The Great Depression was, until the Covid-19 crisis, the biggest economic shock to damage the world in modern history. Output fell 5 per cent in the UK, 20 per cent in Germany and 25 per cent in the US. Prices fell by almost 30 per cent in industrial economies. Unemployment rose to 29 per cent. Maynard Keynes described it at the time as an economic disaster.
Over the last seventy years some of the world’s finest economic scholars have worked to understand what happened and how such a disaster could be avoided today. Among them Milton Friedman and Anna Schwartz, famous for their seminal monetary history of the United States, Ben Bernanke, the chair of the Federal Reserve Board who had responsibility for monetary policy in the Great Recession between 2007 and 2009, and Christina Romer who served as the chair of President Obama’s Council of Economic Advisers.
Different countries experienced the economic crisis in the 1930s in different ways and their response to varying challenges offer us a glimpse of policy that can help and policy measures that are best left avoided.
An independent monetary policy under the control of a country’s government is essential. A permanent deflationary monetary straitjacket where a country’s policy makers do not have discretion to change things spells disaster. In the 1920s the UK returned to the gold standard at the pre-First Word War exchange rate. The result was a permanent monetary induced slump throughout the 1920s. When Britain abandoned the gold standard in September 1931 the exchange rate fell 25 per cent and prompted a swift economic recovery. Other countries that abandoned the gold standard, such as Sweden, enjoyed a similarly good early and sustained recovery. Those, like France, that remained on the limping remains of gold, suffered accordingly.
Monetary expansion is a necessary condition for economic recovery but is not on its own sufficient. Governments have to embrace fiscal policy and the use of deficits and debt. In the first instance that means allowing automatic stabilisers to work – falling tax revenue and increased unemployment and other spending that creates deficits should not be resisted. Governments should go further and stimulate their economies through tax cuts and spending financed by deficits. In 1931 the UK made the mistake of continuing to retrench government spending and the recovery only took flight because of rearmament spending after 1936.
Labour market rigidities in the UK and US made unemployment in the 1930s worse. Prices fell and wages either remained unchanged or higher and real wages rose. The result was cash wages were above their real market clearing level. While a person who had a job enjoyed higher real spending power and living standards, for those that lost jobs the consequences were devasting. In the UK this was largely the result of increasingly apparent trade union power in the work place. Lord Keynes referred to it as institutional rigidities. In America it resulted directly from policies pursued by the Hoover and Roosevelt administrations to raise wages.
Governments should not vitiate their expansionary policies by politically motivated tax policies to balance the budget or to impose an additional tax burden on an unpopular category of taxpayers. Roosevelt’s deficits were never sufficient or ambitious enough for the task of returning the American economy to full employment. Yet the Revenue Acts, passed in 1932, 1934 and 1936, raised tax rates and tax receipts, roughly doubling full employment tax yields.
New excise duties were applied to developing and innovative technology, such as pipelines, electricity transmission and communications. Along with new rules and taxes on capital stock, dividends, excess profits and a surtax on undistributed earnings. This distorted economic behaviour. The revenue collected was small but the taxes distorted decisions about investment and the use firms made of cash flow. Undistributed profits were penalised, which particularly affected small firms undergoing rapid expansion.
The Great Depression in terms of international economics will always be associated with the Smoot Hawley Tariff imposed by the US. It is not clear that the measure in itself was as significant as it is sometimes assumed to be. Yet the retreat from open competitive international markets that distinguished 1930s’ trade policy still offers a lesson in what not to do – whether it is the extremes of autarky that were pursued by governments in Germany and central and eastern Europe or the establishment of Imperial Preference and protection in the UK. The later lasted for decades into the middle of the 20th century. It explains part of the relative failure of the British manufacturing sector in terms of innovation, productivity and competitiveness from the 1950s through to the 1970s.
One of the political lessons of the Great Depression, with its social distress of unemployment, lost incomes and ruined businesses and hopes, is not to compound matters by aggressive retrenchment or austerity. This was plain from the political chaos that ensued in Germany between 1930 and 1933 because of the challenge of its foreign currency dollar debt and in France’s commitment to gold, culminating in the Front Populaire taking power in 1936.
In the event of a big adverse shock to demand, act decisively. Use monetary policy, central bank balance sheets and taxpayer’s money to stabilise financial markets. If the banking system is going down, save it. When interest rates fall along with inflationary expectations, audaciously use fiscal policy to stabilise demand and stimulate output. Policy makers in the world’s most important economy, financially, the USA have learned these lessons. As chair of the Federal Reserve, Ben Bernanke kept his promise that the Fed would never make the mistakes of the 1930s when it contracted the money supply by a third. He went one better in 2008 by saving the banking system and protecting credit institutions to ensure that lending relationships were maintained.
Since March this year, the Fed, the Congress and the Administration have acted decisively to stabilise the economy with every form of macro-economic stimulus available. Other countries have followed this lead. There is one part of the advanced world economy, however, where governments remain hobbled by a modern version of the inflexibilities of the gold standard. They do not even have the capacity to simply give up on it as the UK, USA and eventually France did in the 1930s. These are the economies that make up the Eurozone.