What Keynes Got Right (Much As It Pains Me to Say It)
posted by Nate Oman
I recently read Liaquat Ahamed’s The Lord’s of Finance: The Bankers Who Broke the World, which is basically a collective biography of the world’s top central bankers in the 1920s and early 1930s. It is a good read, especially if you want to understand what Ben Berneke is terrified of becoming. Ahmad, however, doesn’t quite deliver on his central thesis, which is that bad monetary policy by central bankers caused the Great Depression. Here is what I think the book actually shows:
World War I caused the Great Depression, or at least it caused the financial crises that accompanied the Great Depression. In particular, World War I created three huge problems for the international financial system. First, during the course of the war the United States built up huge gold reserves and the gold reserves of the major European economies contracted massively. Second, it created huge debts owed by the Allies to the United States. Third, the system of reparations created by the Treaty of Versailles created a huge debt burden for Germany. These three economic forces ultimately lay behind the enormous pressures placed on the world’s financial system in the 1920s and 1930s.
The book also shows that the gold standard was a really bad idea, especially for Britain. After the war, Germany, the UK, and France all pursued different monetary policies. The Weimar Republic, which lacked broad political legitimacy, decided to spend money hog wild on various forms of government benefits as a way of buying the loyalty of key constituencies. As a result it ran huge budget deficits, which it filled by printing money on a gargantuan scale.
Britain went to the opposite extreme, returning to the gold standard at pre-war levels. This was catastrophic. The government debt of the war years had fueled inflation, and the only way to peg sterling at pre-war levels was to massively contract the monetary supply. In effect, the Bank of England deliberately caused recessions and unemployment for the sake of the gold standard. The sinister reading of this is that the Bank pursued this policy to protect the City of London’s dominant position as a financial center. The loss of gold to the U.S. during the war, however, meant that it could only protect the City by pushing up the value of the currency at the expense of the rest of the country. A less sinister – and ultimately more plausible explanation – is that the Bank of England had an arational faith in the power of the gold standard and was convinced that national honor and prestige was at stake in pegging sterling at the pre-war level.
Finally there were France and the United States. France opted for a moderate devaluation of the franc, returning to the gold standard but not at the prewar levels. This gave them monetary stability (avoiding the German problem) while avoiding tight-money induced recession and unemployment (Britain). Furthermore, as the French economy rebounded after the war, gold flowed in allowing French banks to supply credit without threatening the franc. In the United States, in contrast, the vast store of gold built up during the war meant that American banks could expand credit enormously without placing pressure on the dollar. Furthermore, there was European pressure on the United States to pursue loose money policies because Germany was dependent on borrowing from America to meet its reparation obligations, France and Britain, in turn, looked to revenue from reparations to repay their debts to the United States. The problem, of course, is that loose money in the United States helped to fuel bubbles in residential real estate and stock prices.
At the bottom of these monetary decisions was the gold standard, which demanded that the supply of money in the economy be based not on the demand for credit, the business cycle, the growth rate, or any other measure of economic reality. Rather, money supply grew or contracted based on how much shinny metal a central bank happened to hold it is vault.
If the financial consequences of World War I and the gold standard were the underlying factors driving financial crisis, the book shows that policy makers reacted badly to those crises. The lead villain, I think, was Calvin Coolidge and the general unwillingness of the United States to forgive European war debts. The bottom line was that World War I bankrupted the Allied powers in Europe. Rather than sitting down and working out reasonable reorgization plan, the United States acted like the idiot creditor who blithely demands payment in full as the debtor’s business implodes. Following closely behind the American refusal to renegotiate come the central bankers and their missteps. For the Bank of England, the gold standard became an idée fixe, a way of recapturing lost Edwardian glory. The over-valuation of sterling then placed huge pressures on the British economy, as well as pressures on other central banks to make loans to the Bank of England to retain their gold reserves. The Americans were willing to do so, at least for a time. The French were not. Indeed, French central bankers seem to have seen France’s accumulated gold reserves as a political weapon to be used to chasten an overweening Britain or else to threaten Germany with financial catastrophe at will, by using French gold to lure depositors out of the German banking system. Finally, the Fed found itself trying to do several things at once. First, they kept interest rates down, mainly so that over extended Europeans – in particular the Bank of England and the German government – could borrow the money they needed in large part to repay war debts to the United States. Second, at the same time there was also European pressure for the United States to raise rates. The low rates fueled a bubble in American stock market, whose returns sucked in huge amounts of European capital. Needless to say, these pressures pointed in diametrically opposite directions.
Finally, the book shows the extent to which John Maynard Keynes was right. I am not a big fan of Keynsianism. I learned to think about his theories through the prism of the late 1970s, when they broke down so spectacularly. Furthermore, I think that Keynes was terribly naive about political economy, a fact testified to by the way in which his theories are used to justify an expanded state. Strictly speaking, it doesn’t seem to me that Keynes tells us much about whether the state should constitute say about 35 percent of GDP (roughly the level in the US) of 57 percent of GDP (roughly the level in France). Keynes simply says that we should engage in counter-cyclical government spending. Nevertheless, Keynes is often invoked to expand the size of the state.
That said, seeing Keynes from 1919 to 1933, it is hard not to appreciate the iconoclastic brilliance of the man. He was right about the insanity of reparations. (As he predicted, they weren’t ultimately paid and they were politically poisonous.) He was right about the insanity of the United States’ refusal to renegotiate war debts (or its refusal to renegotiate them more quickly and more generously). Finally, he was spectacularly right about the insanity of the gold standard. Not a bad accomplishment that, even when one throws the pathos of the Carter Administration into the scales on the other side.
March 9, 2010 at 11:45 am
Posted in: Articles and Books
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