policy is one of the main explanations of the severity and it was followed by most of the governments until 1933. Why they follow this monetary policy? It’s the economic policy inherent to the Gold Standard what generates, propagates and sharpens the depression. The Gold Standard restoration restricted the availability of economic policy instruments: It was not the strict rules of the Gold Standard but something ideological. The idea of the economic policy that governments had to follow was subject to the Gold Standard mentality.
3 reasons why we are blaming the economic policy = 1-The adjustment mechanism of a deficit country in terms of BoP rests on deflation (not in devaluation) –> change in domestic Prices. 2-It was penalized to run out of gold reserves but it was not accumulating them and it wasn’t not following the rules. 3-The Gold Standard explained how to deal with a shock in an individual country, assuming that other countries were immune to what happened to that country.
Adjustment BoP Deficit
When you have a deficit you need to increase interest rate in order to contract Money Supply. By rising interest rate, you create deflation (devaluation was not an option) and you are supposed to receive gold or money convertible into gold, so by this mechanism the country corrects the deficit and also receives capital from Rest of the World. On the contrary, when you have a surplus, there will be an increase in gold reserves and interest rates will be decreased. This is what the Fed Reserve should have done since the US had an increase in gold reserves. However, it acted as if the US was a deficit country. Increased gold reserves = decreased interest rate. Decreased gold reserves = increased interest rate
In 1928, US & France accumulated +60% gold reserves = they were accumulating more of the gold circulating in the international market. These 2 countries have decreased interest rates in order to create deflation but they didn’t do it because by that time inflation was refused by most of the governments (they considered it was not economically viable because of the hyperinflation memories) and because of the Golden Fetters which was the idea of not devaluating & following the rules of the game.
Depression – American Phase (1929-31)
NY Stock Exchange Crash
The stock market crash reduced American aggregate demand. Consumer purchase of durable goods & business investment fell sharply after the crash (many industries producing business suffered a lot because of reduction in consumption). Negative effects = reduce private investment wealth by 10% and increase uncertainty resulting on a contraction in consumption. Rational expectations: At that time the stock ownership was confined to the rich and the mid class Americans owned little stock. However, the crash affected everyone´s economy; bad times were coming. Change in expectations & perception of the economy; people anticipated bad times were coming & they restricted consumption, stopped buying durable goods and there was a fall in demand, which had a negative effect for many countries. Therefore, many industries producing durable goods had to close and lay off their employees, causing a rise in unemployment. The reason why this happened is because people reacted by contracting consumption.
Smooth-Hawley Tariff (1930)
The commercial tariff increased the already high US tariffs by 2.5% on average –> This tariff was very protectionist. Since mid-1920s the American economy had been heavily protected by high commercial duties, this is an increase in protection. The depression had negative impact on US exports due to the retaliation against the tariff. The idea fails because: a- Any tariff shifts demand for foreign goods towards domestic goods (the demand increases). b- The decrease in US exports cannot be explained only by trade relations = between 1920-31 exports decreased from 7.5% to 1.5% of US GNP plunged by 15%; for the US it was not vital import goods, they were low dependence on foreign products.
1st Banking Crisis
The next blow to aggregate demand occurred in the fall of 1930 when the first of four waves of banking panics happened in the US. By 1933, one-fifth (1/5) of the banks in existence at the start of 1930 had failed. The Federal Reserve did little to try to stem the banking panics and continued with a contractionary policy. In this first Banking Crisis, people run to the bank to get their money, as they were not sure what was going to happen with their deposits in the bank. And a bank cannot give all the money everyone has at the same time. When they did so, panic was created, because at certain point, the bank closed the doors because they cannot give all the deposits to everyone. There were 2 alternatives: Let the bank go bankrupt or helping the banking system.
Collapse of Prices of Primary Products
(affects all the world) Drop in export prices and reduction of international credit (lack of international finance) leads to an excess supply and a fall in food and raw material prices. Def suspension of US loans and capital repatriation (after the crash, American money went back home because of the feeling of uncertainty of the American economy and the need to recover the capital invested in other countries). Real disaster for debtor countries (they tried to compensate the loss of the American capital by increasing Exports & plunge agricultural prices in world markets; this lead to a worsening Terms of Trade – If the Price of your Exports falls & collapse, you cannot import because your Terms of Trade are going to be deteriorated). Restriction of Imports of industrial products thereby generating a negative impact on industrial countries. Wholesale international price index fell dramatically between 1929-36 (the agricultural products in the US fell by 25% and this was the complete ruin of the American farmers. This is the misery in US rural areas because they were producing like in Rest of the World and there was a deep fall in Prices). 2 views of deflation: 1- STATIC EFFECT = for the same nominal amount of money, higher Purchasing Power and therefore increase in real wages; this is good in the short-run because prices are falling. 2- DYNAMIC EFFECT = works through expectations; in the long run, through expectations, if I expect during Year 1…