1930s confirmed again the description of interwar era as a testing ground for different economic policies and exchange rate regimes. This time Britain was on the "cheating" role compared to other economies - it raised its tariff' levels and allowed its currency to depreciate in order to artificially favour her own producers. Many argue that it was about the time for the UK to stop unilateral free trade and fixed exchange rate policies, because they were damaging local producers. However, there were definitely bad long-term effects to London's City. Financial services earning decreased, because investors lost some confidence to British pound. As these long-term effects are very hard to measure, they tend to be ignored by literature - the approach I am going to adopt as well.
The underlying reasons of recession help us to understand the recovery better. During 1929-32 GDP fell by 5.8%, industrial production by 11.4% and exports by 32%. It was thus a mild recession, especially compared to the rest of the world. At that time 40% of the UK's trade was with primary producing countries. Following the collapse of USA's foreign investment these countries experienced a major recession with balance of payment problems and UK's trade fell off. Thus the external reasons are to blame for the recession. But there were also national shocks contributing. Investment to dwellings fell off, because of 20's high interest.
There were also secondary effects to the real causes - the monetary repercussions. Hicks has found that real causes (such as export contraction) introduced international financial crises in 1931 with the collapse of Credit Ansalt. Monetary factors did not explain why recession started, but increased its magnitude. Furthermore, rational expectations theory says that monetary shocks can have permanent effects - the hysteresis approach. In this case these effects were lost business confidence due to high interest in recession. This might have slowered the recovery later.
The reasons for relatively mild recession can be found in the UK's strong financial sector (no banks collapsed) and right abandonment of gold standard (just before Wall street crashed). UK had also a small agricultural sector - primary sectors were the ones that got into largest slump. However, the recession occurred at the time of already high unemployment. This worsened the situation of working class a lot more than previous recessions. That is why 30's are called "the devils' decade".
Recovery started in 1932. UK growth rate then - 2% - was double the world's average for 1930's. According to different measures of recovery, like the unemployment and output gap UK did not do that well. Unemployment did fell, but it still remained above 10% for most of the period and was not eliminated before the 2nd World War. Output gap was also big and also not eliminated during the recovery.
Having looked at the factors causing recession we might want to suggest that it should have been exports that led to the recovery. In fact, exports did increase quite a bit and were an important short term initiating factor for the recovery, but the root long-term causes of the recovery were located in the change of government's policy and upturn in investment.
Government abandoned the gold standard in Sept. 1931 and thus relaxed its exchange rate. Pound depreciated 30% against dollar, but this measure is not quite fair, because several other countries depreciated or pegged their currencies to pound. So effective exchange rate (Redmond index) should be used. Effective rate only fell 8%. Furthermore, UK went into managed exchange rate after 193. The advantages of depreciation to the export sector were lost in a couple of years, because other countries were depreciating as well.
However, monetary shocks like this can have persistent hysteresis effects. In this case money supply was allowed to rise (cheap monetary policy). This allowed the interest to fall, leading to higher investment and lower repayments on the war debt. Increased money supply should also have direct cash balance effects (Pigou). Surprisingly, unlike in USA, consumption decrease was not causing recession in UK, similarly the increase in consumption was not observed empirically during recovery.
International evidence supports strongly the view that floating exchange stimulated the economy. All countries that abandoned gold standard recovered much faster from the recession. Thus by keeping to gold standards in 1920's UK unknowingly set herself a way of recovering from 30's recession. Countries that had already depreciated against gold could not allow that any further and thus had bitter recessions.
Depreciated rate also made UK's exports more competitive, but before talking of the trade I must look at the other major government policy that affected the trade - imposition of General Tariff of 10% ad valorem. It is hard to extract the precise effects of tax. Other countries were raising protection at the same time as well. Eichengreen and Foreman-Peck reached independently the conclusion that tariff increased GDP by 2.3% until 1938, however, Kitson, Solomou and Weale using the method of effective exchange rate reached the conclusion that protected industries were not doing significantly better. So the import tariff is more of a hypothetical measure - domestic producers did take control of domestic market and pushed imports away. Without the tariffs foreign imports could have penetrated the British economy (e.g. large companies using dumping strategies to take British market). However, the UK was definitely using the strategy of second best here - tariff distorted the world trade pattern even further and might have reduced the comparative advantage the UK had in old staple industries. That happened, because despite the governments aim to avoid tax on raw materials, they were still put on iron. This made the effective protection rates negative to some sectors.
However, tariff should have had allocative effects as well. It definitely showed the UK's imperial preference - tariffs were lower for the Empire countries. Glen and Booth have claimed that it also helped the industrial structural reallocation and changed the British position in the world economy, because the tariff protected new industries more than old ones. But effective protection rates do not clearly support this view. And old industries were developing new products as well. This complicates matters even further.
Besides tariff and floating exchange rate government supported the economy later on by wartime investment. This gave the economy a fiscal boost and made the recovery very fast after 1938. Many writers argue that this should have been done a lot earlier to combat unemployment. However as it was not done earlier it did not quite contribute to the recovery phase. Furthermore, the UK's economy developed very fast during the wartime, because her capital stock was not extensively damaged. This has got nothing to do with the health of the economy - it was just sheer luck.
These government policies needed a transmission mechanism to affect the growth of economy (Eichengreen). I have described the main ones already when discussing the policies. However to be clear the short term factors and long-term factors need to be distinguished. Consumption and export increase are short term effects. However, exports were only 80% of their 1929 level in 1937. When assuming that the producers were just passing the effects of tariff through (world price did not change) then the increased exports gave 80m balance of payment improvement. This is equivalent to 3% of GDP, when assuming fiscal multiplier of 1.75 (Broadberry). Thus export gave a significant short term boost.
Long term factors for recovery, that were not eliminated by other countries devaluing their currencies and getting over their slumps can be summarised to three categories: investment in housing, non-consumer investment and war-time investment. Housing investment had been depressed for a long time due to high interest rates, so housing sector just waited there to be boomed. Dwelling building increased by over 50%. Banks were increasingly willing to give out mortgages. Housing boom continued all through 1930's. Prices did not increase considerable, instead the output rose. This gives evidence of large output gap and suggests the economy was in need of a fiscal boost.
The recovery however was not complete according to two measures. The structural change had not occurred completely and unemployment was still high. Classically demand side reasons were assigned to unemployment. It was thought that there was insufficient aggregate demand (Keynes). However lately Benjamin and Kochin have argued for supply side reasons. Real wage was too high due to deflation and money illusion, so people and trade unions demanded too high real wage. This allowed the wage gap to continue existing (Broadberry and Beenstock) and led to people increasingly participating in workforce. Firms were unwilling to employ the extra people as their marginal revenue product (MRP) had fallen below their money wage. To explain, MRP=marginal physical product times the price level. However as there was deflation without corresponding increase in productivity the MRP and thus employment fell.
According to Beveridge report there were 43 000 unemployed for more than a year in 1929 and 288 000 in 1937. Insider-outsider models explain why long-term unemployment causes high overall unemployment in recovery (Crafts). Basically once people became unemployed for more than a month than their chances of getting back to work were very small. Trade Unions did not take them into account anymore when bargaining for wages either, so wages did not come down. Atrophy of human skills also occurred. However this theory does not explain why trade unions and long-term unemployment appeared in the first place.
Numerous other theories have been developed to explain the persistent unemployment. Implicit contract theory assumes firms to pay the same wage although booms and busts and adjust employment. Firms had become used to high wages. Labour force also grew naturally, furthermore different regions grew differently leading to regional unemployment. Dimsdale and Matthews have contradicting views on hove exchange rate appreciation and unemployment are linked and which causes which. There are also numerous other theories. Unfortunately the lack of empirical evidence renders most of them only hypothetical.
The reorganisation of the economy towards new industries (motor cars, electrical industry) did not Finnish completely either. A dual economy emerged - some regions with new industry needed a fiscal boost to expand their demand, while old staple industries needed deflation to decrease their real wage. Evidence to this lies in high unemployment of old staple industries and in the artificially small size of new industries, compared internationally. However regional fiscal boosts have limited multiplier effect as most of the money is spend on other region goods. Considerable modernisation of technology did occur in 1930's together with rationalisation and mergers. Structural change was twice as fast as in 1900-1913. But mergers led to cartels that just passed the tariff through increased prices to consumers. They did not employ modern management techniques and did not rationalise their production by closing down inefficient plants and utilising the economies of scale. Productivity was mostly increased in old staple industries, not in new sectors of the economy. And the structural change was still a lot slower than after the 2nd World War. Crafts and Broadberry found larger wage gaps in protected industries - this showed that the protection was only expanding output in short term and in long term led to higher prices without increased output.
Britain lost the trump of gold standard to current economic growth in 1930s. However, the lost business confidence arising from floating rates was minimised after 1931 by managed rate, which still avoided the import of external monetary shocks. So Britain generally made right decisions throughout the 1930-s to minimise her losses in the era of high instability in world markets. Only unemployment record could have been much better, but at that time of the macroeconomy even Philips hadn't written his theory on inflation and unemployment, not speaking of insider-outsider and rational expectations. So whereas the labour market was definitely in need of a fiscal boost to eliminate the 1929-32 recession effects, it was perfectly reasonable for the Treasury for not to listen to Lloyd-George and fear inflation. However, the evidence that the housing boom and war investment were not causing inflation strongly suggests that the fear for inflation was unjustified, if we think globally then it is not clear at all whether the adaptation of tariffs benefited more British producers than it damaged world producers. In my opinion, the recovery in Britain was paid to a large extent by enterprises loosing output in USA and in rest of the world. The final outcome of depreciating currencies and adopting tariffs is usually close to 0 for the whole world as the small economies of scale gained are usually wasted as administration costs.
i. strong financial sector
ii. abandonment of gold
iii. primary sector(aggrc) small.
i. growth 2% per anum - double the worlds.
ii. Specially high before war and during - no capital destruction.
iii. Solomou has revised and put 1928 as first year of recession as services exports fell off.
i. Effective rate should be counted (Redmond index). Depreciated a lot less than against dollar. Anyway appreciated back quite quickly, adv not for long. effective e-rate only fell 8%
ii. managed rate after 1931.
iii. Ms increased. Link with interest and cash balance effect. Cheap money policy
iv. Right timing just before USA stock mkt. collapse
v. International evidence - others that abandoned did well. Britain by sacrificing 1920s could now do well. However thinking of future
vi. Low interest
war debt smaller
Some industries already protected. Other countries raised taxes, UK using 2nd best strategy. Hard to extract precise protection effects.
i. Effective tariff debate between Capie and Solomou. Steel
ii. Had little effect on exports, but more on reducing import penetration
iii. Incomplete recovery - price for it was loss of comparative adv. But theory of dead weight loss assumes small economy and domestical full employment. and constant returns to scale. so when country is large tariff lowers prices, adjustment costs in trade cycles avoided, but subsidy is a better policy.
iv. evidence of domestic producers using pass-through. inflationary effects not strong - spare capacity - Mundels elasticity theory.
v. imperial preference
vi. New industries - not clear from effective rate whether they had higher protection. This should have favoured resource reallocation. Evidence is weak
i. Short term - initiating factors. Not very important.
(1) Export increase (but only 80% in 37 of 29) Recovery cannot be explained by exports but they gave a kick (Broadberry). Using pass through 80m improvement in BoP, 1.75 multiplier on GDP - 3% of GDP. Impact eliminated by others devaluing.
BUT hysteresis - kick has a permanent effect - imports reduced.
(2) Cash balance effect and increased consumption - not much evidence
ii. Long term
(1) investment to housing
(2) non-consumer investment
(3) wartime stuff
i. Insider-outsider theory (Crafts). Does not explain why TU appeared/ Atrophy of human capital. Investment also permanently affected in 1929 although no evidence.
ii. Supply side and demand side reasons
Demand side classical, but now more supply side - Benjamin and Kochin - too high real wage due to deflation. Dimsdale - exchange rate appreciation led to higher wages. Matthews - other way round.
iii. continuing wage gap (Broadberry and Beenstock) Led to increased participation
iv. Auction mkt. Pigou - cash balance effect, TUs creating rigidities, price uncertainty with monetary illusion(Friedman). Implicit contract model (stable wage through booms)
v. growth theory - different regions grew differently. Natural and warranted and actual growth rate differed (Solow)
vi. Labour force grew
i. technology modernisation
ii. rationalisation and mergers. But cartels and tariff pass-through
iii. Structural change twice as fast than in 1900-13
BUT most productivity in old staples
Structural change still slower than after 2nd WW
Crafts & Broadberry found larger output gaps in protected industries - protection good only in short term
Fiscal Policy - can Lloyd George do it. Example of high war intervention. Dual economy