LESSON 7. THE FIRST WORLD WAR AND THE INTERWAR CRISIS

THE FIRST WORLD WAR

The 1st WW was debated between two opposing blocks:

 The Allies: France, UK and the Russian Empire (with the collaboration of Italy, Japan, Belgium and the USA)
 And the Central Powers: Germany and Austria-­‐Hungary (together with the Ottoman Empire and Bulgaria) It was a global war centred in Europe that began on 28th July 1914 and lasted until 11th November 1918, the moment the Allies obtained the victory. By the end of the war the map of Europe was redrawn with several independent nations restored or created, and as a result of the Paris Peace Conference that ended the First World War (the Treaty of Versailles), an intergovernmental organisation was founded with the aim of preventing any repetition of such a terrible conflict (the League of Nations).

PROBLEM: This aim failed and, as a result, the renewed European nationalism (together with the German feeling of humiliation) contributed to the rise of fascism that gave birth to the Second World War some years later (1939).
The First World War represented the break with the 19th century and a dramatic change in the political situation worldwide.

Before the war:

 Europe had political and economic predominance in the world.
 There was a proper functioning of the international payment system.
 Freedom was given to the movement of factors (labour and capital)
 And there was limited intervention of the government in the economic life.

After the war:

|  | The United States became the first world economic power. Important distortions appeared in production and trade. Workers and soldiers’ claims started. | |  | Poor functioning of the international payment system once the war finished (lots of economic problems appeared against the Gold Standard System) | |  | Protectionist policies increased. International movements of labour and capital went down. And governments assumed an important role in economic decision-­‐making processes. | | | |
War financing

There are three ways to finance any war:

1. Increase in taxes
2. Spoil (botín) obtained in occupied territories
3. Government indebtedness through:
 Public debt issuing
 International lending or
 Money issuing

All countries used money issuing (increase in fiduciary circulation) as the main way to finance the war. This led to an obvious increase in inflation and the Gold Standard System was progressively abandoned. The fact that too much money was printed and that the amount of gold in the economy decreased (as it was used to pay for weapons and to do other international purchases) led to an inability to sustain the system any more. All countries suspended the convertibility of their currencies and depreciated with respect to the American dollar.

The Treaty of Versailles -­‐ 1919

There were two different positions in the Paris Peace Conference:

a. France and Belgium: “Germany is guilty, they are responsible of the war and they should pay for the debt”. (France wanted Germany to be as weak as possible to slow down the possible future conflict between them)

b. British position (represented by David George): The United Kingdom, together with the USA, wanted to be severe with Germany but promoted cooperation between countries so as to guarantee the peace. Finally the position imposed was the one of France and Belgium, and as between the Allies they were the ones that suffered most destruction, they insisted on receiving enough reparations to cover their debts with the UK and the USA (which had helped them during the war).

Thus, the Treaty of Versailles imposed some sanctions and conditions on the Central Powers (especially Germany had to acknowledge responsibility for “all the loss and damage to which the Allies and Associated Governments had been subjected as a consequence for the aggression of Germany and its collaborators”). Germany was forced, despite its vehement protests, to admit being guilty for having started the war back in 1914 and, consequently, being liable for huge reparations.

The Treaty placed Germany “under legal sanctions, deprived of military power, economically ruined, and politically humiliated”.

These were some of the sanctions imposed to them:

 Payments in kind (coal, gold reserves, weapons…)
 Territorial cessions
 Demilitarization
 Payments in cash (31.455 million of dollars) that were linked to their repayment capacity (the more Germany grew, the more they had to pay)

THE INTERWAR CRISIS

John Maynard Keynes was a well-­‐known British economist who participated in the conference and wrote a book about “The economic consequences of peace”, 1919.

Through his book he claimed that:

 Proposed reparations were economically irrational and politically imprudent.
 He alerted of the danger and the impossibility that Germany could face up those reparations
 As well as also warned about the possible social unrest and danger of a Bolshevik revolution.

Reparations were linked to Germany’s payment capacity. Thus, German governments did not have incentives to foster neither stabilization nor growth policies, and deferred the payments as much as they could.

France and Belgium decided in 1923 to occupy the Ruhr area to exploit by themselves the region and take possession of coal as a mean of payment. As a result, German workers started a strike and social conflicts emerged again.

Later on, in 1924, the Dawes Plan is organized (the Treaty of Versailles is reconsidered):

 The amount to be paid is reduced
 International loans are granted, and
 International trust is fostered in the recovery of the mark.

Monetary problems after the First World War

1. The German hyperinflation
2. The return to the Gold Standard System

During the war, UK and France had accumulated an important debt with the United States. Thus, they expected to receive enough reparations from Germany so as to pay the US back. This was the origin of the German hyperinflation and the return to the Gold Standard System.

THE GERMAN HYPERINFLATION

One of the big problems during the war was how to pay for it. Actually, Germany lost the war because of their economic collapse. The war was expected to be short but finally lasted for four years.

The difference between inflation and hyperinflation is that the latter one is defined as an increase in prices of such a magnitude that economic agents alter their demand patterns. Consequently, a further increase in prices is generated. Hyperinflation is a situation in which people do not want to hold money and, as a result, an artificial demand is generated (people do not purchase things because they want them, but because they want to avoid holding money).

Functions of money:

a. Unit of account (way we measure things)
b. Measure of exchange
c. Deposit of value (wealth)

The problem of a hyperinflation is that money loses so much its value that becomes no longer functional, and this is what happened in Germany. In 1923 the mark was worth a trillion part of the
1918 mark. Germany became a Barter economy (people refused to use money any more and those who had savings lost them).

CAUSES OF THE GERMAN HYPERINFLATION

Two explanations exists that are not mutually exclusive:

 Budget deficit

As reparations were related to payment capacity, the German government had no political intention to control the public deficit (T – G). Actually, the German government itself paid

workers to continue in strike so as to further delay payments, but this led to a progressive increase in the budget deficit, which was financed by money issuing. The results were both an increase in inflation and a depreciation of the mark.

 Balance of payments

Reparation payments and trade deficit (G > T) led to an increase in the supply of marks (the reasons is given by the fact that Germany had to sell marks and products in order to have dollars to repay). The consequence to it was a depreciation of the currency that made imports even more expensive, however, Germany had to import a lot. Just after the war ended Germany had a very inelastic demand for imports (they were so destroyed that had no option but to import a lot from abroad, even if the mark depreciation had led to an increase in the relative price of imports). As a result, Germany printed money to pay for them and this led to an increase in the rate of inflation.

CONCLUSION: The hyperinflation was “brought from abroad” because of being due to the increase in the costs of goods and services purchased by the government.

MARK STABILIZATION

Convincing and believable measures were necessary to rebalance the budget: Germany had become a Barter economy and needed to convince people that prices would not increase more so that they would rely again on the functionality of money.

Different measures were taken to achieve this goal:

1. Germany established a fixed exchange rate of the mark with respect to the dollar in November
1923. With it the currency was actually not directly convertible to the dollar but guaranteed by real state property (physical things such as buildings, land…).

2. The government stopped receiving credit from the Central Bank and reduced the budget deficit. 3. And the last part of the solution came with the Dawes Plan. The United States granted an international loan that allowed Germany to restore the public accounts and the macroeconomic equilibrium by returning to the Gold Standard System. This allowed them to solve the problem of hyperinflation in the short term and during the second half of the 1920s Germany performed better. The international loan made Germany, however, become very dependent of the USA. When this credit ended the German economy suffered an important shock proving that, even if this measure had been effective in the short-­‐run, hard consequences were yet to come in the following years.

THE RETURN TO THE GOLD STANDARD SYSTEM

Even if there was a structural trend to deflation, war financing generated a high inflation that persisted during the post-­‐war period. Under this framework all countries were sympathetic with the idea of restoring the Gold Standard System to promote international trade, but the doubt was how this process had to be done. The value of all currencies had changed during the war and it was not possible to guarantee currency convertibility to the previous parity: gold reserves had abruptly decreased and there was, conversely, more paper money circulating in the economy.

Under those conditions, two strategies of economic policy to return to the GSS existed:

a. Return at the pre-­‐war parity.
During the period of floating exchange rates all currencies had depreciated with respect to the American dollar and lost value in terms of gold (recall that with an inflation a currency is worth less). Thus, returning to the Gold Standard System at the pre-­‐war parity meant a revaluation of the currency through the implementation of deflationary economic policies.

b. Establishment of a new parity.
It was possible to choose an even lower parity than the market price of the currency (this meant a devaluation). At the end each county did what they preferred and at different moments in time (UK in 1925, France in
1926…). There was an absolute lack of coordination that generated important distortions. Conditions in which the Gold Standard System was re-­‐established

 End of the British supremacy: the GSS used to work well because all countries followed the action taken by the Central Bank in Britain. Once the war ended, however, the United Kingdom was not the leader any more.

 New York became the world financial centre and the most important international lender (and this is actually what led to the bubble that ended with the famous crash of 1929).

 High accumulation of gold in some countries (especially France and the USA).

 As each country could decide how to restore the GSS, important economic distortions were generated. New parities did not adjust to economic conditions of each country. Thus, some currencies became artificially expensive and others artificially cheap.

 The rules of the Gold Standard System were not maintained.

 Less flexibility in labour market and international trade.

 Excessive dependence from short capital flows.

THE BRITISH OPTION

The pre-­‐war parity was res-­‐established and the currency, therefore, revaluated.
Drawback: industrial activities in the United Kingdom were highly damaged (especially those focused on international markets)  As prices increased, national products became more expensive.

When the currency was revaluated, British exports automatically became more expensive. This led to a problem of loss of competitiveness of British products abroad (as the price in dollars of British products had increased), and under these conditions the UK suffered a difficult period of trade deficit (X < IM). Why this policy then?

London was at that moment the world financial centre. For the UK, having a strong currency was crucial to attract foreign investors and maintain the stability of the financial business. Thus, if they wanted people to still hold deposits of pounds in London they could, under no circumstance, devaluate the currency.

By following this option (revaluating the currency to re-­‐establish the pre-­‐war parity), Britain had to apply what is nowadays called an internal devaluation; let’s analyse what does this imply.

All countries that had followed the first option suffered problems of trade deficit (their currencies were over-­‐valuated and their products became more expensive abroad). This problem could only be solved in two ways: either to increase exports or decrease imports. Some countries opted to decrease imports through the application of protectionist policies, while others decided to increase exports by reducing internal prices.

Britain option was to do an internal devaluation and, to do so, a deflationary adjustment had to be implemented: what can be done either by monetary or fiscal restrictive policies.

 Restrictive monetary policies: ↑ in interest rates or ↓ of Ms
 Restrictive fiscal policies: ↑ in T or ↓ in G These policies, however, had a decreasing effect on demand:

1. Restrictive monetary policies reduced investment.
2. Restrictive fiscal ones reduced consumption.
3. Economic growth was depressed and caused an increase of unemployment.
4. The cut in social benefits created a generalized social unrest that led to the general strike in
1926.

All in all, the British economic performance during the 2nd half of the 20th century was very bad. This is actually something similar to what is happening now in Spain; our country has become very expensive for Americans.

THE FRENCH OPTION

As a difference with Britain, what the French did was to devaluate their currency (they chose a new parity). Fiduciary circulation had increased more in France than in the UK during the war, and so France suffered a higher inflation. Consequently, the French had no debate with respect to that. It would have been impossible for them to return to the pre-­‐war parity because of the higher inflation, so they decided to devaluate their currency, the French franc.

Between 1919 and 1926 the franc was stabilized and the Gold Standard System re-­‐established. However, not only did France accept that their currency had depreciated, but even chose after the war a cheaper currency with respect to the dollar. The franc became, consequently, artificially cheap.

RESULT: Important increase in the international competitiveness of French products. The French economic situation, therefore, progressively improved leading to a trade surplus. In actual fact, even if internal prices in France increased more than in Britain, British products continued being more expensive than French ones (because of the different evolution of currencies).

On the other hand, important to mention that because of the improvement in competitiveness in markets, France accumulated a lot of gold in the economy, in its Central Bank. Theoretically, the more gold exists in an economy, the more money can be printed. The French government, however, did not increase money supply proportionally to the increase in the amount of gold.

France acted against the rules of the Gold Standard System and so decided to sterilize the increase in money supply that the trade surplus was supposed to cause. They accumulated a lot of gold during this period but the increase in money supply did not happen proportionally to the increase of gold. Why? They did so to prevent prices from increasing too much and so be able to maintain an artificially cheap currency (the franc was kept systematically undervalued for some time).

Exchange rates and real economy: The return to the Gold Standard System in the UK and France

Economic growth during the 1920s in the USA

The decision to return to the Gold Standard System provoked important distortions in European countries during the 20s. The ones that restored the pre-­‐war parity suffered hard consequences, and this is why some economies think that without the GSS the Great Depression would not have been so hard.

In the USA, the 20s were a period of fast economic growth (important difference with Europe, where economic growth went down). This growth, however, was unbalanced and characterized by political instability. = · ∝ · �� +,∝
Although some innovations allowed productivity A to increase, the corresponding increase in production
P was not proportional because of a decrease in the amount of resources used (working days were reduced and, consequently, labour force L went down). This is what led to an unbalanced economic growth. Reasons for this weak growth basis:

 Unbalance between supply and demand of agrarian products
During the war an important inversion to increase agrarian production was done (as rivalry between countries stopped exportation). After the war, however, prices went again to normality and trade between countries was rearranged.

Industrial products were at the beginning kind of luxuries. They were expensive and demand, therefore, was low in comparison to supply (S > D). This made have overproduction in the economy and tendency to deflation.

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Nowadays this ratio has a decreasing trend. Industrial products are still more expensive, but as time goes by they are becoming regular consumption products. This is what has highly damaged in the 20th century those countries that used to export agrarian products. They are exporting cheap and importing expensive (as industrial products are much more elaborated), what leads to a progressive lose in purchasing power.

 High unemployment rate
With the increase in productivity coming from technological innovations, the production increased drastically. The capacity of consumption, however, did not increase proportionally.

Consequence? Increase in unemployment because of the reduction in labour (as consumption had gone down a cut in costs was necessary to avoid losses).

 Growing inequality in income distribution
The increase in productivity given by new technologies went mainly to increase profits (return to shareholders) instead to pay for labour (employees). Thus, wages did not increase proportionally to productivity and a growing inequality in income distribution happened.

FACTORS OF GROWTH

Diffusion of the Second Industrial revolution innovations:

 Most important sectors were electricity and automobile production
 Electric engines fostered production mechanization
 Reduction in transport costs

Agrarian transformations:

|  | Mechanization New fertilizers | |  | New crops are introduced as well Intensive cattle farming | |  | Environmental impact of new techniques |
CHANGES IN TRADE

1. International trade kept low for some time: its recovery after the war was slow and limited.

2. Reduction in European participation in World trade.

3. Due to the collapse in trade during the WWI and once it finished, lot of countries started to produce themselves what they used to import: Creation of import-­‐substitution industries.

4. Increase in protectionism because of:

 Difficulties to equilibrate payment balances
 Increase in international competition
 Progressive emergence of nationalism (fascist regimes defended the idea of being self-­‐ sufficient and so stopped importing from abroad)

INTERNATIONAL MOVEMENTS OF CAPITAL

The European allies (France and UK) borrowed money from the USA to finance the war, but once it ended, a high dependence on American credit was generated: Americans claimed their debt back and European allies had no option but to further increase it to do so.

Furthermore, especially those countries that suffered a high post-­‐war inflation (Germany and Austria) really needed short-­‐term capital borrowings from the USA to keep competitive. The United States, thus, became the most important international investor.

On the other hand, as New York was the main world financial centre, volatility in the American stock market was transmitted to the rest of the world – this entailed important weaknesses.

Even if the 20s was a period of economic growth, there were some weaknesses:

 Overproduction in the agrarian and industrial market
 High levels of debt in some countries

 Instability of the capital market: strong dependency of American capa

Production, productivity and wages in the American industry, 1920 – 1929:

The crisis of the 1930s city of financing

It was the most important one suffered by rich capitalist economies in the Contemporary Age.

The crisis started with a recession in the US real economy, which together with the New York crash of the stock market and some bad economic policies, led to bankruptcy of the American banking system.

RESULT: A deflationary spiral that started as an American crisis led to the so-­‐called Great Depression, and was transmitted to Europe and the rest of the World until 1933.

Why is it called a deflationary SPIRAL? Because it was caused by a Recession + a Crash of the stock market + a Bankruptcy of the American banking system

How was the crisis transmitted?

 International trade
 International movements of capital

ROOTS OF THE AMERICAN DEPRESSION

1. Agrarian production
2. Industrial production
3. Stock market speculation

AGRARIAN PRODUCTION

During the war, a fast increase in agrarian production happened because of a raise in prices and an increase in demand from Europe. Thus, lots of agrarian workers decided to invest on their land (financing it via credit):

 The total cultivated land grew and
 New capital-­‐intensive techniques were introduced in agriculture.

After the war, though, prices began to fall and the response was to increase production to achieve a minimum amount of income to cover the previous investment and return the credit.

If income is determined by prices, times the total amount of products sold (Income = P ·∙ Q), if P , the total production Q needs to  in order to avoid a fall of the total income generated in the economy.

Then, which was the consequence of this fall in prices? Tendency to overproduction and a general trend as well to overinvest in sectors were the expectations of demand were bad. In that situation peasants started defaulting their loans (which were used to finance mechanization) and this generated the first banking crisis.

INDUSTRIAL PRODUCTION

Main characteristics:

 Important increase in productivity
 Great increase in profits but minor increase in wages → Increasing inequality in income distribution.  Production grew faster than population’s purchasing power
 Relative excess of capitalization in some industrial sectors
 Investment was reduced in order to avoid relative overproduction

All in all, this crisis in the industry was a crisis of innovation: in a situation of accumulation of capital in the industry that cannot be reinvested (as demand expectations were very bad), profits were diverted to the financial sector.

STOCK MARKET SPECULATION

Business profits were diverted to the financial system instead of being used to reinvest in the industry. This speculation in the stock market led to a progressive increase in the accumulation of capital in New York. While people were still willing to buy, prices kept increasing.

Another characteristic of the late 20s was the appearance of portfolio societies: New institutions that raised small savings of different people and reinvested that money. Then, at the moment the price of some shares (assets) started to go down, what they did was to sell other assets to buy those ones to prevent their prices from falling.

PROBLEM? This investment in “bad” assets generated a huge instability in the stock market, and to crown it all, the investment was being financed with credits. Some banks were lending people money to invest in the stock market, and this had a multiplicative effect. Shares became at that time the guarantee of these loans.

CRASH OF THE STOCK MARKET

In the late 20s all people, firms and banks founded an interesting economic opportunity in investing their profits in the stock market. A growing demand of shares started and, consequently, prices went up at a surprising speed. This accumulation of capital in the New York stock market was the beginning of a financial bubble. In order to have a proper understanding of what happened, though, it is important to bear in mind that speculative bubbles have two main characteristics:

 Both supply and demand have a positive slope
 Demand is more elastic than supply

But why is demand up-­‐ward sloping?

Usually people purchase assets thinking in terms of liquidity (the cheaper the prices, the more people will purchase). However, in a financial bubble like this, demand is speculative: people purchase assets not because of the value they have for them, but because of their value of exchange (the more prices increase, the higher their value of exchange).

At that moment the New York stock market had a speculative demand. People started purchasing shares because they expected prices to go up, and this implies an increase in expected profits (which are computed doing the difference between the Selling price and the Purchasing one). They bought shares not because they wanted to become shareholders, but because they wanted to sell them in the future and get profit from it.

Thus:
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Price

SUPPLY DE MAND

Quantity

This situation could not be sustained for a long time. When demand is more elastic than supply equilibrium can never be achieved (as little increases in prices generate an important reaction in demand, increasing people’s willingness to buy more). The speculative bubble could last forever.

Moreover, not only was demand more elastic than supply, but also larger at any selling price (this is because demand reacts immediately to price changes, while supply takes always some time to be adjusted).

The situation arrived up to a point that increases in prices had been so exceptional that market prices of shares had nothing to do with their real value. There was not proportional connection between the profits of firms and the prices of their shares. Shares were not priced according to their real value of use, but with their value of exchange (which was increasing over time as prices kept going further up)

In August 1929:

 The Federal Reserve Bank of NY increased the discount rate in order to check the process of speculation  And broker’s access to credit was reduced.

The situation, though, was very difficult to manage; firm’s profits were so high that it was impossible to stop speculation.

How did this nightmare end?

The situation could not be sustained this way forever (and the reason remains on the speculative purposes of demand). As long as prices continued going up, people’s expected profits and willingness to buy went up too.

The problem, however, appears when wanting to sell the assets to make this profit liquid: so huge had become the difference between the purchasing price and the selling one, that there is a moment investors realize that shares were priced too far from their real value. At that moment panic started to spread among citizens. Prices were too unrealistic and the situation was unsustainable. Industrial production, for instance, was depressed, but prices of financial assets (shares) were still increasing at full speed. There was a total disconnection.

Given the beginning of the fall in NY stock market, the spread of panic (3 October 1929) led to the opposite phenomenon: both supply and demand curves turned to a negative gradient.

Price

SUPPLY DE MAND

Quantity

What happens now is that prices of shares started decreasing and nobody wanted to buy: supply was higher than demand. Investor’s expected profits were decreasing, and so they were afraid that prices could fell so much to even arrive to values below the ones shares had before the crash (now it was worth selling as soon as possible).

International Economic and Business History

The crash of the stock market, together with the bankruptcy of the banking system that followed, generated a lot of social movements.

29 October 1929: the Black Tuesday  CRASH OF THE STOCK MARKET.

FROM THE CRASH OF THE STOCK MARKET TO THE BANKRUPTCY OF THE BANKING SYSTEM

Obviously not all of them, but some banks had been lending during the years before the crash a lot of

money to people with the aim of promoting investment in the stock market.

For a bank, the guarantees of loans are assets (shares and debts receivable that can be claimed at some point); bank’s liabilities are the deposits.

The problem remains in the fact that, at the moment the stock market crashed and prices started falling, most people lost such amounts of money that the debts couldn’t be met. Consequently, as banks couldn’t get their money back from their borrowers, they found themselves with problems of insolvency: inability to cover liabilities with assets.

Under this framework a liquidity run happened. A crisis of expectations and a situation of banking panic led many savers (even those that were still solvent) to hurry up to withdraw their deposits. This affected all banks (as all of them have people’s savings in liquid) and caused a general bankruptcy of all the banking system. The banking crisis started between December 1930 and June 1931, and damaged the economy in the following way:
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The effects of the crash diffused beyond the investors’ circle, affecting all American economy. Why?

 General regressive situation of the country.

 Disastrous measures of economic policy implemented by the Federal Reserve and the Hoover administration. In order to stop the process of deflation, the government’s response should have been to increase money supply. What they did, however, was to implement a restrictive policy because of the existence of the Gold Standard System. Governments were forced to maintain a fixed exchange rate between their currency and gold, and so could not implement an expansionary monetary policy (as the GSS did not allow countries to increase money supply if they didn’t face an increase in the amount of gold in the economy as well).

 Connection of the crash with the bankruptcy of the banking system.

Causes of the Great Depression

There are two main interpretations:

1. MONETARISTS (Friedman, Schwartz): they support the idea that the cause of the Great Depression was the reduction in money supply, and that the deflation happened given the reduction in demand (caused by that reduction in MS)
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2. KEYNESIANS (Keynes, Temin): The cause of the Great Depression was an autonomous reduction in demand that led to deflation.

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MONETARIST EXPLANATION

The origins of the crisis were the wrong decisions of the Federal Reserve. A restrictive policy was applied and had negative effects on the real side of the economy. Demand went down given the following changes:

 The amount of money supplied was reduced, and
 Payment methods decreased as well (because of the crash of the stock market and the bankruptcy of the banking system).

All in all, prices went rapidly down and deflation left the United States under what is commonly called the Great Depression, a deep crisis that took little time to be spread all over the world.

KEYNESIAN EXPLANATION

Origins of the depression: autonomous reduction in aggregated demand. There were two possibilities:

 Reduction in the autonomous component
 Reduction in the marginal propensity to consume and invest

Causes of the reduction in demand:

a. Unequal distribution of income in society

b. Product cycle

During the 20s a lot of products with a long production cycle appeared in the market (cars, for instance). There was a boom in this kind of consumption at the beginning of the decade and a lot of people borrowed money to purchase. The problem was, though, that this boom in consumption at the beginning of the 20s led to a deep reduction in the propensity to consume by the late 20s and the beginning of the 30s: people were still paying their debt with banks.

c. Problem of expectations

SUMMARY: The economic policies applied once the crisis had started were completely wrong. A restrictive monetary policy (imposed by the still existence of the Gold Standard System) was applied to the economy in a context in which it was necessary to implement an expansive measure. Besides, the USA defended the dollar convertibility to gold beyond what was reasonable.

Diffusion of the depression

The Great Depression was a crisis in western-­‐economies. The process started in the US, was later spread to Europe, and recovery did not start until countries decided to abandon the Gold Standard System.

But how was the Great Depression transmitted? There were two main mechanisms of expansion:

1. Reduction in international trade

The decrease came mainly from the USA (whose demand decreased and started importing less from abroad). This affected all countries that traded with them and especially those that used to export agrarian production to America and to import industrial one. As a result to the US decrease in demand they suffered a deterioration of their trade balance and had an important loss in purchasing power.

The fast reduction in demand from the United States damaged multiple economies and this is why, at the beginning of the Great Depression, there was a generalization of protectionist measures in many countries worldwide: a tariff war started.

TARIFF WAR: Economic battle between two countries in which Country A raises tax rates on Country B’s exports, and Country B does the same the other way round in retaliation.

The increased tax rate is designed to hurt the other country economically, since tariffs discourage people from buying products from outside (total cost on those products is raised).

2. Collapse of international capital markets

As a consequence of the First World War, an increasing dependency of European countries with the Unites States appeared. This is because, with the crisis that followed the war, the US established a negative flow of capital with the other countries (they stopped lending money and instead claimed the European debt back).

Moreover, some European banks had been financed for a long time with American help. When credit from the USA stops, they suffered important problems of solvency in their financial

systems and deflationary policies had to be applied in order to defend the parity of the currency. Countries that suffered more the consequences of the Great Depression were those with higher dependency with the USA (UK and France). Instead, countries like Spain (which was very protectionist and had few international trade) were not affected that much.

The kind of economic policies applied in Europe were similar to the ones in the US: restrictive monetary policies. But at the end, economies were not rebalanced until they abandoned the GSS (as it allowed governments to implement expansionary policies and recover). The only exception to that was Germany because of its specific trade agreements with eastern European countries.

The way out of the depression (USA)

Just after the crisis of 1929, American governments applied restrictive monetary policies to guarantee the convertibility of their currency. We could say that, in some sense, they followed an orthodox policy: they simply acted according to established and accepted standards, implementing same policies as before and doing nothing to deal with the consequences of the crisis. This was Hoover’s administration.

Moreover, Americans by that time had this liberal tradition according to which the state could not take part in the economic decision-­‐making, but given the growing crisis and the instability of the economy, the unemployment rate arrived to the 25% and there was no economic aid for the unemployed.

In 1932 there were elections. The two main political forces were:

 HOOVER, who defended continuing the same way

 ROOSEVELT, who proposed the New Deal (necessity of a new beginning)

The New Deal referred to a set of different measures (economic policies) that had no internal cohesion and had actually not been planned as a whole project, but that were thought to be implemented with the aim of recovering the economy again.

THE NEW DEAL

The first set of measures had to do with the regulation of banks and the stock market. The purpose was to deal with the problem of “liquidity run” (just after prices started falling, people were so afraid that even those that were solvent went rapidly to their banks to claim their money):

 Banks closed so as to prevent people from outdrawing their money (banking-­‐holiday) Another regulation approved during the New Deal had to do with the problem of risk in the stock market. The crash of 1929 had happened because some banks had been speculating, and to avoid this situation in the future, measures were taken to promote stability and reduce risk:

 Commercial banks were separated from investment ones
 And an organism was created to control the stock market and give permissions if necessary

(The current crisis happened, in part, because some of these regulations were supressed just before the stock market crashed). Monetary policies: Suspension of the Gold Standard System and devaluation of the currency

Fiscal policies:

 Breaking off of the principle of budget orthodoxy

 Taxes were not reduced but the government started spending more (G > T = Budget deficit).

The purpose was not to stimulate the economy by increasing demand, but to deal with poverty and the bad social circumstances that the crisis had left.

Fiscal policy, therefore, was not used as an instrument for economic recovery (the policy implemented was not designed to improve the economy, but to help the poorest in society). There was no desire to increase government deficit to compensate the reduction in demand, it was just an indirect consequence to the social measures taken. What were the measures that increased the government spending?

1. Unemployment was so high (about 25%), that to beat the situation the government created public programs of unemployment to help people who had no source of income.

2. AGRARIAN POLICY: A program was planned with the aim of reducing the cultivated surface and solving, therefore, the problem of overproduction. The government subsidized those who agreed to cultivate less through what were called “rural credits”.

3. INDUSTRIAL POLICY: The most important objective was to beat the consequences of deflation (because of the decrease in demand and consumption). What governments did was to supress the antitrust legislation and to recognize strike rights and collective bargaining.

4. SOCIAL BENEFITS:

 Recognition of trade unions and collective bargaining

Cartels and monopolies (collusive strategies) were no longer forbidden. The government allowed firms to join and fix prices to raise them. In this way, wages increased because workers altogether had more bargaining power.

 Social aids were given, such as accident subsidies, retirement, and unemployment ones. On balance, the New Deal contributed to stimulate economic recovery and improved the situation of the most disadvantaged. It was, therefore, effective, but the scope of the program was limited:

 It had obstruction from the Republican Party.
 In some sectors of society the New Deal was seen as a communist program and generated a social conflict.
 It had, moreover, limited macroeconomic coherence; there were some contradictions in the plan. The final stimulation in the economy that ended the recovery was the mobilization to war in 1938.

The way out of the depression (EUROPE)

There were two main patterns:

1. Those who continued with their traditional democracies
2. And fascist countries

UK and France are clear examples of the first pattern, but measures taken were actually very different between them.

FRANCE

The advantage of an undervalued franc disappeared with the crisis of the 30s.

They continued in the Gold Standard System until 1936, what delayed the process of recovery and gave more importance to the public sector.

Until 1936:

 The GSS forced the government to maintain the convertibility of the currency fixed
 Budget equilibrium (G ~ T)
 Imports were reduced because of protectionist measures
 And the only measure done was an aid given to the industry

In 1936, Government of the Popular Front:

 The economic situation was not sustainable any more
 Suspension of the convertibility of the franc and devaluation
 Policies to stimulate demand were implemented

UNITED KINGDOM

UK was the first to suspend the convertibility (1931) and the recovery depended mainly on the private sector (low government intervention). Moreover, as they suspended the GSS early they could apply expansive policies and gain competitiveness in international markets.

Protectionist measures and tariffs were used as well.

In the case of fascist countries the stimulation came from a massive intervention of the government in the economy. In economic terms, the main objective was to be self-­‐sufficient and have an autarky, what implied the substitution of all imports by national production and so many new sectors had to be developed.

ITALY

 Depression + Effects of the maintenance of the “quota novanta”
 Massive intervention of the government in economic decision-­‐making
 Corporativism and autarky: Italy wanted to be self-­‐sufficient in AGRARIAN PRODUCTION.
 Creation of IRI (Institute for Industrial Reconstruction)

Italy maintained the Gold Standard System until the end and the impact of the autarky in demand really compensated the effects of the Great Depression: expansive fiscal policy through increase in G but maintained a restrictive monetary one. As years went by, however, the overvaluation of the Italian lira had bad consequences in the economy.

In 1936 the convertibility of their currency into gold was suspended and a growing mobilization for the war started.

GERMANY
In Germany, instead, they did not have this objective of being self-­‐sufficient in agrarian production. Main goals of the Nazi regime: full employment, corporativism and autarky.

Germany had special agreements with the eastern European countries. Thus, the overvaluation of the mark did not damage the international competitiveness of German firms (as they used to exchange goods for goods; the currency did not intervene).

Because of the objective of being self-­‐sufficient and having an autarky, the government spending increased considerably. They started producing everything they needed and this had amazing results in terms of the reduction in unemployment. It was a good stimulation for the economy.

Meanwhile:

 Suppression of trade unions and hierarchical organization in factories
 Maintenance of the convertibility of the mark in terms of gold

In 1936, the four-­‐year plan was implemented: The economic system was organized in order to do a transition to a war economy (negative point).

Conversely, Germany had amazing results in industrial production and an important reduction in unemployment.