Fantastic new research from Barry Eichengreen and Olivier Accominotti over at VoxEU comparing the ongoing Recession/financial crisis in Europe to the Great Depression. The key driver of the crisis on both occasions was a large capital flow from one half of the continent to another, followed by a sudden stop and quick flow reversal. While this fact has certainly been acknowledged over the past several years, the authors felt that this acknowledgment had been primarily anecdotal, and sought to add rigor to our understanding of capital flows and their impact on the current crisis/Great Depression by flushing out a more thorough analysis of the determinants of the capital reversals.
The key takeaway, for me, was the following:
Interwar experience thus underscores the extent to which global factors largely exogenous to conditions in the borrowing countries shaped the capital inflows and outflows to which European countries were subject. This was a precedent of which European countries in the period leading up to subprime/global credit crisis of 2007-8 could have usefully taken heed.
I think one of the most important lessons from the Great Depression was the re-discovery that sovereign-debt fueled current account deficits where the debt is denominated in a foreign currency (or the country’s currency is pegged to a foreign currency/gold) are extremely dangerous when the capital inflow reverses.
The evidence for this lies in the fact that recovery from the Great Depression proceeded quite nicely, once most of the countries threw out the gold standard (though fiscal stimulus from war preparation certainly helped as well). Via Romer, through Krugman (note–France stayed on the Gold Standard):
After a brief return to a fixed exchange rate system after the war,** eventually the US (and many other major currencies) moved to floating exchange rates to take full advantage of an independent monetary policy. Unfortunately, Europe forgot its lessons from the Great Depression and went in the opposite direction, first establishing the European Exchange Rate Mechanism in the early 1990’s after German reunification, eventually moving to the single currency at the turn of the century.
In what is probably the most ironic turn of all, the exchange rate mechanism and single currency were ideas that were primarily driven, at least initially, by French President Mitterand in an attempt to minimize German influence over European monetary affairs (this was the price Helmut Kohl and Germany paid for a rapid reunification after the fall of the Berlin wall). While the reasons for tying a reunified Germany into the political and economic institutions of Western Europe were sound, the logic behind and execution of the single currency zone was highly flawed. Unfortunately, France (and, even more so, the southern periphery countries in Europe) are paying the price of being tied into a currency union where a robust German economy drives monetary policy-making.
The worst part of the ordeal is that even with a pegged exchange rate or gold standard, countries can decide to not honor the peg and devalue their currency; while initially disruptive, the chart above shows that this tends to lead to very quick, export-driven recoveries. Unfortunately, countries in the Euro-zone don’t have the technical, legal, or physical capacities to leave the Euro. That is the primary reason that recovery has been so slow over the past 5 years (absolutely horrendous fiscal and poor to mediocre monetary policy has contributed), and there is a very real possibility that the current crisis will have exceeded the economic damage inflicted by the Great Depression in Europe when all is said and done.
Found this great lecture on the economics of the Great Depression from Brad Delong.
**After the war, the international system returned to a system of fixed exchange rates, though with a bit more flexibility than before–through Bretton woods, individual countries tied their currency to the US dollar (which was pegged to gold), and currencies were allowed to fluctuate within a narrow band around the target rate (to allow for some flexibility in domestic monetary policy). Furthermore, the Bretton Woods system led to the creation of the IMF, which was an international institution dedicated to assisting countries experiencing balance of payments crises (with bridge financing and oversight of currency devaluation). Eventually, the Bretton Woods system broke down, as the US was consistently running current account deficits to finance European expansion and domestic social programs after the war–this led to Gold shortages in the US, severe overvaluation of the dollar, and, eventually, to the US moving to a floating exchange rate system.