FERAIOS SouthEast EU & Mesogaia INVESTMENT FUND

Sunday, January 27, 2013

THINKING IN THE BOX (Elast)

(BEING CONTINUED FROM 12/12/12)

A)The Gold Standard, Deflation, and Financial Crisis in the Great Depression:

2.5 Regression Results

In this section we present empirical results based on our panel data set. The

principal question of interest is the relative importance of various transmission

mechanisms of deflation to output. We also address the question, so far not

discussed, of whether banking crises could have intensified the deflation process

itself.

The basic set of results is contained in table 2.9, which relates the logdifferences

in industrial production for our set of countries to various combinations

of explanatory variables. The definitions of the right-hand-side variables

are as follows:

DlnPW: log-difference of the wholesale price index;

DlnEX: log-difference of nominal exports;

DlnW: log-difference of nominal wage;

DISC: central bank discount rate, measured relative to its 1929 value (a

government bond rate is used for Canada; since no 1929 interest rate

could be found for New Zealand, that country is excluded in regressions

including DISC);

PANIC: a dummy variable, set equal to the number of months during the

year that the country experienced serious banking problems (see below);

AlnMO: log-difference of money and notes in circulation.

Exports are included to control for trade effects on growth, including the

benefits of competitive devaluation discussed by Eichengreen and Sachs

(1986); and the wage is included to test for the real wage channel of transmission

from deflation to depression. Of course, theory says that both of these variables should enter in real rather than in nominal terms; unfortunately, in practice the theoretically suggested deflator is not always available (as we noted in our discussion of the real wage above).

We resolve this problem by supposing that the true equation is, for example,

(1) Dln/P = Be (DlnEX - DlnPe,) + Bw (DlnW - DlnPw )+ error

where Pe and Pw, the optimal deflators, are not available. Let the projections

of log-changes in the unobserved deflators on the log-change in the wholesale

price deflator be given by

(2) DlnPi, = ψDlnPW + ui i=e,w

where the ui are uncorrelated with DlnPW and presumably the ψ, are positive.

Then (1) becomes

(3) ΔlnΙP = - ( βeψe + βwψw)ΔlnPW + βeΔlnEX + βwΔlnW + new error

This suggests allowing ΔlnPW and the nominal growth rates of exports and

wages to enter the equation separately, which is how we proceed.18 Putting

ΔlnPW in the equation separately has the added advantage of allowing us to

account for any additional effect of deflation (such as debt deflation) not explicitly

captured by the other independent variables.

The discount rate DISC is included to allow for the interest rate channel and

as an additional proxy for monetary policy. Since ΔlnPW is included in every

equation, inclusion of the nominal interest rate DISC is equivalent to including

the actual ex post real interest rate, that is, we are effectively assuming

that deflation was fully anticipated; this should give the real interest rate hypothesis

its best chance.

In an attempt to control for fiscal policy, we also included measures of central

government expenditure in our first estimated equations. Since the estimated

coefficients were always negative (the wrong sign), small, and statistically

insignificant, the government expenditure variable is excluded from the

results reported here.

Construction of the dummy variable PANIC required us to make a judgment

about which countries' banking crises were most serious, which we did from

our reading of primary and secondary sources. We dated periods of crisis as

starting from the first severe banking problems; if there was some clear demarcation

point (such as the U.S. bank holiday of 1933), we used that as the

ending date of the crisis; otherwise we arbitrarily assumed that the effects of

the crisis would last for one year after its most intense point. The banking

crises included in the dummy are as follows (see also table 2.7):

1. Austria (May 1931-January 1933): from the Creditanstalt crisis to the

date of official settlement of the Creditanstalt's foreign debt.

2. Belgium (May 1931-April 1932; March 1934-February 1935): for one

year after the initial Belgian crisis, following Creditanstalt, and for one

year after the failure of the Banque Beige de Travail led to a general

crisis.

3. Estonia (September 1931-August 1932): for one year after the general

banking crisis.

4. France (November 1930-October 1932): for one year following each of

the two peaks of the French banking crises, in November 1930 and October

1931 (see Bouvier 1984).

5. Germany (May 1931-December 1932): from the beginning of the major

German banking crisis until the creation of state institutes for the liquidation

of bad bank debts.

6. Hungary (July 1931-June 1932): for one year following the runs in Budapest

and the bank holiday.

7. Italy (April 1931-December 1932): from the onset of the banking panic

until the takeover of bank assets by a massive new state holding company,

the Istituto por le Riconstruzione Industriale (IRI).

8. Latvia (July 1931-June 1932): for one year following the onset of the

banking crisis.

9. Poland (June 1931-May 1932): for one year following the onset of the

banking crisis.

10. Rumania (July 1931-September 1932): from the onset of the crisis until

one year after its peak in October 1931.

11. United States (December 1930-March 1933): from the failure of the

Bank of the United States until the bank holiday.

The inclusion of Austria, Belgium, Estonia, Germany, Hungary, Latvia,

Poland, Rumania, or the United States in the above list cannot be controversial;

each of these countries suffered serious panics. (One might quibble on

the margin about the exact dating given—for example, Temin [1989] and others

have argued that the U.S. banking crisis did not really begin until mid

1931—but we doubt very much that changes of a few months on these dates

would affect the results.) The inclusion of France and Italy is more controversial.

For example, Bouvier (1984) argues that the French banking crisis was

not as serious as some others, since although there were runs and many banks

failed, the very biggest banks survived; also, according to Bouvier, French

banks were not as closely tied to industry as other banking systems on the

Continent. For Italy, as we have noted, early and massive government intervention

reduced the incidence of panic (see Ciocca and Toniolo 1984); however,

the banks were in very poor condition and (as noted above) eventually

signed over most of their industrial assets to the IRI.

To check the sensitivity of our results, we reestimated the key equations

omitting first the French crisis from the PANIC variable, then the French and

Italian crises. Leaving out France had a minor effect (lowering the coefficient

on PANIC and its f-statistic about 5% in a typical equation); the additional

exclusion of the Italian crisis has essentially no effect.19

As a further check, we also reestimated our key equations omitting, in

separate runs, (i) the United States; (ii) Germany and Austria; and (iii) all

eastern European countries. In none of these equations were our basic results

substantially weakened, which indicates that no single country or small group

of countries is driving our findings.

The first seven equations in table 2.9 are not derived from any single model,

but instead attempt to nest various suggested explanations of the link between

deflation and depression. Estimation was by OLS, which opens up the possibility

of simultaneity bias; however, given our maintained view that the deflation

was imposed by exogenous monetary forces, a case can be made for treating

the right-hand-side variables as exogenous or predetermined.

Note: For variable definitions, see text. The sample period is 1930-36. The panel consists of

twenty-four countries except that, due to missing wage data, Finland, Greece, and Spain are

excluded from equations (5)-(8). Estimates of country-specific dummies are not reported. Standard

errors are in parentheses.

*Export growth is measured in real terms in equation (8).

The principal inferences to be drawn from the first seven rows of table 2.9

are as follows:20

1. Export growth consistently enters the equation for output growth

strongly, with a plausible coefficient and a high level of statistical significance.

2. When wage growth is included in the output equation along with only

wholesale price and export growth (row 5), it enters with the wrong sign.

Only when the PANIC variable is included does nominal wage growth have

the correct (negative) sign (rows 6 and 7). In the equation encompassing all

the various channels (row 7), the estimated coefficient on wage growth is of

the right sign and a reasonable magnitude, but it is not statistically significant.

3. The discount rate enters the encompassing equation (row 7) with the

right sign and a high significance level. A 100-basis-point increase in the discount

rate is estimated to reduce the growth rate of industrial production by

3.6 percentage points.

4. The effect of banking panics on output is large (a year of panic is estimated

in equation (7) to reduce output growth by 12 X .0138, or more than

16 percentage points) and highly statistically significant (f-statistics of 4.0 or

better). The measured effect of the PANIC variable does not seem to depend

much on what other variables are included in the equation.

5. There may be some residual effect of deflation on output not accounted

for by any of these effects. To see this, note that in principle the coefficient on

DlnPW in equation (7) of table 2.9 should be equal to and opposite the

weighted sum of the coefficients on DlnEX, DlnW, and DISC (where the

weights are the projection coefficients of the respective "true" deflators on

DlnPW). Suppose for the sake of illustration that each of the projection coefficients

equals one (that is, the wholesale price index is the correct deflator).

Then the expected value of the coefficient on DlnPW should be approximately

.052; the actual value is .296, with a standard error of .123. Thus there may

be channels relating deflation to depression other than the ones explicitly accounted

for here. One possibility is that we are simply picking up the effects

of a simultaneity bias (a reverse causation from output to prices). Alternatively,

it is possible that an additional factor, such as debt deflation, should be

considered.

As an alternative to the procedure of nesting alternative channels in a single

equation, in equation (8) of table 2.9 we report the results of estimating the

reduced form of a simple aggregate demand-aggregate supply (AD-AS) system.

Under conventional assumptions, in an AD-AS model output growth

should depend on money growth and autonomous spending growth (represented

here by growth in real exports21), which shift the AD curve; and on

nominal wage growth, which shifts the AS curve. In addition, we allow

PANIC to enter the system, since banking panics could in principle affect both

aggregate demand and aggregate supply. The results indicate large and statistically

significant effects on output growth for real export growth, money

growth, and banking panics. Nominal wage growth enters with the correct

sign, but the coefficient is very small and statistically insignificant.

We have so far focused on the effects of banking panics (and other variables)

on output. There is an additional issue that warrants some discussion

here; namely, the possibility that banking panics might have themselves worsened

the deflationary process.

Some care must be taken with this argument. Banking panics undoubtedly

had large effects on the composition of national money supplies, money multipliers,

and money demand. Nevertheless, as has been stressed by Temin

(1989), under a gold standard, small country price levels are determined by

international monetary conditions, to which domestic money supplies and demands

must ultimately adjust. Thus banking panics cannot intensify deflation

in a small country.22 Indeed, a regression (not reported) of changes in wholesale

prices against the PANIC variable and time dummies (in order to isolate

purely cross-sectional effects) confirms that there is very little relationship

between the two variables.

The proposition that bank panics should not affect the price level does not

necessarily hold for a large country, however. In econometric language, under

a gold standard the price level of a large country must be cointegrated with

world prices; but while this means that domestic prices must eventually adjust

to shocks emanating from abroad, it also allows for the possibility that domestic

shocks will influence the world price level. Notice that if banking panics

led to deflationary shocks in a large country and these shocks were transmitted

around the world by the gold standard, a cross-sectional comparison would

find no link between panics and the price level.

The discussion of the gold standard and deflation in section 2.2 cited Hamilton's

(1987) view that the initial deflationary impulses in 1928-29 came

from France and the United States—both "big" countries, in terms of economic

importance and because of their large gold reserves. This early deflation

obviously cannot be blamed on banking panics, since these did not begin

until at least the end of 1930. But it would not be in any way inconsistent with

the theory of the gold standard to hypothesize that banking panics in France

and the United States contributed to world deflation during 1931-32.23

Empirical evidence bearing on this question is presented in table 2.10. We

estimated equations for wholesale price inflation in the United States and

France, using monthly data for the five-year period 1928-32. We included an

error-correction term in both equations to allow for cointegration between the

U.S. and French price levels, as would be implied by the gold standard. This

error-correction term is the difference between the \og-levels of U.S. and

French wholesale prices in period t — 1; if U.S. and French prices are in fact

cointegrated, then the growth rate of U.S. prices should respond negatively to

the difference between the U.S. price and the French price, and the French

growth rate of prices should respond positively. Also included in the equations

are lagged inflation rates (to capture transitory price dynamics), current and

lagged base money growth, and current and lagged values of the deposits of

failing banks (for the United States only, due to data availability).

The results are interesting. First, there is evidence for cointegration: The

error-correction terms have the right signs and reasonable magnitudes, although

only the U.S. term is statistically significant. Thus we may infer that

shocks hitting either French or U.S. prices ultimately affected both price levels.

Second, both U.S. base money growth and bank failures are important

Note: Deposits of failing banks are from the Federal Reserve Bulletin. USAWPI and FRAWPI are

wholesale price indexes for the United States and France, respectively. Monthly data from 1928

to 1932 are used.

determinants of the U.S. (and by extension, the French) deflation rates; these

two variables enter the U.S. price equation with the right sign and marginal

significance levels of .0005.

With respect to the effect of banking panics on the price level, then, the

appropriate conclusion appears to be that countries with banking panics did

not suffer worse deflation than those without panics;24 however, it is possible

that U.S. banking panics in particular were an important source of world deflation

during 1931-32, and thus, by extension, of world depression.

2.6 Conclusion

Monetary and financial arrangements in the interwar period were badly

flawed and were a major source of the fall in real output. Banking panics were

one mechanism through which deflation had its effects on real output, and

panics in the United States may have contributed to the severity of the world

deflation.

In this empirical study, we have focused on the effects of severe banking

panics. We believe it likely, however, that the effects of deflation on the financial

system were not confined to these more extreme episodes. Even in countries

without panics, banks were financially weakened and contracted their

operations. Domestic debt deflation was probably a factor, to a greater or

lesser degree, in every country. And we have not addressed at all the effect of

deflation on the burden of external debt, which was important for a number of

countries. As we have already suggested, more careful study of these issues is

clearly desirable.

THE END

Author: Ben Bemanke, Harold JamesConference

Date: March 22-24,1990

Ben Bemanke is professor of economics and public affairs at Princeton University and a research

associate of the National Bureau of Economic Research. Harold James is assistant professor

of history at Princeton University.

The authors thank

David Fernandez, Mark Griffiths, and Holger Wolf for invaluable research

assistance.

Support was provided by the National Bureau of Economic Research and the National

Science Foundation.

Notes

17. Causality could run in both directions. For example, Wigmore (1987) argues

that the U.S. banking panic in 1933 was in part created by a run on the dollar.

18. It has been pointed out to us that if nominal wages were literally rigid, then this

approach would find no effect for wages even though changes in the real wage might

be an important channel for the effects of deflation. The reply to this is that, if nominal

wages are completely rigid, the hypothesis that real wages are important can never be

distinguished from an alternative which proposes that deflation has its effects in some

other way.

19. In another sensitivity check, we also tried multiplying PANIC times the change

in the deposit-currency ratio, to allow for differential severity of panics. The results

exhibited an outlier problem. When Rumania (which had a change in the depositcurrency

ratio of — .76 in 1931) was excluded, the results were similar to those obtained

using the PANIC variable alone. However, inclusion of Rumania weakened both

the magnitude and statistical significance of the effect of panics on output. The "reason"

for this is that, despite its massive deposit contraction, Rumania experienced a

5% growth of industrial production in 1931. Whether this is a strong contradiction of

the view that panics affect real output is not clear, however, since according to the

League of Nations the peak of the Rumania crisis did not occur until September or

October, and industrial production in the subsequent year fell by 14%. Another reason

to downplay these results is that the change in the deposit-currency ratio may not be a

good indicator of the severity of the banking crisis, as the Italian case indicates.

20. Results were unchanged when lagged industrial production growth was added

to the equations. The coefficient on lagged production was typically small and statistically

insignificant.

21. Deflation is by the wholesale price index.

22. A possible exception to this proposition for a small country might be a situation

in which there are fears that the country will devalue or abandon gold; in this case the

country's price level might drop below the world level without causing inflows of reserves.

An example may be Poland in 1932. A member of the Gold Bloc, Poland's

wholesale price level closely tracked that of France until mid 1931, when Poland experienced

severe banking problems and withdrawals of foreign deposits, which threatened

convertibility. From that point on, even though both countries remained on the

gold standard, money supplies and prices in Poland and France began to diverge. From

the time of the Polish crisis in June 1931 until the end of 1932, money and notes and

circulation dropped by 9.1% in Poland (compared to a gain of 10.5% in France); Polish

commercial bank deposits fell 24.5% (compared to a 4.1% decline in France); and

Polish wholesale prices declined 35.2% (compared to a decline of 18.3% in France).

Despite its greater deflation, Poland lost about a sixth of its gold reserves in 1932,

while France gained gold.

23. This hypothesis does not bear on Temin's claim that there was little that central

banks could do about banking crises under the gold standard; rather, the argument is

that if, fortuitously, French and U.S. banking panics had not occurred, world deflation

in 1931-32 would have been less severe.

24. Indeed, if banking panics induced countries to abandon gold, they may have

indirectly contributed to an eventual rise in price levels.

References

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der fruhen dreissiger Jahren: Zur Revision des uberlieferten Geschichtesbildes.
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Bouvier, Jean. 1984. The French banks, inflation and the economic crisis, 1919-1939.
Journal of European Economic History 13: 29-80.
Campa, Jose Manuel. Forthcoming. Exchange rates and economic recovery in the
1930s: An extension to Latin America. Journal of Economic History.
Choudhri, Ehsan U., and Levis A. Kochin. 1980. The exchange rate and the international
transmission of business cycle disturbances: Some evidence from the Great
Depression. Journal of Money, Credit, and Banking 12: 565-74.
Ciocca, Pierluigi, and Gianni Toniolo. 1984. Industry and finance in Italy, 1918-40.
Journal of European Economic History 13: 113-36.
Eichengreen, Barry. 1986. The Bank of France and the sterilization of gold, 1926-
1932. Explorations in Economic History 23: 56-84.
. 1987. The gold-exchange standard and the Great Depression. Working Paper
no. 2198 (March). Cambridge, Mass.: National Bureau of Economic Research.
Eichengreen, Barry, and T. J. Hatton. 1987. Interwar unemployment in international
perspective: An overview. In Interwar unemployment in international perspective,
ed. B. Eichengreen andT. J. Hatton, 1-59. Boston: Kluwer Academic Publishers.
Eichengreen, Barry, and Richard Portes. 1986. Debt and default in the 1930s: Causes
and consequences. European Economic Review 30: 599-640.
Eichengreen, Barry, and Jeffrey Sachs. 1985. Exchange rates and economic recovery
in the 1930s. Journal of Economic History 45: 925-46.
. 1986. Competitive devaluation in the Great Depression: A theoretical reassessment.
Economic Letters 21: 67-71.
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perfect foresight world. NBER Working Paper no. 691 (June). Cambridge, Mass.:
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States, 1867-1960. Princeton: Princeton University Press.
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B)Why the U.S. Has Launched a New Financial World War -- and How the Rest of the World Will Fight Back

By August 1971, war spending in Vietnam and other foreign countries forced the United States to suspend gold convertibility of the dollar through sales via the London Gold Pool. But largely by inertia, central banks continued to settle their payments balances in U.S. Treasury securities. After all, there was no other asset in sufficient supply to form the basis for central bank monetary reserves. But replacing gold – a pure asset – with dollar-denominated U.S. Treasury debt transformed the global financial system. It became debt-based, not asset-based. And geopolitically, the Treasury-bill standard made the United States immune from the traditional balance-of-payments and financial constraints, enabling its capital markets to become more highly debt-leveraged and “innovative.” It also enabled the U.S. Government to wage foreign policy and military campaigns without much regard for the balance of payments.

The problem is that the supply of dollar credit has become potentially infinite. The “dollar glut” has grown in proportion to the U.S. payments deficit. Growth in central bank reserves and sovereign-country funds has taken the form of recycling of dollar inflows into new purchases of U.S. Treasury securities – thereby making foreign central banks (and taxpayers) responsible for financing most of the U.S. federal budget deficit. The fact that this deficit is largely military in nature – for purposes that many foreign voters oppose – makes this lock-in particularly galling. So it hardly is surprising that foreign countries are seeking an alternative.

Contrary to most public media posturing, the U.S. payments deficit – and hence, other countries’ payments surpluses – is not primarily a trade deficit. Foreign military spending has accelerated despite the Cold War ending with dissolution of the Soviet Union in 1991. Even more important has been rising capital outflows from the United States. Banks lent to foreign governments from Third World countries, to other deficit countries to cover their national payments deficits, to private borrowers to buy the foreign infrastructure being privatized, foreign stocks and bonds, and to arbitrageurs to borrow at a low interest rate to buy higher-yielding securities abroad.

The corollary is that other countries’ balance-of-payments surpluses do not stem primarily from trade relations, but from financial speculation and a spillover of U.S. global military spending. Under these conditions the maneuvering for quick returns by banks and their arbitrage customers is distorting exchange rates for international trade. U.S. “quantitative easing” is coming to be perceived as a euphemism for a predatory financial attack on the rest of the world. Trade and currency stability are part of the “collateral damage” being caused by the Federal Reserve and Treasury flooding the economy with liquidity in their attempt to re-inflate U.S. asset prices. Faced with U.S. quantitative easing flooding the economy with reserves to “save the banks” from negative equity, all countries are obliged to act as “currency manipulators.” So much money is made by purely financial speculation that “real” economies are being destroyed.

The coming capital controls

The global financial system is being broken up as U.S. monetary officials change the rules they laid down nearly half a century ago. Prior to the United States going off gold in 1971, nobody dreamed that an economy – especially the United States – would create unlimited credit on computer keyboards and not see its currency plunge. But that is what happens under the Treasury-bill standard of international finance. Under this condition, foreign countries can prevent their currencies from rising against the dollar (thereby pricing their labor and exports out of foreign markets) only by (1) recycling dollar inflows into U.S. Treasury securities, (2) by imposing capital controls, or (3) by avoiding use of the dollar or other currencies used by financial speculators in economies promoting “quantitative easing.”

Malaysia successfully used capital controls during the 1997 Asian Crisis to prevent short-sellers from covering their bets. This confronted speculators with a short squeeze that George Soros says made him lose money on the attempted raid. Other countries are now reviewing how to impose capital controls to protect themselves from the tsunami of credit from flowing into their currencies and buying up their assets – along with gold and other commodities that are turning into vehicles for speculation rather than actual use in production. Brazil took a modest step along this path by using tax policy rather than outright capital controls when it taxed foreign buyers of its bonds last week.

If other nations take this route, it will reverse the policy of open and unprotected capital markets adopted after World War II. This trend threatens to lead to the kind of international monetary practice found from the 1930s into the ‘50s: dual exchange rates, one for financial movements and another for trade. It probably would mean replacing the IMF, World Bank and WTO with a new set of institutions, isolating U.S., British and Eurozone representation.

To defend itself, the IMF is proposing to act as a “central bank” creating what was called “paper gold” in the late 1960s – artificial credit in the form of Special Drawing Rights (SDRs). However, other countries already have complained that voting control remains dominated by the major promoters of arbitrage speculation – the United States, Britain and Eurozone. And the IMF’s Articles of Agreement prevent countries from protecting themselves, characterizing this as “interfering” with “open capital markets.” So the impasse reached this weekend appears to be permanent. As one report summarized matters: “‘There is only one obstacle, which is the agreement of the members,’ said a frustrated Kahn .”

Paul Martin, the former Canadian prime minister who helped create the G20 after the 1997-1998 Asian financial crisis, said “said the big powers were largely immune to being named andshamed.” And in a Financial Times interview Mohamed El Erian, a former senior IMF official and now chief executive of Pimco said, “You have a burst pipe behind the wall and the water is coming out. You have to fix the pipe, not just patch the wall.”

The BRIC countries are simply creating their own parallel system. In September, China supported a Russian proposal to start direct trading between the yuan and the ruble. It has brokered a similar deal with Brazil. And on the eve of the IMF meetings in Washington on Friday, October 8, Chinese Premier Wen stopped off in Istanbul to reach agreement with Turkish Prime Minister Erdogan to use their own currencies in tripling Turkish-Chinese trade to $50 billion over the next five years, effectively excluding the U.S. dollar. “We are forming an economic strategic partnership … In all of our relations, we have agreed to use the lira and yuan,” Mr. Erdogan said.

On the deepest economic lane, the present global financial breakdown is part of the price to be paid for the Federal Reserve and U.S. Treasury refusing to accept a prime axiom of banking: Debts that cannot be paid, won’t be. They tried to “save” the banking system from debt write-downs in 2008 by keeping the debt overhead in place. The resulting repayment burden continues to shrink the U.S. economy, while the Fed’s way to help the banks “earn their way out of negative equity” has been to fuel a flood of international financial speculation. Faced with normalizing world trade or providing opportunities for predatory finance, the U.S. and Britain have thrown their weigh behind the latter. Targeted economies understandably seeking alternative arrangements.

THE END

Michael Hudson is a former Wall Street economist. A Distinguished Research Professor at University of Missouri, Kansas City (UMKC), he is the author of many books, including Super Imperialism: The Economic Strategy of American Empire (new ed., Pluto Press, 2002) and Trade, Development and Foreign Debt: A History of Theories of Polarization v. Convergence in the World Economy . He can be reached via his website,mh@michael-hudson.com

Labels: BOOKS

Wednesday, December 12, 2012

THINKING IN THE BOX (D)

(BEING CONTINUED FROM 11/10/12)

A)The Gold Standard, Deflation, and Financial Crisis in the Great Depression:

Crises

Financial crises were of course a prominent feature of the interwar period.

We focus in this section on the problems of the banking sector and, to a lesser

extent, on the problems of domestic debtors in general, as suggested by the

discussion above. Stock market crashes and defaults on external debt were

also important, of course, but for the sake of space will take a subsidiary role

here.

Table 2.7 gives a chronology of some important interwar banking crises.

The episodes listed actually cover a considerable range in terms of severity, as

the capsule descriptions should make clear. However the chronology should

also show that (i) quite a few different countries experienced significant banking

problems during the interwar period; and (ii) these problems reached a

very sharp peak between the spring and fall of 1931, following the Creditanstalt

crisis in May 1931 as well as the intensification of banking problems in

Germany.

A statistical indicator of banking problems, emphasized by Friedman and

Schwartz (1963), is the deposit-currency ratio. Data on the changes in the

commercial bank deposit-currency ratio for our panel of countries are presented

in table 2.8. It is interesting to compare this table with the chronology

in table 2.7. Most but not all of the major banking crises were associated with

sharp drops in the deposit-currency ratio; the most important exception is in

1931 in Italy, where the government was able to keep secret much of the banking

system's problems until a government takeover was affected. On the other

hand, there were also significant drops in the deposit-currency ratio that were

not associated with panics; restructurings of the banking system and exchange

rate difficulties account for some of these episodes.

What caused the banking panics? At one level, the panics were an endogenous

response to deflation and the operation of the gold standard regime.

When the peak of the world banking crisis came in 1931, there had already

been almost two years of deflation and accompanying depression. Consistent

with the analysis at the end of the last section, falling prices lowered the nominal

value of bank assets but not the nominal value of bank liabilities. In addition,

the rules of the gold standard severely limited the ability of central

banks to ameliorate panics by acting as a lender of last resort; indeed, since

banking panics often coincided with exchange crises (as we discuss further

below), in order to maintain convertibility central banks typically

tightened

monetary policy in the face of panics. Supporting the connection of banking

problems with deflation and "rules of the game" constraints is the observation

that there were virtually no serious banking panics in any country after aban

donment of the gold standard—although it is also true that by time the gold

standard was abandoned, strong financial reform measures had been taken in

most countries.

However, while deflation and adherence to the gold standard were necessary

conditions for panics, they were not sufficient; a number of countries

made it through the interwar period without significant bank runs or failures,

despite being subject to deflationary shocks similar to those experienced by

the countries with banking problems.15

Several factors help to explain which

countries were the ones to suffer panics.

1.Banking structure.
The organization of the banking system was an important

factor in determining vulnerability to panics. First, countries with

"unit banking," that is, with a large number of small and relatively undiversified

banks, suffered more severe banking panics. The leading example is of

course the United States, where concentration in banking was very low, but a

high incidence of failures among small banks was also seen in other countries

(e.g., France). Canada, with branch banking, suffered no bank failures during

the Depression (although many branches were closed). Sweden and the

United Kingdom also benefited from a greater dispersion of risk through

branch systems.16

Second, where "universal" or "mixed" banking on the German or Belgian

model was the norm, it appears that vulnerability to deflation was greater. In

contrast to the Anglo-Saxon model of banking, where at least in theory lending

was short term and the relationship between banks and corporations had

an arm's length character, universal banks took long-term and sometimes

dominant ownership positions in client firms. Universal bank assets included

both long-term securities and equity participations; the former tended to become

illiquid during a crisis, while the latter exposed universal banks (unlike

Anglo-Saxon banks, which held mainly debt instruments) to the effects of

stock market crashes. The most extreme case was probably Austria. By 1931,

after a series of mergers, the infamous Creditanstalt was better thought of as a

vast holding company rather than a bank; at the time of its failure in May

1931, the Creditanstalt owned sixty-four companies, amounting to 65% of

Austria's nominal capital (Kindleberger 1984).

2.Reliance of banks on short-term foreign liabilities.
Some of the most

serious banking problems were experienced in countries in which a substantial

fraction of deposits were foreign-owned. The so-called hot money was more

sensitive to adverse financial developments than were domestic deposits.

Runs by foreign depositors represented not only a loss to the banking system

but also, typically, a loss of reserves; as we have noted, this additional external

threat restricted the ability of the central bank to respond to the banking situation.

Thus, banking crises and exchange rate crises became intertwined.

The resolution of a number of the central European banking crises required

"standstill agreements," under which withdrawals by foreign creditors were

blocked pending future negotiation.

International linkages were important on the asset side of bank balance

sheets as well. Many continental banks were severely affected by the crises in

Austria and Germany, in particular.

3.Financial and economic experience of the 1920s.
It should not be particularly

surprising that countries which emerged from the 1920s in relatively

weaker condition were more vulnerable to panics. Austria, Germany, Hungary,

and Poland all suffered hyperinflation and economic dislocation in the

1930s, and all suffered severe banking panics in 1931. While space constraints

do not permit a full discussion of the point here, it does seem clear that the

origins of the European financial crisis were at least partly independent of

American developments—which argues against a purely American-centered

explanation of the origins of the Depression.

It should also be emphasized, though, that not just the existence of financial

difficulties during the 1920s but also the policy response to those difficulties

was important. Austria is probably the most extreme case of nagging banking

problems being repeatedly "papered over." That country had banking prob

lems throughout the 1920s, which were handled principally by merging failing

banks into still-solvent banks. An enforced merger of the Austrian Bodencreditanstalt

with two failing banks in 1927 weakened that institution,

which was part of the reason that the Bodencreditanstalt in turn had to be

forceably merged with the Creditanstalt in 1929. The insolvency of the Creditanstalt,

finally revealed when a director refused to sign an "optimistic" financial

statement in May 1931, sparked the most intense phase of the European

crisis.

In contrast, when banking troubles during the earlier part of the 1920s were

met with fundamental reform, performance of the banking sector during the

Depression was better. Examples were Sweden, Japan, and the Netherlands,

all of which had significant banking problems during the 1920s but responded

by fundamental restructurings and assistance to place banks on a sound footing

(and to close the weakest banks). Possibly because of these earlier events,

these three countries had limited problems in the 1930s. A large Swedish bank

(Skandinaviska Kreditaktiebolaget) suffered heavy losses after the collapse of

the Kreuger financial empire, and a medium-sized Dutch bank (Amstelbank)

failed because of its connection to the Creditanstalt; but there were no widespread

panics, only isolated failures.

A particularly interesting comparison in this regard is between the Netherlands

and neighboring Belgium, where banking problems persisted from 1931

to 1935 and where the ultimate devaluation of the Belgian franc was the result

of an attempt to protect banks from further drains. Both countries were heavily

dependent on foreign trade and both remained on gold, yet the Netherlands

did much better than Belgium in the early part of the Depression (see

table 2.4). This is a bit of evidence for the relevance of banking difficulties to

output.

Overall, while banking crises were surely an endogenous response to

depression, the incidence of crisis across countries reflected a variety of institutional

factors and other preconditions. Thus it will be of interest to compare

the real effects of deflation between countries with and without severe banking

difficulties.

On "debt deflation," that is, the problems of nonfmancial borrowers, much

less has been written than on the banking crises. Only for the United States

has the debt problem in the 1930s been fairly well documented (see the summary

in Bernanke 1983 and the references therein). In that country, large corporations

avoided serious difficulties, but most other sectors—small businesses,

farmers, mortgage borrowers, state and local governments—were

severely affected, with usually something close to half of outstanding debts

being in default. A substantial portion of New Deal reforms consisted of various

forms of debt adjustment and relief.

For other countries, there are plenty of anecdotes but not much systematic

data. Aggregate data on bankruptcies and defaults are difficult to interpret

because increasing financial distress forced changes in bankruptcy practices

and procedures; when the League of Nations.

Monthly Bulletin of Statistics

dropped its table on bankruptcies in its December 1932 issue, for example,

the reason given therein was that "the numerous forms of agreement by which

open bankruptcies are now avoided have seriously diminished the value of the

table" (p. 529). Perhaps the most extreme case of a change in rules was Rumania's

April 1932 Law on Conversion of Debts, which essentially eliminated

the right of creditors to force bankruptcy. Changes in the treatment of bankruptcy

no doubt ameliorated the effects of debt default, but the fact that these

changes occurred indicates that the perceived problem must have been severe.

More detailed country-by-country study of the effects of deflation on firm balance

sheets and the relation of financial condition to firm investment, production,

and employment decisions—where the data permit—would be extremely

valuable. A similar comment applies to external debt problems,

although here interesting recent work by Eichengreen and Portes (1986) and

others gives us a much better base of knowledge to build on than is available

for the case of domestic debts.

Author: Ben Bemanke, Harold JamesConference

Date: March 22-24,1990

Ben Bemanke is professor of economics and public affairs at Princeton University and a research

associate of the National Bureau of Economic Research. Harold James is assistant professor

of history at Princeton University.

The authors thank

David Fernandez, Mark Griffiths, and Holger Wolf for invaluable research

assistance.

Support was provided by the National Bureau of Economic Research and the National

Science Foundation.

Notes

15. In the next section we divide our sample into two groups: eleven countries with

serious banking problems and thirteen countries without these problems. In 1930, the

year before the peak of the banking crises, the countries that were to avoid banking

problems suffered on average a 12% deflation and a 6% fall in industrial production;

the comparable numbers for the group that was to experience panics were 13% and

8%. Thus, there was no large difference between the two groups early in the Depression.

In contrast, in 1932 (the year following the most intense banking crises), industrial

production growth in countries without banking crises averaged -2%; in the

group that experienced crises the comparable number was — 16%.

16. Although this correlation seems to hold during the Depression, we do not want

to conclude unconditionally that branch banking is more stable; branching facilitates

diversification but also increases the risk that problems in a few large banks may bring

down the entire network

B)Why the U.S. Has Launched a New Financial World War -- and How the Rest of the World Will Fight Back

U.S. officials say that this is all part of the free market. “It is not good for the world for the burden of solving this broader problem … to rest on the shoulders of the United States,” insisted Treasury Secretary Tim Geithner on Wednesday.

So other countries are solving the problem on their own. Japan is trying to hold down its exchange rate by selling yen and buying U.S. Treasury bonds in the face of its carry trade being unwound as arbitrageurs are paying back the yen that they earlier borrowed to buy higher-yielding but increasingly risky sovereign debt from countries such as Greece. Paying back these arbitrage loans has pushed up the yen’s exchange rate by 12 per cent against the dollar so far during 2010. On Tuesday, October 5, Bank of Japan governor Masaaki Shirakawa announced that Japan had “no choice” but to “spend 5 trillion yen ($60 billion) to buy government bonds, corporate IOUs, real-estate investment trust funds and exchange-traded funds – the latter two a departure from past practice.”

This “sterilization” of unwanted financial speculation is precisely what the United States has criticized China for doing. China has tried more “normal” ways to recycle its trade surplus, by seeking out U.S. companies to buy. But Congress would not let CNOOC buy into U.S. oil refinery capacity a few years ago, and the Canadian government is now being urged to block China’s attempt to purchase its potash resources. This leaves little option for China and other countries but to hold their currencies stable by purchasing U.S. and European government bonds.

This has become the problem for all countries today. As presently structured, the international financial system rewards speculation and makes it difficult for central banks to maintain stability without forced loans to the U.S. Government that has long enjoyed a near monopoly in providing central bank reserves. As noted earlier, arbitrageurs obtain a twofold gain: the arbitrage margin between Brazil’s nearly 12 per cent yield on its long-term government bonds and the cost of U.S. credit (1 per cent), plus the foreign-exchange gain resulting from the fact that the outflow from dollars into reals has pushed up the real’s exchange rate some 30 per cent – from R$2.50 at the start of 2009 to $1.75 last week. Taking into account the ability to leverage $1 million of one’s own equity investment to buy $100 million of foreign securities, the rate of return is 3000 per cent since January 2009.

Brazil has been more a victim than a beneficiary of what is euphemized as a “capital inflow.” The inflow of foreign money has pushed up the real by 4 per cent in just over a month (from September 1 through early October). The past year’s run-up has eroded the competitiveness of Brazilian exports, prompting the government to impose 4 per cent tax on foreign purchases of its bonds on October 4 to deter the currency’s rise. “It’s not only a currency war,” Finance Minister Guido Mantega said on Monday. “It tends to become a trade war and this is our concern.” And Thailand’s central bank director Wongwatoo Potirat warned that his country was considering similar taxes and currency trade restrictions to stem the baht’s rise, and Subir Gokarn, deputy governor of the Reserve Bank of India announced that his country also was reviewing defenses against the “potential threat” of inward capital flows.”

Such inflows do not provide capital for tangible investment. They are predatory, and cause currency fluctuation that disrupts trade patterns while creating enormous trading profits for large financial institutions and their customers. Yet most discussions of exchange rate treat the balance of payments and exchange rates as if they were determined purely by commodity trade and “purchasing power parity,” not by the financial flows and military spending that actually dominate the balance of payments. The reality is that today’s financial interregnum – anarchic “free” markets prior to countries hurriedly putting up their own monetary defenses – provides the arbitrage opportunity of the century. This is what bank lobbyists have been pressing for. It has little to do with the welfare of workers.

The potentially largest speculative prize of all promises to be an upward revaluation of China’s renminbi. The House Ways and Means Committee is backing this gamble, by demanding that China raise its exchange rate by the 20 per cent that the Treasury and Federal Reserve are suggesting. A revaluation of this magnitude would enable speculators to put down 1 per cent equity – say, $1 million to borrow $99 million and buy Chinese renminbi forward. The revaluation being demanded would produce a 2000 per cent profit of $20 million by turning the $100 million bet (and just $1 million “serious money”) into $120 million. Banks can trade on much larger, nearly infinitely leveraged margins, much like drawing up CDO swaps and other derivative plays.

This kind of money already has been made by speculating on Brazilian, Indian and Chinese securities and those of other countries whose exchange rates have been forced up by credit-flight out of the dollar, which has fallen by 7 per cent against a basket of currencies since early September when the Federal Reserve floated the prospect of quantitative easing. During the week leading up to the IMF meetings in Washington, the Thai baht and Indian rupee soared in anticipation that the United States and Britain would block any attempts by foreign countries to change the financial system and curb disruptive currency gambling.

This capital outflow from the United States has indeed helped domestic banks rebuild their balance sheets, as the Fed intended. But in the process the international financial system has been victimized as collateral damage. This prompted Chinese officials to counter U.S. attempts to blame it for running a trade surplus by retorting that U.S. financial aggression “risked bringing mutual destruction upon the great economic powers.

From the gold-exchange standard to the Treasury-bill standard to “free credit” anarchy

Indeed, the standoff between the United States and other countries at the IMF meetings in Washington this weekend threatens to cause the most serious rupture since the breakdown of the London Monetary Conference in 1933. The global financial system threatens once again to break apart, deranging the world’s trade and investment relationships – or to take a new form that will leave the United States isolated in the face of its structural long-term balance-of-payments deficit.

This crisis provides an opportunity – indeed, a need – to step back and review the longue durée of international financial evolution to see where past trends are leading and what paths need to be re-tracked. For many centuries prior to 1971, nations settled their balance of payments in gold or silver. This “money of the world,” as Sir James Steuart called gold in 1767, formed the basis of domestic currency as well. Until 1971 each U.S. Federal Reserve note was backed 25 per cent by gold, valued at $35 an ounce. Countries had to obtain gold by running trade and payments surpluses in order to increase their money supply to facilitate general economic expansion. And when they ran trade deficits or undertook military campaigns, central banks restricted the supply of domestic credit to raise interest rates and attract foreign financial inflows.

As long as this behavioral condition remained in place, the international financial system operated fairly smoothly under checks and balances, albeit under “stop-go” policies when business expansions led to trade and payments deficits. Countries running such deficits raised their interest rates to attract foreign capital, while slashing government spending, raising taxes on consumers and slowing the domestic economy so as to reduce the purchase of imports.

What destabilized this system was war spending. War-related transactions spanning World Wars I and II enabled the United States to accumulate some 80 per cent of the world’s monetary gold by 1950. This made the dollar a virtual proxy for gold. But after the Korean War broke out, U.S. overseas military spending accounted for the entire payments deficit during the 1950s and ‘60s and early ‘70s. Private-sector trade and investment was exactly in balance.