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The 1930s All Over Again?

Thursday, November 29, 2012

Then, as today, societies were uncertain about which model of society to strive for and how to repair monetary systems. Societies bet on the wrong ideas; we may be committing similar mistakes now.

Many people draw parallels between today and the 1930s, labeling this the Great Recession. They note the high unemployment rate, referring not to the mismeasured, official statistic, but to the number more than double that rate, which also accounts for those who dropped out from the labor force and are no longer counted as “unemployed.” Others worry about the deflationary risk, the dollar devaluation, and the status of the U.S. dollar as reserve currency. Still others worry that the “vital few” — those with high scientific aptitudes and entrepreneurial drive — no longer come to or stay in the United States, but stay in or go back to the many countries whose Iron Curtains have been punctured since 1989.

Yet the most worrying parallel with the 1930s is one that is not discussed. Then, as today, societies were uncertain about the model of society they should strive for and about how to repair domestic and international monetary systems after wildly varying expansions of credit during and after World War I in the different countries. In addressing these two questions, societies ended up betting on the wrong ideas, which had long-term, disastrous consequences. We may be committing similar mistakes now.

Recall the 1920s and 1930s: Germany, Hungary, Austria, and Italy all destroyed their middle classes and financial markets with hyperinflation — a destruction that has always been a recipe for both political instability and predictable centralization of power. After all, once financial markets are destroyed, even if inadvertently, governments and central banks become financial intermediaries — by default.

It happened in Austria, which — following the large credit expansion during and after WWI, and later the collapse of its largest deposit bank, Credit Anstalt — injected funds, though the problem was not liquidity, but solvency. While this happened, Austria first kept the schilling linked to gold, though investors realized that this could not be for long. As capital flight continued, the government first imposed exchange controls, but eventually delinked the schilling from gold in 1931. Austria’s experiment precipitated the United Kingdom’s own exit from the gold standard in that same year, after it mistakenly relinked the pound to gold at the pre-WWI level in 1925 — in spite of the high inflation the United Kingdom experienced during the war — resulting in predictable deflation and unemployment.

As in the 1920s and 1930s, remedies are thus thought to be not in repairing the mistakes and making sure that the unguarded expansions of credit won’t be repeated anytime soon, but in governments and central banks getting into the voids left in capital markets.

France learned from the United Kingdom’s 1925 mistake. When Raymond Poincaré became French premier in 1926, he commissioned Jacques Rueff to determine the level at which the French franc should be stabilized. Though Poincaré thought initially to return to the prewar gold parity of the currency, as the United Kingdom had done, Charles Rist and Pierre Quesnay, the deputy governors of the Bank of France, persuaded him not to. France relinked to gold by fixing the franc at only one-fifth the pre-WWI parity. Rueff chose this level to be on the safe side and prevent deflation and unemployment, at the risk of pricing the franc low relative to gold. Emile Moreau, the governor of the bank, approved. The franc was stabilized, capital flowed back to France, credit expanded, and the economy boomed without inflation or unemployment, though France’s “competitive devaluation” — France and the United Kingdom were competing powers — quickly destabilized the brief international monetary calm.

Perhaps if Benjamin Strong, chairman of the Federal Reserve at the time, lived a bit longer, he might have managed to sustain order. But he died in 1928, and the short-lived international cooperation he engineered in the inter-war years fell apart. From then on, the mazes of monetary and political errors compounded rapidly around the world, ending in Europe’s devastating political bets that led to WWII.

This is the similarity with the 1930s, and the far bigger danger the world faces today than the aforementioned, superficial, acknowledged ones, which draw on macroeconomics — today’s astrology. Now, as then, the fact that grave monetary mistakes and lack of international collaboration to stabilize exchange rates have drastic political implications appears to be out of most sights and minds. Yet the links are straightforward.

Prosperity is the result of matching talents with capital, holding all parties accountable: the talent, the capital, and the matchmakers. This is easy to say, but hard to realize — building and sustaining the maze of institutions to keep the matchmakers responsible, in particular.

After all, societies have five sources of capital: inheritance/resources; savings; access to financial markets; government; and, last but not least, “crime,” through military power in particular, the use of such power being rationalized by various ideas. During the 1920s and 1930s, the series of monetary blunders and lack of international cooperation decimated people’s savings and the Versailles Treaty kept resources captive. These factors combined caused the weakening or the destruction of capital markets and international trade. Banks failed, markets crashed, unemployment rose, the middle classes lost their anchors, and the 1930s saw a series of devaluations and introduction of tariff policies, Smoot-Hawley being one of them.

Without dispersion of powers — which only deeper, independent sources of capital can create — votes and beautifully written constitutions have little if any meaning.

The first three sources of capital thus evaporated. People turned to the two remaining “institutions” for accessing capital: government and “crime” — in a far broader sense of the word. People need comforting rationalizations for such new trends, and “intellectuals” are never late offering them. Words are cheap. “Intellectuals” produce them promptly, as they easily rehash ideas sitting on shelves. Predictably, the 1920s and 1930s saw socialism and communism rationalizing governments’ expanded roles in some countries. In other countries, theories about public works and, eventually, the Keynesian — bombastically titled “general” — framework became popular, rationalizing the permanent increases in governments’ roles in raising and allocating capital.

At the same time, “crime” took ominous “national and racist” meanings in some countries — Germany was the most prominent — with the new theories “justifying” confiscation of capital, be it from “foreigners” or groups made “foreigners” by novel theorizing. Neither the new rationalizations of Greece’s Golden Dawn party, the Catalans’ and Scots’ wishes to secede, nor the many other parties emerging across Europe along its older “tribal” lines should come as a surprise: it has all happened before. Although it might come as a surprise to link them to grave monetary mistakes, drastic expansions of credit, and lack of international cooperation.

Intellectuals have always been good at turning real issues into so-called moral ones with religious, racist, and nationalist undertones, rationalizing immediate access to capital and its confiscation with new jargons. In the 1930s, these were “tribal” jargons. In earlier times, they were religious ones. In 1576, when conquering Antwerp, the Spanish troops forced the Augsburg house of Fugger to advance a “loan” of 8 million Rhenish gulden (about $500 to $800 million today, though such comparisons are tenuous). This Spanish paper was never paid back — the King of Spain had no intention to repay it to start with. By 1598, the King gave the highly placed priesthood the role “to deal” with it. The king thought that only the priesthood could rationalize and put a moral stamp on lack of repayment by using theological arguments.

What about today? The main jargon rationalizing not paying back debts draws on the vocabulary of “victimhood” that is rationalized in a variety of ways, particularly on economic jargons. Not much new under the sun — except the languages that help disguise what we are talking about. 

The mazes of monetary and political errors compounded rapidly around the world, ending in Europe’s devastating political bets that led to WWII.

According to this view of the world, unstable capital markets are the problem, due to loss of accountability and sudden, unjustified bursts of optimism and pessimism. The view that grave regulatory and monetary policy mistakes, as well as increased government spending with no guards to guard the public guardians, bring about loss of accountability too, seems to be now out of many sights and minds.

As in the 1920s and 1930s, remedies are thus thought to be not in repairing the mistakes and making sure that the unguarded expansions of credit won’t be repeated anytime soon, but in governments and central banks getting into the voids left in capital markets — though without attempting to stabilize exchange rates. Yet their instability was then — as it is now — a major source of preventing the world from regaining its footing.

For Western countries with still-deep capital markets, stabilizing exchange rates does not seem a priority at present, as the hundreds of trillions of derivatives mitigate the rates’ destabilizing impact. But for the rest of the world, as their capital markets are in their infancy, the instability prevents them from developing.

Unless this trend is reversed — and international cooperation to stabilize exchange rates takes priority — the image of a model of society worthy of emulation will get further blurred. The thinner capital markets, the less they are democratized. As cash flows through governments’ bureaucracies — by default the prevailing financial intermediary —  this leads to or perpetuates inevitable centralization. Without dispersion of powers — which only deeper, independent sources of capital can create — votes and beautifully written constitutions have little if any meaning. Bureaucracies end up matching talent and capital, and power stays concentrated, votes notwithstanding.  

Centralization of powers and the thinning of capital markets are the most dangerous parallels to the 1930s. What model of society will people bet on as these trends continue, and Europe and the United States get into mazes of error? The 1920s and 1930s offer warnings.

Reuven Brenner holds the Repap Chair at McGill University’s Desautels Faculty of Management. The article draws on his books, The Force of Finance and History: The Human Gamble.

FURTHER READING: Brenner also writes “Eurozone Bonds: Learning from Pre-Nuptial Agreements.” Desmond Lachman says “Don Quixote Is Alive and Well and Living in Spain” and discusses “President Obama’s Ticking Greek Time Bomb.” Lachman, John H. Makin, and Aparna Mathur comment on “3 Tough Choices: The Fed, the Euro, and the U.S.” Makin also contributes “All That Glitters: A Primer on the Gold Standard.”

Image by Dianna Ingram / Bergman Group

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