Lecture 9: Interwar Instability

Instructor: Ling Zhu

Fall, 2013

(ECON 442)

Lecture 9: Interwar Instability

Fall, 2013

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Goal of the Lecture

How and why did the new gold standard (GS) fail after the WWI?

(ECON 442)

Lecture 9: Interwar Instability

Fall, 2013

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Recall: how does GS Work?

Channel 1: Automatic Adjustment Mechanism– Price Specie Flow Channel 2:Central Bank Intervention: Discount Rates Channel 3: Central Bank Credibility: “Good” Speculative Capital Flows, or the Lack of ”Bad” Speculative Capital Flows Channel 4:International Cooperation Remark: as long as any one of the four channels works, GS should work. Hence for the new GS to fail after WWI, all four channels must have failed.

(ECON 442)

Lecture 9: Interwar Instability

Fall, 2013

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Suspension of the old GS during WWI

How to finance a war and reconstruction after war? Suspension of GS and use of fiat money: all the core countries except for US Hyperinflation

(ECON 442)

Lecture 9: Interwar Instability

Fall, 2013

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Fig 1. Depreciation of Mark

(ECON 442)

Lecture 9: Interwar Instability

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Fig 2. Hyperinflation in Germany

(ECON 442)

Lecture 9: Interwar Instability

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Fig 3. Number of Countries on GS between 1921-37

(ECON 442)

Lecture 9: Interwar Instability

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Return to GS

Currency Reform: countries that had hyperinflation Return to the prewar parity: UK Lower than the prewar parity: France

(ECON 442)

Lecture 9: Interwar Instability

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The New GS

Problem: too much money, too little gold. The problem is even more severe than before WWI. Solution 1: Gold-Exchange Standard: allow central bank to hold both gold and foreign exchange as reserve to back up its currency Solution 2: Proportional System: gold + foreign exchange reserve could not fall below some proportion of money in circulation These solutions helped solved the gold shortage problem. But they sowed the seed for the failure of the new GS. The new system allowed for sterilization policy that could be used to stabilize price levels.

(ECON 442)

Lecture 9: Interwar Instability

Fall, 2013

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The New Political Landscape

Rise of labor union and labor party: wage becomes more rigid Government’s increasing role in stimulating domestic economy during recession: shift of central bank policy priority European disintegration Strong aversion to inflation in countries that had hyper-inflation.

(ECON 442)

Lecture 9: Interwar Instability

Fall, 2013

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Failure of Price Specie Flow

How it worked in the old GS: trade surplus → gold inflow → increases domestic money supply → domestic price increase → exports become more expensive → deterioration of terms of trade → trade deficit → gold outflow Which arrow stopped functioning and why? Countries with gold inflow has incentive to hoard gold by using the sterilization policy that prevent prices from rising. Labor union prevent wage from lower in countries with gold outflow, which exacerbates the problem.

(ECON 442)

Lecture 9: Interwar Instability

Fall, 2013

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Table 1.Gold Reserve (percent of world total)

(ECON 442)

Lecture 9: Interwar Instability

Fall, 2013

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Table 1.Gold Reserve (percent of world total)

(ECON 442)

Lecture 9: Interwar Instability

Fall, 2013

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Lack of International Cooperation

Banking crisis in Austria in 1931 Who could help? France: strings attached Contagion to Hungary and Germany US: we could lend only if you promise not to use it! Solution: Bank holiday and off GS

(ECON 442)

Lecture 9: Interwar Instability

Fall, 2013

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Two Goals One Instrument: failure of discount rate to defend GS

Recession and CA Deficit Currency Attack UK in 1931

(ECON 442)

Lecture 9: Interwar Instability

Fall, 2013

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“Bad” Hot Money

Speculators: UK abandoned GS, the same could happen in US! Run on Dollar Speculators were right: Roosevelt declared bank holiday the month he assumed office (March 1932); then three weeks later, he suspended gold convertibility.

(ECON 442)

Lecture 9: Interwar Instability

Fall, 2013

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Fall of GS

1931: Austria, Hungary, Germany, UK 1933: US How about France and others? 1. Less competitive in trade compared to the floating countries→ gold outflow; 2. Depreciation of foreign exchange reserve, equivalent to gold outflow; 3. Network Effect

(ECON 442)

Lecture 9: Interwar Instability

Fall, 2013

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Lecture 9: Interwar Instability

Channel 3: Central Bank Credibility: “Good” Speculative Capital. Flows, or the Lack of ”Bad” Speculative Capital Flows ... Rise of labor union and labor party: wage becomes more rigid. Government's increasing role in stimulating domestic ... defend GS. Recession and CA Deficit. Currency Attack. UK in 1931. (ECON 442).

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