1920-21 Recession Flashcards

1
Q

Speculative boom (1918-20) (6)

A
  • Huge speculative boom in 1918-20 (big domestic inflationary pressures)
    o Consumption increased rapidly – pent-up demand, end of rationing & end of price controls – 46% over the 1918-20 period (15% in real terms)
    o Supply contracting at the same time – collapse of military orders & firms unable to retool from military to civilian production
    o As a result, prices rose by 42% (Thomas, 1994)
  • Boom facilitated by
    o Extremely liquid state of firms as a result of high war-time profits
    o Relatively easy money – M3 surged by 37% between 1918 and 1920
  • Asset bubble created in 1919-20, focused on the old staples (Thomas, 1994)
    o Cotton – 80% of productive capacity was bought/sold at 8x paid-up capital
    o Shipbuilding – asset values decreased by 75% after inflationary expectations fell
    o Iron/steel – 30% overcapacity persisted even through the best of the 1920s
    o ‘Expectations were considerably overinflated’ (due to profits)
  • Howson (1975) – boom involved ‘much speculative buying’, especially in old industries
  • Thomas (1994) – ‘a slump was inevitable’ due to ‘unreal, speculative and brittle’ boom
    o Expectations were slipping even before the end of the boom in mid 1920
    o Share prices peaked in Jan 1920, raw material imports fell in Feb 1920 & new capital issues in London peaked in March – slowdown in production/profits was anticipated
  • Bubble burst in summer 1920
    o Spring 1920 saw monetary contraction to reduce inflation
    o Wholesale prices peaked in May & business activity peaked in August
    o Thomas (1994) – ‘monetary policy triggered the downturn, but did not decree it’
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2
Q

Decision to Return to Gold (2)

A
  • Clear from the First Interim Report of the Cunliffe Committee in August 1918 that Britain will return to gold at the pre-war parity of £1 = $4.86 (Broadberry, 1986)
  • Policy announcement for returning to gold at pre-war parity is made in November 1919
    o During the war, GB inflation had outstripped US inflation (20% p.a. ct 5-10% avg.)
    o Hence equivalent to announcement of contractionary MP to deflate the price level, according to PPP theory
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3
Q

Effects of 1920-21 Recession (4)

A
  • GDP down 10%
  • Volume of exports down 30%
  • Industrial production down 20%
  • u/e up from 2% in 1920 to 11% in 1921 (Thomas, 1994)
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4
Q

Causes of 1920-21 Recession (7)

A
  • Return to Gold
  • Monetary Policy
  • Fiscal Policy
  • End of Boom
  • Supply Side
  • Exports collapse
  • Coal strike
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5
Q

Causes of Recession - Return to Gold (2)

A
  • Solomou (1996) – returning to gold = announcement of contractionary monetary stance
    o Under flexible ER, meant ER increased due to expected lower price level/higher r
    o Encouraged consumers to have inelastic inflationary expectations (low πe) lower consumption and higher money demand
  • Anticipations of contractionary policy led to the downturn
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6
Q

Causes of Recession - Monetary Policy (7)

A
  • MP was particularly restrictive to facilitate the return to gold – inflation was at 20% p.a.
  • Much of this was anticipated at the time of announcement of return to gold at 1913 parity
  • Bank Rate increased to 7% in April 1920, up from 5% in 1918 – contractionary policy
  • May not have been key
    o Solomou (1996) – increase in r in 1920 not key, but merely a symbol of recessionary forces under way since 1919 (deflationary MP & “wage gap”)
    o Howson (1975) – increase in r too small to have a significant effect
  • However, Dow (1998) argues it was ‘potent’ by triggering a change in confidence
  • Broadberry (1986) – evaluates effectiveness of MP
    o LM steep (interest elasticity of money demand ≈-0.2) MP effective
    o IS steep (interest elasticity of non-housing I ≈-0.1, housing I ≈-1.1) ineffective
    o Interest elasticity of consumption low (≈0.05) ineffective (real balance effect)
    o Therefore main effects are via external sector, through the ER (high r → ↑ ER)
    o Early 20s also saw decline in velocity of money, reinforcing contractionary policy
  • Contraction contributed to deflation, increasing real wages & reducing X competitiveness
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7
Q

Causes of Recession - Fiscal Policy (7)

A
  • Government expenditure fell by 75% (1918-20) due to demobilisation
    o Dow (1998) – fiscal impact is -9.2% of GDP in 1920
    o In 1918, taxation was just 50% of govt expenditure; budget balanced by 1922
    o Initially, fiscal consolidation surpassed by boom, but filtered through by 1920-21
  • Broadberry (1986) concludes that the overall fiscal stance is moderately deflationary
    o Nominal budget surplus is largest in 1920
    o CEBS (given rise in u/e 1920-21) is strongly deflationary
    o Lower prices increase real interest payments, offsetting some of the contraction
    balanced budget orthodoxy led to higher taxation 🡪 AD contraction
  • Ellison et al (2019) – after WW1, government debt over 175% of GDP, classical belief in balanced budgets to pay back debt during peacetime 🡪 increase in taxation from 20% of GDP to 30% 1920-21, debt interest payments reached 7% of GDP. Also fall in defence expenditure post-war
    o Resulted in a surplus of 5% of GDP by 1921
  • Cloyne et al (2023) - tax multiplier of about 2 in interwar years, very large -> this contraction had a large effect
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8
Q

Causes of Recession - End of Boom (4)

A
  • The reconstruction period after the war generated both demand pull and cost push
    inflationary pressures:
    o Demand pull: economy operated at full employment from 1918-20, rapid growth of demand for consumer and investment goods at home and abroad.
    o Cost-push: stronger unions, work week slashed from 54 to 47 hours in 1919 (Dowie, 1975).
  • Pigou (1947) – post-war demand was worked off by 1921, meaning ‘there was nothing obvious to take their place’ 1920-1 recession
  • Thomas (1994) – ‘a slump was inevitable’ due to ‘unreal, speculative and brittle’ boom
    o Expectations were slipping even before the end of the boom in mid 1920
    o Share prices peaked in Jan 1920, raw material imports fell in Feb 1920 & new capital issues in London peaked in March – slowdown in production/profits was anticipated
  • Dow (1998) – this doesn’t fit with the evidence
    o Cumulative disinvestment of WWI not reversed until 1926
    o Negative saving continued until 1923
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9
Q

Causes of Recession - Supply-Side (3)

A
  • Broadberry (1986,1990)
    During WWI, consumers saved (C down 14% due to diversion of resources), increasing their purchasing power, so demanded more leisure, so less hours (normal good)
    1919 – average working week fell from 54 hours to 47 hours (8hr day) (Dowie, 1975)
    Therefore, real hourly wage rate rose 13% on average (nominal wage rigidity)
    Not helped by restrictive MP to raise ER putting downward pressure on prices
    Created a “wage gap” (gap between labour productivity & real wages)
    Unit labour costs, ULC= W/P ÷ Y/L; wage gap raised ULCs via real wages
    Higher ULCs makes GB less competitive, reducing exports and hence AD
  • Scott & Spadavetcchia (2011)
    Majority of lost weekly output was made up in increased hourly productivity
    Reflects improvements in speed/quality of work, abolition of in-work rest breaks/periods of idleness due to bottlenecks & reductions in sickness/accidents
    Reduction in working hours occurred in almost all other industrialised countries
    GB had lowest proportional reduction in hours over 1913-1920, except France
    GB real wage growth 1913-1920 was 6.9%, slightly above Australia/US, but lower than Europeans – relative competitiveness should not have suffered
    Major “social multiplier” effects associated with reduction in hours – e.g. growth of industries associated with working-class leisure
  • Cole & Ohanian (2002)
    Construct a DSGE model to analyse a 15% reduction in the hours worked
    Assuming constant MC of labour, leads to reduction in steady state output of 3%, not big enough to explain recession (predicts 20% increase in steady-state employment)
    Assuming rising MC of labour, leads to reduction in output of 10% (20-21), which could explain the recession (predicts 10% increase in steady-state employment) - UK employment should have increased during IW
    Problem with model is that it assumes wage flexibility, which completely misses the point of the literature on the working hours shock
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10
Q

Causes of Recession - Exports (6)

A
  • Exports collapse (Thomas, 1994)
    o Export volumes decrease by 30% between 1920 and 1921
    o Even more severely, exporters saw prices collapse by 45% between 1920 and 1922
  • Dow (1998) – exports collapse for three reasons
    o Competing supplies as countries recovered from war (unlikely because exports recovered in 1922 to only 4% below their 1920 level)
    o Speculative element to exports on expectation of further demand
    o Strikes, especially in 1921 (textiles/coal mining), reduced supply
  • Other reasons seem to be more important
    o Rise in unit labour costs (ULCs) due to the fall in the working week
    o ER appreciates due to expectation of return to gold
  • However, Thomas (1994) – most of real appreciation in 1919-20 was due to rapid nominal depreciation of European & Asian currencies after the Armistice (around 35%)
  • ER appreciation appears to be key here
    o Solomou & Vartis (2005) calculate that RER appreciated by around 10% between 1920 and 1921 – significant appreciation
    o Solomou (1996) – ER appreciation can’t be seen as an exogenous cause, because it resulted from the expectation (& reality) of contractionary policy
  • ER appreciation explained in “exchange rate overshooting” framework (Dornbusch, 1976)
    o Asset market adapts quickly to news, but goods market is more sluggish (due to sticky prices)
    o Via uncovered interest parity, nominal exchange rate appreciates significantly in order to capitalise on higher interest rates (for deflationary policy)
    o In goods market, prices are slow to adjust, so change little in the SR
    o Therefore, the real exchange rate overshoots its LR PPP equilibrium, returning slowly
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11
Q

Causes of Recession - Coal Strike (2)

A
  • Mitchell, Solomou & Weale (2012) – construct monthly GDP data
    o Turning points are August 1920 (peak) and May 1921 (trough)
    o Decline evident from August 1920 to March 1921, then decline steepens, followed by recovery in May
    o This pattern is due to the coal strike (31st March 1921 to 28th June 1921), which leads to coal rationing and significant reductions in industrial production (little evidence)
    o Therefore, the 1921 coal strike causes part of the severity of the 1920-21 recession
  • Eichengreen & Temin (2000) – strike ∵ reluctance to accept lower wages due to deflation
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12
Q

Causes of Recession - Overall (2)

A
  • Eichengreen (lecture) – to evaluate which is key we need to look at inflation – decreased rapidly over 1920-21, so the recession was caused mainly by a negative demand shock
  • Dow (1998) – MP/fiscal ‘greatly intensified’ by ‘speculative conditions’ with which they interacted, but the collapse of the bubble ‘is at some point inevitable’
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13
Q

Persistence Effects of 1920-21 Recession (6)

A
  • Hours shock – Broadberry (1986, 1990)
  • Real indebtedness – Solomou (1996)
  • Trade hysteresis – Solomou (1996)
  • Labour market hysteresis
  • Exchange rate effect
  • Regional issues
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14
Q

Persistence Effects of 1920-21 Recession - Hours shock Broadberry (1986, 1990) (2)

A
  • “Wage gap” is sustained until 1940, causing a one-off shift in the SRAS (left), permanently reducing output for given level of aggregate demand
  • Solomou (1996)
    o Broadberry deflates the nominal wage series with the RPI
     Key to hiring is product real wage, not consumption real wage
     Therefore, should deflate with the price of final output, i.e. GDP deflator
    o Doing this, wage gap is eliminated by 1922 – only a transitory effect
    o Any persistent effect must occur via a version of hysteresis (trade etc.)
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15
Q

Persistence Effects of 1920-21 Recession - Real indebtedness – Solomou (1996) (4)

A
  • During 1918-20 boom, staple industries increased debt to finance investment (optimistic at end of war and in absence of German competition)
  • Permanent deflation (return to gold) meant that real debt burdens increased substantially
  • As a result, new investment was held back as they struggled to meet large debt repayments alongside poor export performance and rising import penetration
    o Private sector investment rate = 6% of GDP in 1920s (lower than GFC)
  • Goldsmith (1984) UK debt/income ratio increased from 1.55 in 1913 to 2.76 in 1929, whereas these ratios fell in France/Belgium – supports this view
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16
Q

Persistence Effects of 1920-21 Recession - Trade hysteresis – Solomou (1996) (4)

A
  • ER overvaluation 1920-22 increased import penetration
  • M as % of GDP up from 21% in 1920 to 24-25% by 1923 (stayed here until after 1932 Tariff)
  • Exports fell sharply by 30% in 1920-21 and in LR only recovered to approximately 80% of the pre-war level indicating permanent loss of export markets
  • Once foreign firms had established distribution networks, changes to ER didn’t lead to reversion to old equilibrium – the market had been lost permanently
17
Q

Persistence Effects of 1920-21 Recession - Labour market hysteresis (2)

A
  • Via skills atrophy or insider-outsider theory
  • Crafts (1987) – long term unemployment was only 5% of total u/e in 1929 (fairly rare), compared to 25% of total u/e in 1936
18
Q

Persistence Effects of 1920-21 Recession - Regional Issues (1)

A

Staples suffered due to overinvestment/debt in boom, creating regional u/e in areas where they are concentrated, which persisted due to geographic/sectoral immobility of labour

19
Q

Return to Gold - why? (4)

A
  • Ensures economic stability because it binds government policy
    o Monetary stability – can’t simply print money because you need gold to back it (expansion of M –> inflation –> lower X, higher M –> outflow of gold –> reduced M)
    o Fiscal stability – can’t run large budget deficits because can’t inflate debt away
  • Uncertainty reduced
    o Leads to higher saving/investment, foreign investment, more financial flows
    o Increases network trade (lower transaction costs/ER instability)
    o Gregory (1935) – enormous growth of international trade and development of gold standard in 19th century aren’t coincidental (although post-1973 contradicts this)
  • Eichengreen & Temin (2000)
    o Benjamin Strong (Governor of NY Fed. Reserve Bank) said not returning to gold would lead to ‘unsettled conditions too serious really to contemplate’
    o Late 19th century – investors were worried about US leaving gold (1896 Presidential campaign) –> ‘interest rates soaring’ and ‘disrupted international financial transactions’ –> US Gold Standard Act of 1900, affirming US’ commitment to gold
  • Britain pressured to return to gold by dominions (Australia, South Africa, etc.) who linked their currency to sterling – winter of 1924-25, AUS and RSA put GB on notice that they wished to return to gold (Bordo et al., 1999)
20
Q

Why $4.86? (2)

A
  • Political Factors/Prestige
    ○ ‘A weak currency is a sign of a weak economy and a weak government’ (Gordon Brown)
    ○ When you judge credibility of govt commitment - past and future
    ○ Past - if country is serial defaulter on its promises, ruins reputation
    ○ $4.86 dominates any other ER from reputation POV - this was the promise made before the war - 1st priority to people was to maintain the value of their money - will not devalue
    ○ Therefore, to weaken the currency would be politically damaging - would show that WW1 damaged competitiveness
    • To win back financial business
      ○ London is dominant capital market pre-WW1 - pre-war parity would establish dominance
      ○ Issue - New York - dollar already in gold - nobody thinks that US govt will take away that promise
      ○ First thing govt should do to re-establish dominance - have currency on gold as credibly as the dollar is
      ○ Dollar is in gold and is credible - US becoming more attractive for business. If UK in gold, London may return to be more attractive
      ○ Policymakers saw it as a way to restore prestige/influence
      ○ Thomas (1994) – market traders & international financial community expected UK to renew commitment to gold (loss of confidence in financial markets if not restored) – devaluation would reduce value of portfolios, and may prompt large outflows of financial capital (impacts on UK as global financial centre).
      ○ (Benefit does not appear to be realised - other countries focus on financial autarky)
21
Q

Actual benefits of Returning to Gold at pre-war parity? (2)

A
  • Price stability, compared to other European countries of which many experienced hyper-inflation
  • Eichengreen – enabled policy flexibility later in 30s
    o Countries benefitting from depreciation in the 1920s had high social costs of doing so (inflation increasing inequality), creating fear of leaving in 30s (inflation paranoia).
    o French retail prices index for Paris shows inflation at 35% p.a. in 1926.
    o Countries returning at pre-war parity in 1920s able to devalue in response to Great Depression
    o So pre-war parity (via positive inflation experience) created future policy flexibility.
22
Q

Deflationary Policy / interest rates (5)

A
  • Implemented almost immediately following war
  • In short-term, increasing Bank Rate pushed up entire i/r structure, creating positive i/r differential with other countries –> flow of capital into UK, allowing pound to appreciate (so e increased)
  • In LT, required to reinforce belief that UK would return to $4.86 - indeed, Bank Rate held at 7% until April 1921, then reduced in steps of 0.5% to 3% by July 1922
  • BoE reluctant to reduce rates further to avoid creating an unfavourable interest differential with New York (which would reduce capital inflows)
  • so pre-1925 MP supports idea of gold peg being credible - value of £ increased almost instantly from 1919 onwards due to expectations (shows that investors believed gold peg would indeed be restored to $4.86
23
Q

Costs of revaluation (5) M(TSB)B(S)S

A
  • 1924-25, £ appreciated ($4.32 to $4.86) – overseas sales stopped dead (from growth of 12%)
  • Moggridge (1972) estimates that 750k jobs are lost as a result (1924-25)
    o Takes an elasticities approach where x=-1.5 and m=-0.5 (so M-L holds)
    o Effect of overvaluation depends on firms’ pricing behaviour – assumes that exporters reduce profit margins to boost competitiveness & importers increase mark up to take advantage of extra demand
    o With these assumptions and a multiplier of 1.75, 750k jobs are lost
  • Critiques of Moggridge (1972)
    o Thomas (1994) – political consequences more key because it leads to the General Strike of 1926, which causes the 1926 recession according to Solomou (1996)
    o Solomou (1996) – based on assumptions not tested empirically, in particular the extent of price pass-through
    o Broadberry (1986) – only looks at 1924-25, whereas the biggest effect is in 1920 upon announcement
  • Broadberry (1984) – comparative analysis of UK/Scandinavia vs. other countries
    o Overvaluation resulted in poor economic performance, as measured by u/e rate
    o Solomou (1996) – u/e is a poor indicator – Scandinavia experienced high growth rates in the 1920s, despite their high u/e levels
  • Solomou (1996) – runs several regressions to explore costs of returning to gold
    o For cyclical recovery, regressions show devaluers did not do better in the 1920s – it is a sufficient but not necessary condition (US, Japan & Australia also did well)
    o However, there are persistent negative output effects by not returning at the pre-war parity – not a growth effect, but a level effect
24
Q

Overvaluation (5) K(M)RSST

A
  • Keynes concluded GB prices rose 10% relative to US prices 1913-1925 – uncompetitiveness
    o Moggridge (1969) showed this hinged on the price index used – Keynes used a retail price index (non-tradeable - should use wholesale) for just Massachusetts (not representative of whole US) for the US (should use multilateral not bilateral)
  • Redmond (1984)
    o Calculates effective exchange rate (EER) for GB – weighted avg. of £ vs. all currencies
    o Peak multilateral REER overvaluation by 5-8% in 1926 using wholesale prices
  • Solomou & Vartis (2005)
    o Problems with Redmond (1984) – weights matter (he says they don’t), uses an arithmetic average (geometric is modern norm), price indices (causes discrepancies) and Germany is omitted (crucial to pattern)
    o Significant appreciation in NEER/REER of 10% on Fisher index (1919-1922), ct 1924-1925
    o Major shock was 1919 due to exchange rate overshooting
    o By 1924-25, deflation had helped to restore some competiveness
    o Consistent with export data – 1921 exports were 50% of 1913 level; 1925 = 75%
  • Solomou (1996) – RER much more overvalued in 1920-21 than in 1925, so the key effect is the impact effect in the 1920-21 Depression – focus on 24-25 is misleading
  • Thomas (1994) – overvaluation just one aspect of 20s failure – other underlying problems more crucial, especially weak performance of staples, wage inflexibility & hours shock
25
Q

Evidence from BoF (Accominotti, 1995) (3)

A
  • BoF large player on FX market + significant holder of £ assets
  • BoF holds almost all its foreign reserves in £ and $, but clearly rebalances in favour of the latter from June 1929 onwards
    • Strong evidence of growing concern at the Bank of France over a sterling collapse
      ○ Note to the finance minister on 17 October 1929 mentioned ‘world-wide concern about the future of the British currency’
      ○ According to the note, ‘people [were] even wondering if the Bank of England’s metallic reserves [were] sufficient to durably guarantee the sterling pound’s gold convertibility’
      ○ As of 1929, the Bank of France feared that Britain would devalue.
      ○ In order to limit the exchange loss, it sold its pounds, and bought dollars
26
Q

Conclusions/Further Thoughts

A
  • Solomou (1996) – in the longer run, trade-off between performance in 20s and 30s
    o Countries benefitting from depreciation in the 1920s had high social costs of doing so (inflation increasing inequality), creating fear of leaving in 30s (inflation paranoia)
    o Countries returning at pre-war parity in 1920s able to devalue in response to 1929
    o So pre-war parity (via positive inflation experience) created future policy flexibility
    o French retail prices index for Paris shows inflation at 35% p.a. in 1926
  • From as early as 1929 on, the pound was not credible anymore