The 1930′s Forgotten Economic Lessons
Three mistakes world leaders learned from the Great Depression, and forgot.
By 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 finance the 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 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.
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.
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.
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.