Postwar Economic Frailty and the Crash of 1929: Causes, Consequences, and Responses
T9: Postwar Economic Frailty
9.1 Financial Difficulties and Precarious Monetary Stability
The international economy enjoyed a period of stability at the turn of the 20th century. However, the economic expansion of the 1920s was weak and slowed down abruptly with the crisis of the 1980s and later with the advent of World War II (which arose from the crisis of 1929).
During this period, the economy evolved in two stages:
I. Reconstruction
In Europe:
Europe was slow to recover its pre-1914 production levels, taking almost 10 years. This delay was due to socio-political conflicts arising from unstable governments and border disputes, as well as monetary instability and a lack of financial resources.
Spatial differences were also observed. For example, Northwestern Europe experienced less war destruction and received more American aid, allowing for a faster recovery. Central and Eastern Europe suffered more from war destruction and received little outside help.
Overseas:
Overseas periphery and neutral countries experienced general expansion as demand from the former warring nations remained high while their supply was insufficient. Evidence of this is the limited trade between the U.S. and Europe. By 1914, Europe accounted for 50% of U.S. trade, but at its peak in 1923, it did not exceed 23%.
II. Expansion (1925-1929)
During this period, both production and trade increased, benefiting all nations. Northwestern Europe’s industry growth rates matched those of the USA and Japan. However, primary production yielded better results for raw material suppliers due to the industrial boom than for food suppliers due to the recovery of supply from the former warring nations.
This expansion was atypical and differed from previous periods because high unemployment persisted despite the business cycle peak.
Main Problems of the Period:
a) Monetary System:
Most belligerent countries emerged from the war with misaligned currency systems (except the USA and Japan). Currencies were devalued against pre-war parities due to payment deficits and inflationary financing of the conflict. After the war, monetary systems had to be readjusted.
This process took two forms: monetary stabilization and restoration of the gold standard.
Monetary stability was a priority for many governments. However, it was done individually and based on political rather than economic criteria. For example, while Britain restored the gold parity of its currency, other countries opted for devaluation. Some countries were even forced to introduce new currencies due to hyperinflation, as in the case of postwar Germany.
The consequences of this arbitrary and differential stabilization were that nations that devalued their currencies faced difficulties in paying for imports, while those that maintained parity experienced more expensive exports.
In addition, this readjustment of currencies led to the restoration of the gold standard. This new standard differed significantly from the previous one. It was not a strict gold standard because most countries abolished both the accumulation of gold coins and the convertibility of banknotes due to shortages and reduced gold reserves related to the war.
From 1919 onward, a “gold exchange standard” emerged, where a country’s currency was linked to the currency of another country with which it had the closest business relationship and had metal backing. From 1919, the U.S. dollar became the cornerstone of the system as the U.S. held most of the world’s gold reserves due to its commercial and financial transactions. This new standard posed risks for other countries as linking their currency to another country’s currency meant that if the latter suffered a financial crisis, other countries would be directly affected.
b) Financial System (International Credit)
Apart from war debts and reparations demanded by the victors from the vanquished, financial transactions in the 1920s financed reconstruction. The USA became the primary lender.
These loans were not used to increase the productive capacity of borrowing countries, which would have allowed them to generate foreign exchange and repay the loans. Instead, they were primarily used to finance balance of payments deficits and, secondly, budget imbalances. This resulted in the need for these countries to seek new loans to meet their payments, creating a spiral where any problem affecting or weakening the pace of U.S. investments threatened the growth of their economies.
9.2 The Crash of 1929
The crisis began in late 1929 with the bursting of the New York stock market bubble. It is considered one of the most significant crises in the global economy, lasting for almost three years and taking nearly a decade to recover from.
Causes:
Explanations for the crisis of 1929 are varied. Generally, the cause lies in the fragility of the economic recovery in the 1920s. This can be summarized as follows:
Real Factors:
From the supply side:
Overproduction of both manufactured and primary goods caused a fall in prices. There was a significant feedback effect, as the industrial crisis caused an increase in the excess supply of primary goods and vice versa.
From the demand side:
The problem was not only overproduction but also significant under-consumption during the 1920s. This fueled production growth driven by the expectation of future profits. However, unemployment persisted, and income inequality widened (5% of Americans owned 60% of the wealth).
Monetary Factors:
The restoration of the gold exchange standard and domestic capital flows fostered significant credit inflation that financed overproduction and contributed to the excessive valuation of financial assets. The falling profitability of various sectors caused a wave of defaults, leading to bank failures and financial panic in the U.S. The distribution of capital spread the crisis to the rest of the world.
Consequences:
By 1931, the crisis had become global. Its most dramatic consequence was unemployment, followed by declines in production and trade.
The crisis did not affect everyone equally. It hit hardest those countries that had experienced the highest growth in previous years, particularly the USA and Germany. At the other extreme was the Soviet Union, which experienced considerable growth under its first five-year plan. Britain and France were in a buffer zone. Britain responded quickly to the crisis, while France was affected later due to the devaluation of the franc during the 1920s.
The decline in production affected foreign trade, with exports declining. The decline in export volume was 30%, and the decline in value was even greater, reaching almost 60%. In commodity-producing areas, the decline in prices was almost 60% due to oversupply caused by Europe’s recovery in the 1920s and reduced demand from 1929 onward. This devastated countries whose income depended on exports of these goods.
Unemployment was the most significant consequence as workers’ living conditions worsened due to oversupply in the labor market. Unemployment rates reached unprecedented levels, with Germany experiencing 40% unemployment and the USA and Britain experiencing almost 25%.
9.3 The Responses to the Crisis
Initially, most countries adopted austerity policies aimed at improving profitability by reducing production, selling surpluses, and cutting wages. These policies aimed to reduce production and financial costs by reducing credit.
This strategy was intended to allow the most efficient firms to survive and maintain a balanced state budget. However, it deepened the crisis by encouraging under-consumption as it placed the burden of the crisis on workers. Public budgets became unbalanced due to continued subsidies and aid to increasingly affected businesses and a decrease in government revenue due to the contraction in output, income, and consumption.
This deflationary strategy failed because each country opted for different and unorthodox economic policies. In all cases, the state had to become more actively involved in the economy due to the failure of market mechanisms to correct the situation.
Most Significant Examples:
- Great Britain: The British deficit increased significantly, forcing a break with the paradigms of liberal economic policy that had been in place since the Industrial Revolution. Free trade was abandoned as the crisis forced the implementation of protectionist measures, including tariff protection, which only applied to raw materials and food products affecting domestic production. Britain also abandoned the gold standard, leading to the devaluation of the pound. This was a cyclical aspect of the time and reflected the recognition of the loss of financial dominance to the USA.
- United States: The “New Deal” marked a change in the direction of U.S. policy, which had previously been characterized by “no action.” This new program was based on the idea that the problems stemmed from under-consumption, so most measures were designed to stimulate demand. The dollar was devalued to encourage exports, and control measures were introduced on banks by raising their reserve requirements. In the agricultural sector, the government tried to limit supply by granting compensation for reduced production and subsidies to ensure income levels. In the industrial sector, a strategy was developed to avoid overproduction while maintaining activity. Wages were frozen, working hours were reduced, and companies were encouraged to form cartels.
- Sweden: In contrast to these production-focused approaches, Sweden, under the Social Democrats, focused on its capital base. This involved a public investment policy that aimed to stimulate demand and production within a social system that allowed for moderate wage growth and provided for the accrual of profits by firms, which would then be reinvested in the production process. U.S. dollars earned were also reverted to the state budget through taxes. A “covenant” was instituted to foster social interaction between unions, employers, and workers, contributing to economic recovery and the consolidation of the welfare state.