Another extract from my book-in-progress, Economic Consequences of the Pandemic
The 20-year armistice from 1919 to 1939 was a period of economic stagnation in Europe, punctuated by crises which had disastrous economic and political effects. And while the US boomed in the 1920s, the Great Depression that began in 1929 caused massive unemployment and suffering which lasted through the 1930s. What lessons can we learn for the present?
The most important is the danger of ‘austerity’ policies based on the perceived need for governments to balance budgets and ‘tighten their belts’. Keynes’ second great polemic, The Economic Consequences of Mr Churchill was a critique of the austerity policies of Winston Churchill, then Chancellor of the Exchequer (equivalent to Treasury Secretary) in the Conservative government of Stanley Baldwin.
Churchill’s critical mistake was made in 1925 when he announced that Britain’s return to the gold standard. Before the outbreak of the Great War, both the British pound and the US dollar had been convertible to gold at fixed rates, such that one pound sterling was worth $4.86. By imposing exchange controls when war broke out, Britain effectively ended convertibility and left the gold standard.
Churchill’s decision restored the pre-war exchange rate, even though the price level in Britain had risen substantially faster than in the US. This implied the need for a sharp deflation, driven by budget cuts and credit restrictions. The inevitable outcome was an increase in unemployment rates. Churchill’s decision was the culmination of a long period of austerity policies aimed at driving down price levels, which had already pushed the rate of unemployment towards 10 per cent. Unemployment remained at or above this level until the return to war in 1939, at which point it vanished almost instantly.
Churchill’s policies were disastrous, but the damage was mostly limited to Britain. Far worse in its consequences was the austerity policy adopted by Heinrich Bruning, the Chancellor of Germany from 1930 to 1932 in response to the Great Depression. The resulting upsurge in unemployment produced massive social discontent. Bruning was forced from office and replaced, after a brief interval, by Adolf Hitler. Repudiating Bruning’s austerity policies, Hitler adopted a policy of large scale spending on public works and military expansion which greatly reduced unemployment. This success increased his popularity and allowed him to crush his opponents without significant resistance.
These examples are the rule rather than the exception. Austerity policies have almost invariably failed as a response to depression and unemployment. Further examples ….
Despite its disastrous consequences, Bruning’s austerity policies have been forgotten almost entirely. The same can’t be said of the German hyperinflation of 1923 (discussed in detail later). The Imperial German government had relied heavily on inflation and debt to finance the war, relying on the spoils it expected to seize to resolve its problems. Instead, its democratic successor inherited high levels of debt and continuing inflation, along with the reparations imposed under Versailles. When the government tried to support striking workers in the French-occupied Ruhr valley and acquire gold to pay reparations at the same time, it had no tax revenue to cover the costs. Instead it relied on printing money which depreciated rapidly.
The hyperinflation caused less suffering than the Great Depression. Nevertheless, it wiped out the savings of millions of people and contributed both to radicalisation and to the embrace of austerity policies in Germany, not only in the 1930s, but right down to the present day.
There’s no serious prospect of inflation now, and there won’t be for years to come. But that doesn’t mean that it’s safe to rely on money creation rather than taxation to finance large new public spending programs. It took ten years for the German mark to go from gold-backed hard currency to worthless paper. The process could have been stopped earlier. But, as we learned in the 1970s and 1980s, squeezing inflation out of a system is a painful process.
To sum up, we can draw two lessons from the economic failures of the 20-year armistice.
First and most importantly, market economies do not automatically tend towards full employment . Governments must be willing to fill the gap when private consumption and investment expenditure is inadequate. Conversely, in the rarer case when private demand is excessive, governments and central banks must act to constrain demand to a level consistent with the productive capacity of the economy.
Second, the ordinary operations of government require resources that must, in the end, be supplied by taxation. Attempting to deliver substantially increased public expenditure while leaving private expenditure untouched will run up against the constraints imposed by the productive capacity of the economy. These constraints will initially be reflected in shortages, queues and reduced quality and ultimately inflation.