Tag Archives: history

What Germany can Learn from Interwar France

The story of interwar France should warn governments of the consequences of large capital flows in a fixed exchange rate area. It also reminds us how countries who have trade surpluses in this situation will deny the effects, and how deficit countries suffer as a result. These insights imply that if Germany wants to keep the Eurozone together, it needs to look past a moralizing story about Greek borrowing and instead accept that dramatically more expansionary monetary policy may be needed.

This post has three parts. I first discuss the theory of fixed exchange rates and how they played out in the interwar period. I then make comparisons to today’s Eurozone and conclude with implications for Eurozone monetary policy.

The Interwar Gold Standard

Under fixed exchange rates, capital flows are controlled by relative price adjustments. If the price level is low in a country, its exports become competitive. Goods flow out of the country as its central bank buys up gold from abroad. This continues until prices are too high and exports uncompetitive. Then prices grind down until they became competitive again. Savvy readers will recognize this as David Hume’s price-specie flow mechanism.

This is painful. Prices and nominal wages are downward sticky, and as such uncompetitive countries suffer through long stretches of unemployment and social unrest. As such, in the prewar gold standard there were “rules of the game” to ease adjustment. Central banks in trade surplus countries were supposed to expand monetary policy to raise their price levels. The trade deficit countries would then have an easier adjustment — they no longer had to lower their price levels by as much to become competitive.

A short note on how to think about balance of payments. Readers with an economics background might wonder how the trade surplus countries could also run a capital surplus. Aren’t they experiencing “gold inflows”? So there’s an excess of capital flowing in from abroad! This is incorrect intuition. The better way to think about it is that foreigners are giving their foreign currencies to domestic exporters in exchange for goods. The exporters, who cannot use the foreign currency on domestic purchases, instead buy up gold from foreigners with that currency. As such, “gold inflows” are actually purchases of foreign assets, and as such correspond to a capital deficit.

Back to the history. France destabilized the interwar gold standard by refusing to play by the “rules of the game”. Due to large fiscal battles in the immediate aftermath of the war, the Franc was forced to devalue several times. Eventually it settled at a level that made the Franc very competitive, and exports flowed out of France (read: gold flowed in). But instead of following the rules of the game and letting the French price level rise, the Bank of France sterilized the gold inflows, stuffing them under the proverbial central banker’s mattress.

From Irwin 2010, “Did France Cause the Great Depression”

This caused severe problems in deficit countries such as the UK and Germany. Since the French price level was not rising, the deficit countries were stuck with their trade deficits. And so while France boomed, the UK suffered through a mass strike of coal miners in 1925 and both the UK and Germany experienced mass protests of unemployed workers in 1929.

But French officials did not see this as their fault. I quote economic historian Douglas Irwin directly: “French officials such as Rist (1931) argued that the inflows represented confidence in their economic policies and that they were doing nothing to encourage the gold movement.” Or as Eichengreen describes in Hall of Mirrors: “If France enjoyed a balance-of-payments surplus, then this reflected the innate frugality of the French, who preferred saving over spending.”

The French government also argued that there was nothing they could do. The Monetary Law of 1928, which prevented government financing of fiscal deficits, tied their hands. As such open market operations were not an option†. While this may have been literally true, it also demonstrated how a deep fear of how monetary policy would simply finance fiscal expenditures.

Back to Present Day

In an ironic twist of history it is now Germany that runs a trade surplus. The deficit bug has traveled south to Spain, Italy, and Greece. For example, ever since the founding of the Euro Germany has had net exports at around 7% of GDP, whereas Greece has had net imports of around 15%.

This gap did not close because prices did not adjust in the correct direction. Unit labor costs stagnated in Germany while they rose in Greece. This was not a story of blistering German productivity growth. Rather, it was the result of purposeful restraints on wages.

From Shambaugh 2012, “The Euro’s Three Crises”

And so Greece was left with trying to adjust a roughly 30% gap in unit labor costs. Admittedly, the reason for Germany’s competitiveness is very different from the sharp devaluation that interwar France used. And the fact that Greece had a dysfunctional tax collection system does not help the moral case for further bailouts. But reversing trade flows in a fixed exchange rate regime is just as painful, no matter the initial cause of the trade balance.

That German policy makers are committing many of the same mistakes as French policy makers during the prelude to the Great Depression is, frankly, depressing. Again we see claims about national identity and thriftiness and a refusal to recognize the difficulty of current account adjustment. Again there is fear of monetary financing even though nominal GDP has fallen off a cliff. Lars Christensen also finds that French newspapers accused Germany of economic crimes in language eerily similar to what you might expect in a German paper today:

Germany reduced the national debt to nothing, then borrowed abroad on short terms credit which was invested on long terms, and is thus unable to repay her creditors. Now the enriched country merely declares it is insolvent and spits on Its victims

The solution must be monetary. Sustained inflation would allow sticky nominal wages in Greece to become more competitive. This would ease the adjustment process and make sure that Greece has the ability to finance its debt. Yes, it would incidentally be a “bailout” of Greek debt as debtors are now able to pay back with inflated euros, but the necessity of higher inflation to help with relative price level adjustment comes with the territory of a currency union. And yes, it would lower Germany’s overall competitiveness, but that’s just a part of the “rules of the game” that keeps a fixed exchange rate area together.

The Greek debt negotiations obscure the more fundamental dilemma facing the Eurozone: how do countries adjust relative price levels? History has shown that “natural adjustment” does not work — monetary policy must support the process. And so the question is whether policy makers are willing to shut out the echoes of interwar gold standard and come out in strong support of reflation in the name of preserving a currency union.

†See Eichengreen’s Golden Fetters, Ch. 7 “The Interwar Gold Standard in Operation”

Germany’s GDP Linked Debt

A recent proposal from the Greek finance minister includes a debt for equity swap, replacing some of the existing bonds with growth linked bonds that will only pay coupons if Greece grows. The stock market certainly liked it. After the news was announced the Athens stock market shot up 11% and the country’s bank stocks were up 18%..

But Germany’s experience with GDP linked debt should give Greece some caution about the potential political ramifications of GDP linked debt. I am referring to, of course, is Germany’s reparations burden after World War II. The German experience should serve as a reminder that if GDP linked debt is to work, it requires the good will of both creditors and debtors to encourage macroeconomic policies that help the debt get paid.

After World War I, the treaty of Versailles imposed an extremely harsh reparations payment on the German government. The numbers make the Greek situation of having to raise primary surpluses by a few percent look trivial. As noted in Barry Eichengreen’s classic “Golden Fetters”, the total reparations bill for Germany totaled 132 billion gold marks — over 4 times national income at that time. Around 50 billion of that burden was to be paid unconditionally, with initial payments around 10% of national income.

The other 80 billion was linked to the economic recovery of Germany. As such, around 60% of the new external debt burden was GDP linked.

This created a poisonous dynamic in German politics as officials knew that much of the fruits of their economic reforms would be sent abroad. As Barry Eichengreen writes:

“By linking reparations payments to the condition of the German economy, the Allies diminished the incentive for German policymakers to put their domestic house in order. Hyperinflation was only the most dramatic illustration. Politicians were not encouraged to implement painful programs designed to promote growth by the knowledge that the fruits of their labor would be transfered abroad.”

The German situation was not helped when the allied nations raised trade barriers in the wake of World War I. By definition, if Germany was to run a capital deficit and pay these reparations, then by definition it must also run a trade surplus. But since Allied nations were unwilling to allow dramatically greater German competition in what were already intensely competitive industries, the only alternative for Germany was to endure a severe internal devaluation in an effort to restore competitiveness and have funds to send abroad.

Now, I am not trying to draw an equivalence between German reparations payments — which were forced upon the country—and the Greek government’s debt—which was voluntarily accumulated. But I do want to use Germany’s interwar experience to sound out two potential concerns about GDP linked debt:

  1. It can have toxic effects on domestic politics. Politicians are unlikely to make sacrifices to shore up growth when a substantial part of the marginal benefit will be going to bondholders abroad.
  2. It’s useless without supportive policies from abroad. Even when more than half of the reparations bill was at stake, Allied nations were unwilling to ease trade conditions to ease the German reparations burden. In the current context, unless there’s support from the ECB to raise nominal GDP across the Eurozone, Greece’s debt burden will continue to be massive relative to the underlying nominal size of the economy.

Cross-listed on Medium

Macroeconomic “Excuses”: A Look at Europe

Policy makers are good at coming up with excuses for bad policy. That’s one of my key takeaways from Barry Eichengreen’s recently released “Hall of Mirrors”. In this book, Eichengreen compares the policy responses to the Great Depression and Great Recession and finds that while we may have done better this time around in the initial monetary and fiscal response, we have still managed to unlearn the lessons in the policy responses during the years after the initial crisis. Neil Irwin, summarized this in his NYT review: “Rather than hoist anyone to our shoulders for preventing another Depression, we should be more cleareyed about the ways in which global leaders did not really learn the lessons of the 1930s at all and made many of the same mistakes as their Depression-era counterparts”

An important part of making mistakes is coming up with excuses to justify them. It is here that we see a troubling parallel between the current permissive attitude towards the European collapse in nominal GDP and the passivity of European central bankers in the face of the Great Depression.

Prior to the Great Depression, the global monetary system ran on the gold standard. Since every country’s currency was pegged to gold, each country’s gold stock served as a limit to how much it could expand its money supply. This meant that if you enjoyed the privilege of capital inflows, you could expand your money supply in response to a recession. But if on the other hand you suffered capital outflows, then you were forced to raise interest rates and contract the money supply, even if you were in the depths of a recession.

Prior to the first World War, there were “rules of the game” that helped to mitigate these constraints. In particular, central banks in countries with gold inflows were supposed to expand their money supplies in response to gold inflows. This way, if a country ran a substantial trade surplus and had lots of gold flowing in to buy its goods, the central bank would allow the price level to rise. This would eventually reduce that country’s competitiveness relative to other countries. The trade surplus would turn to deficit, and then gold would flow out as it chased cheaper goods abroad. In doing so, central banks in surplus countries let gold flow back to deficit countries, thereby returning some degree of monetary sovereignty to those deficit countries as they could then expand their money supply

But in the interwar period, France refused to play by these rules. Due to large fiscal battles in the immediate aftermath of the war, the Franc was forced to devalue several times. Eventually it settled at a level that made the Franc very competitive, and gold flowed into France. But instead of following the rules of the game and letting the French price level rise, the Bank of Japan sterilized the gold inflows, stuffing them under the proverbial central banker’s mattress.

From Irwin 2010, “Did France Cause the Great Depression”

This caused severe problems in deficit countries such as the UK and Germany. Since the French price level was not rising, the deficit countries were stuck with their trade deficits. But the French did not see this as a monetary problem. As Eichengreen describes in his new book, “If France enjoyed a balance-of-payments surplus, then this reflected the innate frugality of the French, who preferred saving over spending.” Douglas Irwin, a monetary historian at Dartmouth, notes that French officials attributed the capital inflows to renewed confidence in their economic policies.

This is remarkably similar to the current European situation, except now it is Germany that is the surplus country and peripheral Europe that is running a trade deficit. And again, the surplus country does not see this situation as something about the quasi fixed exchange rate regime of the Euro, but rather as structural superiority relative to the deficit countries. Eichengreen too makes this connection.

The historical lesson for modern Germany would be to recognize that monetary inflation for the Eurozone indeed may be a bad deal for Germany right now. It would open the gate for peripheral Europe to sustainably lower their real wages and thus rob Germany of its competitive advantage relative to peripheral Europe. But that’s the point. Had France consented to expanding their money supply prior to the Great Depression, it would have substantially eased the adjustment process for the UK and Germany. With the benefit of hindsight, Germany should reject moralism about trade surpluses and recognize that monetary expansion is the only true sustainable way to bring South European competitiveness back on track.

Originally posted on Medium.