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... ployment cannot take place. And, said Hayek, depressions are this process of liquidation and preparation for the redeployment of resources. As Schumpeter put it, policy does not allow a choice between depression and no depression, but between depression now and a worse depression later: "inflation pushed far enough [would] undoubtedly turn depression into the sham prosperity so familiar from European postwar experience, [and]... would, in the end, lead to a collapse worse than the one it was called in to remedy. " For "recovery is sound only if it does come of itself. For any revival which is merely due to artificial stimulus leaves part of the work of depressions undone and adds, to an undigested remnant of maladjustment, new maladjustment of its own which has to be liquidated in turn, thus threatening business with another [worse] crisis ahead" This doctrine -- that in the long run the Great Depression would turn out to have been "good medicine" for the economy, and that proponents of stimulative policies were shortsighted enemies of the public welfare -- drew anguished cries of dissent from those less hindered by their theoretical blinders.
British economist Ralph Hawtrey scorned those who, like Robbins and Hayek, wrote at the nadir of the Great Depression that the greatest danger the economy faced was inflation. It was, Hawtrey said, the equivalent of "Crying, 'Fire! Fire!' in Noah's flood. " John Maynard Keynes also tried to bury the liquidation ists in ridicule. Later on Milton Friedman would recall that at the Chicago where he went to graduate school such dangerous nonsense was not taught -- but that he understood why at Harvard-where such nonsense was taught-bright young economists might rebel, reject their teachers' macroeconomics, and become followers of Keynes.
Friedman thought that Keynesianism was wrong -- but not crazy. However, the "liquidation ist" view carried the day. Even governments that had unrestricted international freedom of action -- like France and the United States with their massive gold reserves -- tended not to pursue expansionary monetary and fiscal policies on the grounds that such would reduce investor "confidence" and hinder the process of liquidation, reallocation, and the resumption of private investment. -- - Debt-Deflation Thus governments strained their muscles to balance their budgets -- thus further depressing demand -- and to reduce wages and prices -- in order to restore "competitiveness" and balance to their economies. In Germany the Chancellor -- the Prime Minister -- Heinrich Burning decreed a ten percent cut in prices, and a ten to fifteen percent cut in wages. But every step taken in pursuit of financial orthodoxy made matters worse.
For once the declines in wages and prices in the Great Depression had passed some critical value, they knocked the economy out of its normal business-cycle pattern. Severe deflation had consequences that were much me than an amplification of the modest five to ten percent falls in prices that had been seen in past depressions. When banks make loans, they allow beforehand for some measure of fluctuation in the value of the assets pledged as security for their loans: even some diminution of the value of their collateral will not cause banks to panic, because if the borrower defaults they will still be able to recover their loan principal as long as the decline in the value of the collateral is not too high. But what happens when deflation reaches the previously never seen amount of thirty, forty, or fifty percent -- as it did in the Great Depression?
Banks become keenly aware that their loan principal is no longer safe: that if the borrower defaults, they no longer have recourse to sufficient collateral to recover their loan principal. if the borrower defaults, and if bank depositors take the default as a signal that it is time for them to withdraw their deposits, the bank collapses. As Keynes, wrote, once banks realize that deflation has significantly impaired the value of their collateral: ... they become particularly anxious that the remainder of their assets should be as liquid and as free from risk as it is possible to make them. This reacts in all sorts of silent and unobserved ways on new enterprise. for it means that banks are less willing than they would normally be to finance any project...
In looking at the tracks of interest rates in the Great Depression, you can see a steady widening of the gap between safe interest rates on government securities and the interest rates that borrowing companies had to pay. Even though credit was ample -- in the sense that borrowers with perfect and unimpaired collateral could obtain loans at extremely low interest rates -- the businesses in the economy (few of which had perfect and unimpaired collateral) found it next to impossible to obtain capital to finance investment. Thus the banking system freezes up. It no longer performs its social function of channeling purchasing power from savers to investors. As a result private investment collapses; falling investment produces more unemployment, excess capacity, further falls in prices, and more deflation; and further deflation renders the banking system even more insolvent. Moreover, not only past deflation but also expected future deflation depresses investment.
Why invest now if you expect deflation, so that everything you would buy this year will be ten percent cheaper next year? In the end the spiral of deflation will continue to depress the economy until something is done to restore solvency to the banking system, and break the anticipations of further falls in prices. A few economists understood this process at work during the Great Depression -- Irving Fisher, John Maynard Keynes, R. G. Hawtrey -- but they did not walk the corridors of power at the nadir of the Great Depression. -- - Golden Fetters Countries without massive gold reserves did not have the luxury of even attempting to expand their economies, at least not until they abandoned the gold standard, let their exchange rates float freely, and so cast off their "golden fetters. " A government that wished to stimulate demand in the Great Depression would seek to inject credit and bring down interest rates to encourage investment. But additional credit would mean higher imports, and lower interest rates would encourage domestic investors to invest abroad.
The result would be a balance-of-payments gap: economic expansion at home was inconsistent with gold convertibility. And few countries wished to abandon the gold standard at the start of the Great Depression. There were exceptions that proved the rule. Scandinavian countries cast off their "golden fetters" at the start of the Great Depression, pursued policies of stabilizing nominal demand under the intellectual influence of the Stockholm School of economists, and did relatively well. In Japan fiscal orthodoxy and budget balance were abandoned in 1931, when Korekiyo Takahashi became Minister of Finance.
Industrial production in Japan in 1936 was half again as much as it had been in 1928; in Japan the Great Depression was over by 1932. But these were unusual exceptions. Before World War I the major industrial economies might have had some freedom of action. Before the war major industrial countries' commitment to the gold standard was unquestioned.
Whenever an exchange rate fell to the lowest "gold point", the bottom of the band and the point at which it was profitable to begin shipping gold out of the country, capital would flow in betting on the future recovery of the exchange rate to the mid-point of its band, making the central bank's task of maintaining convertibility easy. But in the 1920 s, with governments under greater pressure from newly expand electorates to generate prosperity, it was not clear that the country was committed to the gold standard. Speculators, instead, began to pull their capital out of a country facing a balance-of-payments deficit, on the principal that the loss they would suffer should the currency recovery would be dwarfed by their profits if they could take advantage of a full-fledged devaluation. With the growth of concern about currencies, central bankers wondered if the gold-exchange standard -- by which they kept their reserves in sterling or in dollars -- was wise. What if the pound or the dollar devalued? As the Great Depression gathered force, central banks fell back on gold as their principal reserve, increasing strains on the system.
One might have thought that those countries that had restored their pre-World War I parities would be immune from destabilizing speculation. Had not Britain returned to the gold standard at the pre-World War I parity precisely to give investors confidence that its commitment to the gold standard was absolute? But governments like Britain and the United States that had maintained pre-World War I parities found themselves lacking credibility. Because they had not experienced the 1920 s as a decade of inflation, they lacked the tacit political consensus that inflation was to be avoided at all costs.
By contrast countries that had undergone inflation in the 1970 s found for the most part that they had high credibility, and that their exchange rates came under little speculative attack. Austria's major bank, the Credit Anstalt, was revealed to be bankrupt in May 1931. Its deposits were so large that freezing them while bankruptcy was carried through would have destroyed the Austrian economy, hence the government stepped in to guarantee deposits. The resulting expansion of the currency was inconsistent with gold-standard discipline.
Savers liquidated their deposits and began to transfer funds out of the country in order to avoid the capital losses that would have been associated with a devaluation. In order to keep its banking system from collapsing and in order to defend the gold standard, the Austrian central bank needed more gold to serve as an internal reserve to keep payments flowing and an external reserve to meet the demand triggered by incipient capital flight. The Bank for International Settlements began to host negotiations to coordinate international financial cooperation. It is possible that rapid and successful conclusion of these negotiations might have stopped the spread of the Great Depression in mid- 1931. Austria was a small country with a population well under ten million. There was not that much capital to flee.
A sizable international loan to Austria's central bank would have allowed it to prop up its internal banking system and maintain convertibility. A month later those whose capital had fled would realize that the crisis was over, and that they had lost a percent of two of their wealth in fees and exchange costs in the capital flight. Other speculators would observe that the world's governments were serious in their commitment to the gold standard, that the potential foreign exchange reserves of any one country were the world's, and thus that the likelihood of a speculative attack succeeding in inducing a devaluation was small. Perhaps investors would then have begun returning gold to central banks in exchange for interest-bearing assets, would have begun to shrink down their demand for liquidity, and would have begun to boost worldwide investment. The Economist's Berlin correspondent thought that it might well have done the job: It was clear from the beginning...
that such an institution [as the Credit-Anstalt] could not collapse without the most serious consequences, but the fire might have been localized if the fire brigade had arrived quickly enough on the scene. It was the delay of several weeks in rendering effective international assistance to the Credit Anstalt which allowed the fire to spread so widely. We don't know because it was not tried. The substantial loan to Austria was not made. Speculators continued to bet on devaluation, investors continued to hoard gold, the preference for liquidity continued to rise, and investment continued to fall.
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Research essay sample on American Policies During The Great Depression
