Lesson from Interwar Britain∗

How Depressions End: Lesson from Interwar Britain∗

George, Chouliarakis

Chairman of the Council of Economic Advisers, Greece The University of Manchester † Tadeusz, Gwiazdowski

The University of Manchester‡

April 2015 PRELIMINARY VERSION: Please do not quote or circulate.

Abstract

The forces driving the recovery from the Great Depression in Britain have been the subject of a long and intense debate. Yet, one factor that has been largely neglected is the possible effects on price expectations, and therefore real interest rates, of the decision of the government to commit to a price-level target – a policy initiative akin to what we now know as “forward guidance” (Howson, 1975; Crafts, 2013). Did this commitment to a price-level target constitute a credible policy regime change that shaped expectations and stimulated household consumption and investment just as happened in the USA following Roosevelt’s decision to exit the Gold Standard (Temin and Wigmore, 1990 and Eggertsson, 2008)? We study this question with the use of a small scale Dynamic Stochastic General Equilibrium model that includes households, ﬁrms and a government. We model the policy dogmas of the gold standard and balanced budgets and, in so doing, we analyse whether a policy regime change occurred in Britain in 1932 that stimulated aggregate economic activity. We also estimate the size of the government spending multiplier and consider its implications for the effectiveness of the government works programme proposed by Lloyd George in 1929 and ﬁnd evidence supporting recent empirical work by Crafts and Mills (2013) that the multiplier was below unity. Our paper shows that the expectation effect of unconventional policy initiatives can explain a good deal of the pace of economic recovery in Britain in the 1930s.

JEL-Classiﬁcation: D84, E61, F41, H12, N14. Keywords: Regime Change, Business Cycles, Exchange Rate Policy, Fiscal Policy, Great De- pression, Britain.

∗We are grateful to the following people for their comments and helpful advice in preparing this research: Keith Blackburn, Sama Bombaywala, Barry Eichengreen, Christoph Himmels, Paul Middleditch and Albrecht Ritschl, †Arthur Lewis Building, 3rd Floor, School of Social Sciences, The University of Manchester, Manchester, M13 9PL. E-mail address:[email protected] ‡Address as above. E-mail address:[email protected]

1 1 Introduction

In the wake of the Great Recession of 2007-10, a good number of European economies have experienced economic conditions that are reminiscent of the interwar period. Sharp and persistent declines in output, disruption in financial markets, mass unemployment and price deflation despite zero policy interest rates. The state of these economies brought in the forefront an old question: how can economies that operate at the zero nominal lower bound, with little or no fiscal space, recover from depression? Which policy initiatives can sustain aggregate economic activity in the absence of conventional monetary expansion or fiscal stimulus? In this paper, we seek answers to these questions with the aid of history. In particular, we study the experi- ence of interwar Britain, an economy that, unlike others, recovered from the Great Depression relatively vigorously. We do so, through the lens of a small scale Dynamic Stochastic Gen- eral Equilibrium (DSGE) model and with particular focus on the effects of the government’s commitment to do whatever it takes until the price level returns to its 1929 level.

The forces driving the recovery from the Great Depression in Britain have been the subject of a long and intense debate. Yet, one factor that has been largely neglected is the possible effects on price expectations, and therefore real interest rates, of the decision of the government to commit to a price-level target – a policy initiative akin to what we now know as “forward guidance” (Howson, 1975; Crafts, 2013). Did this commitment to a price-level target constitute a credible policy regime change that shaped expectations and stimulated household consumption and investment just as happened in the USA following Roosevelt’s decision to exit the Gold Standard (Temin and Wigmore, 1990 and Eggertsson, 2008)? We study this question with the use of a small scale DSGE model that includes households, ﬁrms and a government. We model the policy dogmas of the gold standard and balanced budgets and, in so doing, we analyse whether a policy regime change occurred in Britain in 1932 that stimulated aggregate economic activity. We also estimate the size of the government spending multiplier in the DSGE model and consider its implications for the effectiveness of the government works programme proposed by Lloyd George in 1929. We ﬁnd evidence supporting recent empirical work by Crafts and Mills (2013) that the multiplier was below unity, casting further doubt upon whether Lloyd George could have done it.

Although the expectation effect of unconventional policy initiatives can explain a good deal of the pace of economic recovery our paper also identiﬁes that there were two distinct phases in Britain’s regime change after exit from the gold standard. Key macroeconomic indicators in Figure 1 suggest a signiﬁcant positive change in economic activity and business expectations in September 1931 upon exit from the gold standard after which the recovery stalls and re- verses before a new sustained recovery begins after June 1932. Figure 1 shows Real GDP, the Wholesale Price Index (WPI), production of iron and Old Staple (Coal, Iron and Steel) shares suddenly spike in September 1931. For example there is a sudden break in the WPI, which

2 had declined by 34% since its March 1929 peak, before rising by 9% over its September 1931 level by February 1932. Similarly, iron production had declined 64% from its October 1929 peak, before rising 35% above its September 1931 low by March 1932. Old Staple shares had declined fully 55% between April 1928 and August 1931, before climbing over 50% above its trough by October. By February most of the indicators had peaked and quickly resumed their downward slide. The first indicators of a new and sustained recovery occur in June 1932, the month all four stocks and shares time-series hit their lowest value before recovering (Panel D, Figure 1). The WPI also hits a new low in June before recovering again whereas production of iron and steel recovers from August and Real GDP and industrial production recover after their reaching their trough in September 1932. Unlike the brief recovery after September 1931 the recovery of the British economy from the second half of 1932 is sustained and Real GDP recovers to a level above its January 1930 peak by January 1934. Can changes in British policy after September 1931 help explain these two phases of regime change and recovery? From September 1931 policy was distinctly anti-inflationary, symbolized by a large rise in interest rates and continued budgetary orthodoxy whilst policy makers contemplated the optimal policy to pursue once a necessary phase of consolidation, contemplation and economic housekeeping was completed. This period saw a strong national government returned in the October 1931 General Election, the early repayment of credits to the Bank of France and the Federal Reserve by March, and later the announcement of the conversion of the burdensome 5% War Loan to a 3.5% loan in June. In stark contrast sustained recovery only took place after several important institutional changes and policy changes had taken effect between September 1931 and June 1932 that together formed the new Managed Economy strategy; the implementation of which was completed by mid-1932. The components of the Managed Economy strategy include first of all the Treasury taking over responsibility for long-run policy from the Bank of England in September 1931, second, the Bank Rate decreasing from 6% to 2% between February and June 1932, third, the institution of the Exchange Equalization Account (EEA) being established in April 1932 with the target of depreciating and stabilizing the value of sterling, and finally, the Chancellor announcing an explicit price level target. An important question to ask is whether a potential “regime change” leading to sustained recovery was choked off between September 1931 and February 1932 or whether fears of runaway inflation and economic chaos justified the cautious and prudent policies pursued by British policymakers during the immediate period after the gold standard exit? A second question is how large were the expectation effect of the unconventional policy initiatives of exchange rate intervention and a price level target once the transition to the Managed Economy strategy was completed?

In the early 1930s Britain also faced the problem of a lower bound on interest rates (see Crafts (2013) and Figure 2). Research surrounding optimal policy in a liquidity trap has been intense and various potential roots to recovery abound. These includes the policy of quantitative easing (Gertler and Kerardi 2011), the potential for ﬁscal stimulus (Christiano, Eichenbaum and

3 Rebello 2009) and the use of exchange rate policy (Coenen and Wieland 2002; Crafts 2013; Svensson 2003). The concept of quantitative easing was yet to be developed in the 1930s and due to high public sector debt fiscal policy could not come to the aid of the economy; the concept of discretionary fiscal policy was also a new and radical notion. Therefore British policy makers had to focus upon exchange rate policy, this is how Crafts suggests Britain created inflationary expectations to end deflation and reduce real interest rates thus stimulating private spending in Britain from the second half of 1932; akin to Svensson’s “Foolproof Way” to escape from a liquidity trap. Svensson (2003) identifies several methods by which economies can escape the constraints of a zero lower bound on interest. The greatest challenge a policy maker faces is making these policies credible enough to convince the private sector it won’t cheat on any inflationary policy promise that is used to end deflation. The policy maker must pursue a policy Eggertsson (2006) coins “committing to being irresponsible”. Svensson’s “Foolproof Way” is foolproof because it suggests “combining a price level target path, a currency depreciation and a crawling peg, and an exit strategy” and the currency depreciation in particular “serves as a conspicuous commitment to a higher price level in the future” (Svensson 2003).

Therefore in this paper we first document the transition from the currency crisis that hit the British economy in the summer of 1931 to the Managed Economy strategy whose implementation was completed by the second half of 1932. We outline the key institutional changes and policy changes that took place when implementing the Managed Economy strategy and show how they align to Svensson “Foolproof Way” of escaping the liquidity trap a´ la Crafts (2013). In section 3 we outline a small open economy DSGE model of Interwar Britain. In section 4 we present the results of a counterfactual simulation of the British economy between 1925Q1 and 1938Q4 using the model outlined in section 3. In the counterfactual simulation we use data to replicate the large deflationary shocks that hit the British economy from 1925Q1 and also the large world trade shocks that began in 1929Q3. We then outline the three policy regimes used in the counterfactual analysis. In the first we run the simulation as if Britain somehow managed to remain on the gold standard after 1931Q3, in the second we consider the path the British economy may have taken had Britain implemented a non-activist shadow peg after 1931Q3 (a policy option discussed by Howson (1975)), in the third regime we implement a policy rule that seeks to resemble the Managed Economy strategy by incorporating a price level target and the exchange rate intervention of the EEA. Results suggest that had Britain remained on gold recovery from the global recession and international financial crisis would have been slow and painful and the path of the economy very much resembles that of France up to 1936. The shadow peg regime see a less severe downturn but also a less robust recovery than that observed in the data. Finally the simulation of the pro-active Managed Economy strategy sees both a less severe deflation than the other two regimes, a more robust recovery in output and a better match to the data over the period of analysis. The overall results from the simulation suggest that economies experiencing severe difficulties due the presence of deflation, large output

4 losses, a liquidity trap, and little or no ﬁscal space can, and perhaps should, use unconventional means and activist policies to stimulate the economy via expectations management and other unorthodox policy measures.

2 Regime Changes - From Crisis to Cheap Money

Although Keynes had described the Gold Standard as a “barbarous relic” as early as 1923 (Keynes 1933) Britain in every way can be thought of as having done everything it could to remain on gold. This included restrictive policies of balanced budgets and high interest rates when these were not in the interests of the domestic economy. There were even successful attempts by central bankers to persuade the US to lower interest rates in the 1920s to aid the British economy (Eichengreen 2014). However, in 1928 the US raised interest rates in response to potential excesses on Wall Street and through fear of an outflow of capital Britain was forced to follow suit. By early October 1929 the new Labour government established the MacMillan Committee to investigate the difficulties and possible solutions to the problems currently being experienced by the British economy. Later in the month Wall Street crashed. This order of events clearly emphasizes that Britain was experiencing severe difficulties even before the onset of the Great Depression. Nevertheless the already suffering British export industry was hit by the severe contraction in world trade and unemployment rose further than the historically high average of around 8 per cent in the 1920s (Hatton and Thomas 2010). Though there were some early indications of recovery in 1930, recovery never materialized. In 1931 British policy makers were aware of the steady trickle of reserves leaving London and already in January the government was aware of the potential for a currency crisis (Howson and Winch 1977). Chancellor Phillip Snowden set up the May Committee on National Expenditure in February 1931 to examine public finances. There was intense debate about the best policies to aid the ailing British economy. These included: reform to the unemployment benefits system, reducing wages, rationalization of industry, the introduction of a tariff and the conversion of the 5 per cent War Loan to ease the interest burden placed upon public finances (Howson and Winch 1977). Nevertheless domestic considerations were soon overshadowed by the looming financial crisis in central Europe.

2.1 Financial Crisis

The Austrian Bank Credit Anstalt failed on 13th May 1931, the crisis was contained but a new crisis began in Germany where panic was only ended following the closure of the banking system on 13th July. The spotlight then turned to Britain where the MacMillan Committee report was published on 13th July highlighting Britain’s exposure to Germany and a high level

5 of short run debt in London. Soon afterwards a currency crisis began as funds began leaving London with the Bank of England forced to prop up the exchange rate with increasing amounts of gold reserves. It was hoped the announcement of credits on 1st August from the Bank of France and the Federal Reserves would calm the panic of investors. However the publication of the May Committee Report on public finances on the same day highlighted a £120m black hole in the already strained public finances. The need for further austerity when Britain already had high tax levels and had implemented significant expenditure cuts ultimately led to the downfall of the Labour government, unable to agree to cuts to unemployment benefits the cabinet was split 9 to 11 and a National Government was formed almost immediately in late August 1931. Renewed confidence in Britain and further emergency credits and an austerity budget containing savings of £76m was not enough to save Britain’s membership of the Gold Standard. Wage reductions for sailors led to the Invergordon Mutiny where sailors had refused to take orders. This news shocked investors and undermined confidence in Britain’s ability to control its public finances. At this stage the British economy was stretched to the limit with continued high public debt levels, unemployment of 15% in 1931, high taxes, cuts to expenditure, rigid nominal wages with wholesale prices having declined 14% in the last year alone, retail prices 8% and exports having declined fully 43% from their 1929Q3 peak. On 21st September the Gold Standard (Amendment) Act took Britain off the Gold Standard.

2.2 Consolidation, contemplation and housekeeping

The immediate expectation could be that Britain would use its new found freedom from the shackles of the gold standard to pursue inﬂationary and expansionary policies. The small rise in wholesale and retail prices and the sudden surge in stock prices suggest private agents may have believed the same. However it was now that British policy makers entered a period of consolidation, contemplation and housekeeping. This is understandable given the gold standard had been axiomatic and associated with prosperity in Britain’s golden age. As Eggertsson (2008) emphasizes for US policy makers it is difﬁcult to underestimate how dogmatic belief in the gold standard was at this time. This is expressed by several economists of the 1930s and subsequent academic publications in the UK:

“In the conditions of the world before 1914 the gold standard worked remarkably well. Stability of the exchange rates was maintained with so little conscious effort that is came to be regarded as natural” (Crowther 1941, 343-4).

“Henderson believed that the abandonment of the gold standard would have ‘formidable and enduring’ consequences, he considered that the only course open to the government was to balance the budget by a combination of ‘substantial and unpopular’ economies and tax increases” (Howson and Winch, 1977).

6 The great fear of policy makers was of runaway inflation. The shock of gold standard exit combined with the fact that it was less than a decade since the European hyperinflations of the 1920s made this a constant fear of policy makers. Therefore to reassure business expectations and remove any expectations of hyperinflation British policy remained distinctly deflationary after September 1931 (Nevin 1955). The Bank Rate was raised to 6 per cent by October, and fiscal orthodoxy was maintained and despite a landslide Conservative victory in the October 1931 election a government of national unity was formed. Confidence in Britain was further encouraged by the early repayment of credits to the Bank of France and the Federal Reserve in January by the Bank of England and in March by the Treasury. Nevin (1955) further points out that a key reason for increased confidence in Sterling was precisely the fact it was off gold; other international currencies faced uncertainty on the malfunctioning gold standard, sterling in contrast had already adjusted, furthermore sterling was strengthened by the fact London was still a key financial centre.

Vital discussions between British policy makers took place immediately after the exit from Gold. Having been on gold for 200 years this was largely uncharted territory for policymakers. A critical institutional change that took place upon exit from the gold standard was the effective transfer of long run monetary policy from the Bank of England to the Treasury. The first action of the Treasury was to inform the Bank of England to allow the pound to fluctuate with fairly wide limits with some intervention where possible to prevent extreme fluctuations (Howson 1975, 81). It also became clear that to some extent the final value of sterling was not as important as maintaining a stable value for the currency (Howson 1980). Sterling had fallen as low as $3.40 following the exit from gold before rebounding to $3.90 within two weeks, another low of $3.23 in December 1931 before recovering to a peak monthly peak of $3.75 in April 1932. The main debate was between a value of Sterling around $3.40 or $3.90. A higher value was preferred by some as it was feared a value of sterling that was too low would raise prices, increase the cost of living and spark demands for higher wages. In contrast a lower value had the advantage of aiding exporters, reducing the debt burden and by raising prices and thus reducing real wages and therefore firms costs, subsequently increasing profit expectations and the confidence of firms. In the end $3.40 broadly prevailed with the advantages given the advantages stated above and the fact $3.40 was also highly compatible with a cheap money policy and the desire for low interest rates (Howson 1975, 86).

The confidence gains in the British economy were almost complete by March 1932. To complete the housekeeping measures was one last policy, this was the conversion of Britain’s 5 per cent War Loan which had placed a substantial burden upon public finances given the steep interest payments it entailed. It had been hoped to achieve this at a similar time the previous year however market conditions were unfavourable and the conversion was postponed in the wake of the financial crisis. In January 1932 the treasury had asked the governor of the Bank of England to inform them when market conditions would be favourable. On 7th June 1932 the

7 Governor advised the possibility of converting the War Loan from 5 per cent to 3.5 per cent (Howson 1975, 88). The conversion was announced on 30th June and was a real success with 92 per cent of the outstanding loan being converted, this provided considerable respite to the budget as well as further strengthening conﬁdence in the British economy.

2.3 The Managed Economy

As Britain overcame its fear of inflation and continued crisis after exit from gold it soon began to put in place it’s new activist policy. The first policy that signalled a clear break from the past was the implementation of the Import Duties Act on 16th of February followed by the first post gold standard reduction in the Bank Rate from 6 per cent to 5 percent. Following the payment of Treasury Credits on 2nd March the Bank Rate would decrease further to 4% on 10th March and 3.5% on 17th March. April would be another key month on the road to recovery with the National Government’s second budget. This included continued budgetary orthodoxy however also the new institution called the Exchange Equalization Account which would initially be financed by a loan of £150m. This was a key institutional addition to British policy making. Since the exit from gold key policy discussion had focused on the new exchange rate policy that Britain should follow and this institution was a key pillar of the new policy. The monthly dollar value of sterling had risen to $3.75 with growing confidence in the British economic position, though the EEA only officially started working in late June there is evidence it was active soon after the budget announcement of its establishment, in particular between April and December the monthly value of the pound fell from $3.75 to $3.27; the same period saw a substantial increase in reserves held by Bank of England. It is at this point Britain implemented a policy strongly resembling the “Foolproof Way” of escape from a liquidity trap1.

There were three essentially steps in the process. Firstly, interest rates fell to their historic lower bound of 2 per cent on 30th June, the same day of the announcement of the conversion of the War Loan to 3.5% per cent. A second step in the process was the announcement by the chancellor of a desire to see the price level return to its 1929 level. Crafts (2013) identiﬁes the establishment of a price-level target at the British Empire Economic Conference in July 1932 during which a desire to return to the 1929 price-level was stated. This was not a new idea and the comparative gap between wages and prices had been identiﬁed as a key problem for

1Given the Bank rate fell only to 2 per cent can Britain truly be seen as being in a liquidity trap during this time? A glance at the history of the Bank Rate suggests this certainly was the case; interest rates were at their lower bound though this was 2 per cent and not zero. Figure 2 clearly shows that the fall in the Bank Rate for such a long time period was unprecedented and has only been surpassed since 2009 when interest rates hit 0.5 per cent. This is also supported by the statements of the chancellor himself in the House of Commons, “For some time now the Bank rate has been at a comparatively low level, and, although my right hon. Friend desires to see it go even lower still, I doubt myself whether that would bring about any lowering of the bill rate or of the rate charged on overdrafts by the banks” (Hansard 2015). This is further supported by annual evidence presented by Crafts (2013) that shows both the Treasury bill rate and Real short rate fell and stayed below 1 per cent from 1933 onwards.

8 the British economy. In particular, wages were 66 per cent above their pre-war level (Howson 1975) whereas wholesale prices were just 10 per cent below their pre-war level by the end of 1932. The MacMillan Committee Report published in the Summer of 1931 had identified this divergence and subsequent squeeze on firm profits as a key problem. This was acknowledged by the Chancellor during a speech regarding the Finance Bill in parliament as early as May 9th 1932:

“The Macmillan Committee appointed by the Labour Government, in a very important report, pointed to the level of prices as the crucial point which had to be passed before we could expect a reversal of the present distressing position of the world”.

“Perhaps I might just remind the House of a few words in the report of the Macmil- lan Committee which seem to me to be very apposite to the subject: Beyond saying that a large rise towards the price level of 1928 is greatly to be desired, it is difﬁcult for us at the present date to be very precise because the exact answer will depend on the course of events in the meantime. . . ”

Furthermore, the Chancellor, when the government was accused of having no policy stated the following:

“I was certainly under the impression that I had already stated, at any rate in general terms, what the objective of the Government was in this respect”.

“I will repeat that the Government do desire to see a rise in wholesale prices in this country and, although not to the same extent, a rise in retail prices, because it is clear that, if industries in this country, by a rise in wholesale prices, can once more make proﬁts, then we are getting back to the condition which we all desire to see when conﬁdence will be restored, when business will be ready to take advantage of cheap and abundant money, and when we may expect to see our businesses expand and employment once more increase”. (Hansard 2015)

Therefore, it seems clear by May 1932 that the desire to see prices rise to their pre-depression levels was already in place although there is evidence of some difﬁculty communicating the message.

Aside from the 2% Bank Rate and Price-level target the third pillar of the strategy concerned the exchange rate. Though the value of the pound fell to a low in December 1932 it soon rose in dollar value following the dollars gold standard exit in 1933. However now the value of sterling was based upon a value of around Ffr. 88 and from early 1934 this became Ffr. 77-78 (Howson 1980, Crafts 2013). The success of Sterling intervention is highlighted by annual data for the nominal and real effective exchange rates which suggest sterling remained depreciated 20-25 per cent below its gold standard level although this decreased to around 10 per cent

9 after the French exit from gold in 1936. Although after the implementation of the import tariff and the conversion of the war loan in June there was some room for fiscal manoeuvre fiscal policy remained orthodox until the announcement of rearmament expenditure in 1935. From June 1932 the end of deflationary expectations was symbolized by stabilization of the RPI and the gradual but sustained increase in the WPI. How successful was the Managed Economy Strategy at ending deflationary expectations and allowing Britain to return to growth? The data clearly suggests the initial recovery in prices, shares and commodities from September 1931 was quickly checked following the imposition of conservative policies. However, between June to September 1932 growth returned; first in June Stocks and shares rebounded, by September GDP and production rebounded. How much of this recovery can be attributed to the activist policies now pursued by the Treasury? How much could be attributed to natural forces of exit from the gold standard alone? Can we estimate how the British economy would have performed if the Bank of England had somehow managed to maintain gold standard membership? To this end we turn a small scale DSGE model that seeks to capture the key features of the British interwar economy and the key policy changes that took place.

3 A DSGE Model for Interwar Britain

We turn now to a small open economy DSGE model that contains the key features of the interwar British economy. This includes: nominal rigidities, a division between Ricardian and Rule of Thumb consumers, consumption habits, monopolistically competitive firms, investment adjustment costs, monetary policy focused upon fixing or managing the exchange rate and a government sector including government debt. The world economy is exogenous, however the unprecedented and destabilizing shocks to first the world price level and second world trade can be included via exogenous shock processes. The overall mapping of the model is presented in Figure 3. A widely cited standard small open economy DSGE model is that of Gali and Monacelli (2005). Since this early paper there has been increasing research into open economy DSGE models, especially by central banks. A seminal open economy DSGE model is that of Adolfson et al (2007) for the Euro Area. Since this time several open economy DSGE models have been designed by central banks including: Chile (Medina and Soto 2007), Czech Republic (Stork 2011), Iceland (Seneca 2010) and the SAMBA model for Brazil (De Castro et al 2011). The model presented below is based upon an early version of the SAMBA model found in Gouvea et al (2008). There are several reasons for this choice. First and foremost is the ’relative simplicity’ of the model, at least in comparison to more complex open economy models such as Adolfson et al (2007) and De Castro et al (2011). The later SAMBA model of 2011 is much more complex and also highly specific to the modern Brazilian economy, whereas the earlier version is a much more generic open economy model. This is both what is necessary for a general macroeconomic analysis of the interwar British economy (with minor

10 adjustments) in this paper and also an excellent platform upon which to base further research and potentially to develop a richer model in future. Therefore what follows is a DSGE model including: Households, Firms, the Government and an exogenous foreign sector (to avoid the technical details of the model the reader can refer to Figure 3 for a map of the model and skip to section 4).

3.1 Households

Household’s are divided into Riccardian j ∈ [0, 1 − w¯h] and Rule of Thumb Consumers. The problem of Riccardian household’s is to maximize the following utility function:

∞ O 1−σ ! X t c (Cj,t − hCt−1) η ψ 1+η Max Et β Zt − Zt Nj,t (1) j j j ∗j j j j t=0 1 − σ 1 + η Ct ,Nt ,Bt+1,Bt+1Kt+1,Ut ,It

j ∈ [0, 1 − w¯h]

Where this is subject to the budget constraint:

j ∗j j n,k j j ∗j j n j j j j Bt+1 StBt+1 WtNt rt Ut Kt Bt StBt Πt T axt Ct +It +a Ut Kt + + ∗ ≤ + + + + − (2) PtRt PtφtRt Pt Pt Pt Pt Pt Pt

and the following equation for the law of motion of capital:

" Ij !# Kj = (1 − δ) Kj + 1 − S t Ij (3) t+1 t I j t Zt It−1

c j n where β is the rate of time preference, Zt is a preference shock, Ct is consumption, Zt is j j j a labour supply shock, Nt represents hours worked, It is investment, Ut represents capital j j ∗ utilization, Kt represents capital utilization, Bt are one period domestic bonds, Bt j are one n period foreign bonds, Pt is the price level, St is the nominal exchange rate, rt , k is the nominal ∗ rental rate of capital, Rt is the risk free nominal interest rate, φt is the country risk premium, j Wt is the nominal wage, Πt represent proﬁts and Tt are lump-sum taxes. Convex costs are assumed for adjusting the rate of capital utilization so that a0(.) > 0, a(.)00 > 0, a(U j) = 0, j j It U = 1. There are also capital adjustment costs so that S I j satisﬁes: S(1)=0, S’(1)=0 Zt It−1 and S”(1)≡δs > 0 in the steady state.

In contrast Rule of Thumb consumers maximize lifetime utility only with respect to consumption and hours worked. Their utility maximization problem is therefore:

11 ∞ j O 1−σ ! X t (Ct − hCt−1) η ψ j1+η Max Et β − Zt Nt (4) t=0 1 − σ 1 + η Ct,Nt

j ∈ [1 − w¯h, 1]

Where this is subject to the budget constraint:

j n j PtCt ≤ Wt Nt (5)

Where aggregate consumption and labour supply can be represented respectively as:

o r Ct = (1 − w¯h) Ct +w ¯hCt (6)

o r Nt = (1 − w¯h) Nt +w ¯hNt (7)

3.2 Firms: Producers and Retailers

There are three stages in the production process. At the production stage firms minimize the cost of their factor inputs in a monopolistically competitive market before choosing their profit maximizing price to sell their produce. In the second stage retailers sell the homogeneous final good as a price taker in a perfectly competitive market. At the production stage firms minimize costs via a choice between labour, capital and imported goods. The final good is then used for private consumption, private investment, government consumption or it is exported. If the good is exported it is used as a factor input abroad.

There are a large number of monopolistically competitive ﬁrms indexed i ∈ [0, 1]. They minimize costs of production subject to the following domestic production function:

d α 1−α Yi,t = At Ui,tKi,t Ni,t (8)

d Where this domestic input Yi, t is combined with imported input using the following CES production function:

ρ " ρ−1 # 1 1 ρ−1 ρ−1 ρ ρ d ρ ρ Yi,t = ε Yi,t + (1 − ε) (Mi,t) (9)

12 where Mi, t are imported inputs. The cost minimization problem of ﬁrms is:

M n,k ! Pt Wt rt u Min Mi,t + Ni,t + Ki,t (10) u P P P [Mi,t,Ni,t,Ki,t] t t t

M subject to 8 and 9 where Pt is the domestic currency price of imported goods. Producers now have the task of selling their product in a monopolistically competitive market where Calvo (1983) price setting is assumed. This implies only a fraction of ﬁrms (1 − θ) can adjust prices each period. Of those ﬁrms that do adjust prices a fraction (1 − ω¯b) adjust prices optimally whereas a fraction ω¯b adjust prices in a purely backward looking manner.

When setting prices ﬁrms wish to maximize the expected discounted value of current and future proﬁts. Therefore the problem is to maximize:

∞  !1−θ !−θ X i Pt(j) Pt(j) Max Ω = Et w ∆i,t+i  − φt+i Yt+i (11) {P } i,t i=0 Pt+i Pt+i

Where the ﬁrst order condition of this problem implies:

∞  !1−θ !−θ δΩ X i Pt(j) φt+iθ Pt(j) = Et w ∆i,t+iYt+i  −  = 0 (12) δPt(j) i=0 Pt+i (θ − 1) Pt+i where δi, t + i represents the total discount factor. After some algebraic steps this can be re- written:

∞ θ P i Pt+i ! Et w ∆i,t+iYt+iφt+i P (j) θ Pt t = i=0 ∞ θ−1 (13) Pt θ − 1 P i Pt+i Et w ∆i,t+iYt+i P i=0 t

This equation must be combined with the aggregate price index:

1 h 1−ζ α 1−ζ i 1−ζ Pt = θ(Pt−1) + (1 − θ)(Pt ) (14)

a Where Pt represents the price of adjusted prices:

1 α b1−ζ f 1−ζ 1−ζ Pt = ω¯ Pt + (1 − ω¯) Pt (15)

f b Where Pt is the adjusted price of forward-looking ﬁrms and P t is the price set by backward- looking ﬁrms who set prices according to:

13 b α Pt = Πt−1Pt−1 (16)

Finally we have the standard optimization problem of perfectly competitive retail ﬁrms. Proﬁt maximization comes from the following problem:

Z 1 Max PtYt − PitYitdi (17) {Yt,Yi,t} 0

Subject to the following CES aggregator:

ζ Z 1 ζ−1 ζ−1 Yt ≡ (Yit) ζ di ; ζ > 1 (18) 0

From here we derive the demand curve for good i:

−ζ Pit Yi,t = Yt (19) Pt

3.3 External Sector

We derive a stylized external sector where imports are used as inputs into the production process and the sales of retail ﬁrms abroad are used as inputs into the production process abroad. There are a continuum of countries i where it is assumed the domestic economy has no effect on the world price level, output or interest rate.

Based upon these assumptions foreign importing ﬁrms solve the following problem to provide the demand for the domestic countries exports:

Z 1 M k i ki Max Pk,t Mt − Pt Yt di (20) k ki 0 {Mt ,Mt } subject to:

χ  χ−1  χ−1 Z 1 χ k ki Mt ≡  Mt di ; χ > 1 (21) o

k k M where Mt are the aggregate imports of country k, Mt i are the imports from country i, Pk, t i is the aggregate level of imports and Pt is the price level of imports from country i. From the ﬁrst order condition of this maximization problem, aggregating over all countries k and converting to a world currency we obtain the following demand for the domestic countries

14 exports:

!−χ Pt/St ∗ Xt = ∗ (Mt ) (22) Pt

∗ ∗ where Mt are world imports and Pt is the world price level in world currency. Combining equations from the households budget constraint, the ﬁrms proﬁt equation and the governments budget constraint we arrive at an expression for the domestic countries net foreign asset position:

S B∗ t t+1 = S B∗ + NXn ∗ t t t (23) ΦtRt

Where nominal net exports are deﬁned as:

n M NXt = PtXt + Pt Mt (24)

Finally the risk premium of the uncovered interest parity condition depends upon shocks to either foreign investor’s risk aversion, the domestic risk premium and the countries net foreign asset position:

∗  StB ∗  −ψ t+1 − SB +υzφ +zφ 0 PtYt PY t t Φt = ψ exp  , ψ > 0 (25)

SB where PY is the steady-state net foreign asset position.

3.4 Government

The government sector is split into two components, the central bank (or monetary policy authority) and the ﬁscal authority.

3.4.1 Monetary Authority

The monetary authority has two separate rules, these correspond to the different regimes in interwar Britain. The ﬁrst regime represents Britain on the gold standard when holding the exchange rate parity at $4.86 was the aim of the Bank of England, therefore the nominal exchange rate target becomes:

15 ¯ St = S (26)

This is also the policy regime in “Regime 2” speciﬁed below, where as a counterfactual simulation we model British adherence to a shadow peg regime after leaving the gold standard in September 1931; the difference of course is that Sterling is pegged at a devalued rate in this scenario. In contrast once Britain left the gold standard and monetary policy is decided by the treasury we use a simple rule that replicates the Managed Economy strategy via a mixture of a price level target P¯ and a target for nominal exchange rate S¯:

γ (1−γ ) γ γ " P VA ! p S γs # r P VA ! ∆p S ! ∆s R = (R )γr t t t t Zr t t−1 ¯ ¯ VA t (27) P S Pt−1 St−1

With the historic lower bound of 2% on the Bank Rate summarized by the following equation:

Zt = max (Rt, 2) (28)

3.4.2 Fiscal Authority

The implementation of fiscal policy is again conducted in a stylized setting where the only instrument of policy is government spending which is financed by the creation of government debt. The central aim of the fiscal authority is to reach a primary surplus target and stabilize the debt-to-GDP ratio.

The ﬁscal rule is:

y y h γg y i g Gt = γgGt−1 + (1 − γg) γs St−1 − γb (Bt ) + Zt (29)

y γg where variables are expressed as a proportion of GDP, Gt is government expenditure, St−1 y g is the primary surplus relative to its target, Bt is the debt-to-GDP ratio and Zt is a shock to government expenditure. The primary surplus is given by:

γg y y St = T axt − Gt (30)

Finally the government budget constraint is:

y Bt+1 y y y + T axt = Gt + Bt (31) Rt where it is assumed the government can only fund spending via domestic debt.

16 3.5 Market Clearing and Deﬁnitions

Gross output for the economy can be deﬁned as follows:

Yt = Ct + It + Gt + Xt (32)

where Yt includes imports which as included as inputs into production. Therefore a separate deﬁnition can be made for nominal GDP:

VA VA M Pt Yt ≡ PtYt − Pt Mt (33)

We can also include a standard deﬁnition of the real exchange rate:

∗ −1 Qt = StPt Pt (34)

3.6 Linearised Model

From the above equations we approximate the log-linear version of the model as follows:

Consumption of Ricardian households:

! ! ! 1 h 1 1 − h 1 1 − h co = E co + co − E (r − π )+ (1 − ρ ) zc t 1 + h t t+1 1 + h t−1 σ 1 + h t t t+1 σ 1 + h c t (35)

Consumption of rule-of-thumb households:

rot r rot ct = wt + nt (36)

Aggregate consumption: o rot ct = (1 − ω¯) ct +ωc ¯ t (37)

Labour supply of Ricardian households:

1 σ no = wr − co − hco − zn (38) t η t 1 − h t t−1 t

Labour supply of rule-of-thumb households:

1 σ nrot = wr − crot − hcrot − zn (39) t η t 1 − h t t−1 t

17 Aggregate labour supply: o rot nt = (1 − ω¯n) nt +ω ¯nnt (40)

Uncovered Interest Parity condition:

h ∗ ∗ i qt = Etqt+1 − (rt − Etπt+1) − rt + φt − Etπt+1 (41)

Aggregate Demand for labour:

r k nt = yt − (1 − ρ) at − [ρ + α (1 − ρ)] wt + α (1 − ρ) rt + ρφt (42)

Aggregate demand for capital services:

k r kt + ut = yt − (1 − ρ) at − (1 − α (1 − ρ)) rt + (1 − ρ) (1 − α) wt + ρφt (43)

Domestic risk premium: y∗ φ∗ φ φt = −ψbt+1 + υzt + zt (44)

Capital Euler equation:

I I k qt = Etβ (1 − δ) qt+1 + (1 − β (1 − δ)) rt+1 − (rt − πt+1) (45)

Investment Euler equation:

! 1 I β 1 1 − ρI β I it = qt + Etit+1 + it−1 + zt (46) δs (1 + β) 1 + β 1 + β 1 + β

Law of Motion for capital: I k = (1 − δ) k + i (47) t+1 t K t

Export equation: ∗ xt = mt + χqt (48)

Import equation:

mt = yt − ρ (qt − φt) (49)

Capital utilization: k rt = δαut (50)

18 Real marginal cost:

h k r i φt = sd αrt + (1 − α) wt − at + (1 − sd) qt (51)

Phillips curve:

πt = λφt + λbπt−1 + λf Etπt+1 (52) where: (1 − θβ) (1 − ω¯ ) (1 − θ) λ = b (53) θ +ω ¯b (1 − θ (1 − β))

ω¯b λb = (54) θ +ω ¯b (1 − θ (1 − β))

θβ λf = (55) θ +ω ¯b (1 − θ (1 − β))

Net foreign assets:

y∗ ∗ y∗ y y∗ VA VA 1 ∗ y∗ ∗ bt+1 = ΦR bt + nxt + B yt−1 − yt + (qt − qt−1) − πt + B (φt + rt ) (56) sVA

Net exports: y sx sm sx − sm VA sm 1 − sx nxt = xt − mt − yt − qt (57) sva sva sva sva sva

Gold standard policy rule:

st =s ¯ (58)

Exchange Equalization Account policy rule:

h VA i VA r rt = γrrt−1 + (1 − γr) γp(pt − p¯ + γs (st − s¯) + γ∆p∆pt + γ∆s∆st + zt (59)

Fiscal policy rule:

y y h γg y i g gt = γggt−1 + (1 − γg) γs st−1 − γb (bt ) + zt (60)

Primary surplus: y y y st +s ¯t = −gt (61)

Government debt:

y h y y y VA VA VAi y bt+1 = R bt + gt − B yt − yt−1 + πt + B rt (62)

19 Government expenditure:

! VA sva y sm gt = yt + gt − qt (63) sg sva

Resource constraint: C I G X y = c + i + g + x (64) t Y t Y t Y t Y t

GDP: va 1 sm yt = yt − (qt − qt−1) (65) sva sva

GDP Deﬂator: VA sm πt = πt − (qt − qt−1) (66) sva

Household preference shock: c c c zt = ρczt−1 + εt (67)

Labour supply shock: n n n zt = ρnzt−1 + εt (68)

Investment shock: I I I zt = ρI zt−1 + εt (69)

Foreign Investor’s risk aversion:

φ∗ φ∗ φ∗ zt = ρφ∗ zt−1 + εt (70)

Risk premium shock: φ φ φ zt = ρφzt−1 + εt (71)

Technology shock: a at = ρaat−1 + εt (72)

Government spending shock: g g g zt = ρgzt−1 + εt (73)

World trade shock: ∗ m∗ m∗ mt = ρm∗ zt−1 + εt (74)

World inﬂation shock: ∗ π∗ π∗ πt = ρπ∗ zt−1 + εt (75)

20 World interest rate shock: ∗ r∗ r∗ rt = ρr∗ zt−1 + εt (76)

3.7 Data, Calibration and Simulation

The model is calibrated in two ways, either standard values from the DSGE literature are adopted or values are chosen that match British data during this period. The list of parameter values can be found in Table 1 and 2 below. There are several crucial changes that occur during the 1931-32 period in Britain. This includes not only the exit from the Gold Standard but also the presence of a lower bound on interest rates from mid-1932. Such non-linearity and the constraints on high frequency data available make Bayesian Estimation of the model an extremely challenging task. However the existence of the OccBin toolkit (Guerrieri and Iz- coviello 2015) for use in dynare allows us to solve dynamic models with occasionally binding constraints. The toolkit allows for up to four different regimes in the economy and is therefore ideal for use when analysing the potential regime changes that occurred in Britain. To perform the simulation of the model a ﬁrst-order perturbation approach is adapted and applied in a piecewise fashion. The method also allows the comparison of the simulation results when the constraints do and do not bind and therefore provides the potential for performing counterfactual simulations. The two important regime changes that occur in interwar Britain are the ending of the gold standard policy regime and also the presence of a lower bound on interest rates all of which can be incorporated into the analysis via the OccBin toolkit.

The baseline parameters used in the simulation can be found in Tables 1 and 2. We use a value of β = 0.99 implying a steady state annual rate of interest of 4%. Furthermore, using annual data for the interwar period we set the investment share at 9% of GDP and the government share at 10.5%. Britain’s persistent trade deﬁcit during this era is captured by an import share of 23.7%, 3.5% above the share of exports. The model does not capture explicitly the rise in protectionism during the period of analysis, however to account for this important aspect of the interwar years the elasticity of exports with respect to the exchange rate takes a low value of 0.25. The degree of price rigidity has a standard value from the literature (θ=0.75) that sees prices adjust once every four quarters.

Finally the data used in the estimation comes from various sources including: shares of consumption, investment, government spending, imports and exports plus the annual bank rate from Thomas et al (2010) and Sefton and Weale (1995); real GDP and industrial production from Mitchell et al (2012); data for the Retail Price Index, exports and imports from Capie and Collins (1983); the Wholesale Price Index, production of commodities as well stocks and shares data from the NBER (2015); and ﬁnally data for government spending, taxation and debt from The Economist (see Crafts and Mills 2013).

21 To run the simulation several key assumptions must be made regarding shocks and policy rules. Firstly, it must be decided whether shocks are permanent or transitory, and secondly, whether they are anticipated or unanticipated. Further assumptions must be made about policy rules and how monetary and ﬁscal policy makers react to shocks. As this is an historic simulation it is possible run an ”observed variable scenario” (see Vetlov et al 2010) where certain variables take on their ex post values in the simulation. In particular this is the case for foreign variables such as world inﬂation, world trade and the world interest rate. Similarly the government consumption shock is used so that government spending follows its observed value. Finally the risk premium shock and the monetary policy shock can be used so that these variables follow their observed path in the historic data. Introducing these shocks allows us to see what path the model predicts for variables such as consumption, investment, hours worked etc. In addition given that shocks to the world price level and world trade were vital during the post-1925 period this method of simulation is extremely convenient for our analysis.

However important assumptions must be made regarding the change of policy regime in Septem- ber 1931. This is that private agents did not expect Britain to leave the gold standard before 1931Q3 and did not adjust their behaviour in expectation of this. While this is clearly a strong assumption, it seems unlikely agents predicted the exit more than one or two quarters earlier and as such the assumption that the gold standard exit was not unanticipated doesn’t seem particularly strong. A further assumption must be made with regards to the Managed Economy policy rule that came into full effect from 1932Q3. This assumption is that private agents knew, and were clear about, the Managed Economy strategy. Although the EEA was announced in the budget of 1932, it’s goals were never explicit, similarly a form of price-level target was announced from mid-1932 though it is uncertain how well this was understood. Therefore the assumption that private agents know the central banks strategy is perhaps slightly stronger (and perhaps helps to explain why the policy rule has a low weight on the price-level and exchange rate targets). With regards the large loss of world trade and large decrease in the world price level, it does not seem too extreme to suppose that agents expected a recovery to occur rather than expecting a continued systematic deﬂation and loss of world trade. The Vetlov et al (2010) paper considers several similar exercises in their paper. Another example of considering the effect of different policy rules using historic data is undertaken by Vasco and Finocchiaro (2012) who consider the effects of an exchange rate target verses a price level target using data from Sweden. What neither of these papers also include however is the liquidity trap and the lower bound on interest rates which occurred in Britain from June 1932.

22 4 How Depressions End - Results from Interwar Britain

Britain saw a peak in wholesale prices as early as December 1924 and was thereafter subject to first a minor and then a major deflationary shock world price level shock. In contrast world trade and the world economy was expanding up until late 1929 until a dramatic decrease in world trade ensued. We begin the simulation from the first quarter of 1925 and simulate the shocks to both world trade and world inflation. The world inflation shock sees the GDP Deflator in Panel B of Figure 4 decline by 8.5% between 1925Q1 and 1929Q3 matching the data for this period. For completeness a large and highly transitive negative shock is included to replicate the general strike that led to a large loss of GDP in 1926. Thereafter two large negative shocks hit the British economy in late 1929; one for world trade and one for world inflation. This leads to a significant decline in the GDP Deflator of a further 11.5% and also sees imports and exports decline by 39% and 47% respectively. In response to this shock nominal GDP declines by 13.3% between 1929Q4 and 1931Q3. The simulation initially sees a simple fixed exchange rate rule in place as Britain maintained its long sought after parity of $4.86 during this period; despite the significant problems this imposed upon the economy in the 1920s and the difficulties the economy had in adjusting after 1929. The simulation results match the data on output and the price level during the period up to 1929Q3 fairly well.

4.1 Alternatives to Gold

Our focus lies in the period after the exit from the gold standard in 1931Q3 once the large deﬂationary shocks and world trade shocks have hit the British economy. Our focus is therefore Britain’s policy options once freed from the shackles of the Gold Standard. We therefore simulate three counterfactual simulations, using a different policy rules in each counterfactual, and then compare data for this period with the path of output, inﬂation, the real interest rate and other variables predicted by the model. We simulate the following three regimes:

REGIME 1 (Gold Standard) As a baseline simulation we show counterfactual results of the path of the economy had Britain somehow managed to maintain its membership of the gold standard at the pre-war parity of $4.86 all the way up to 1938Q4.

REGIME 2 (Shadow Peg) In the second counterfactual simulation we seek to show the performance of the British economy had Britain devalued but maintained a non-activist shadow nominal exchange rate peg upon exit from the gold standard in 1931Q3.

REGIME 3 (Managed Economy) The ﬁnal scenario contends that Britain pursued an activist policy akin to to Svensson’s “Foolproof Way” to escape from the liquidity trap. This combines a price level target and a nominal exchange rate target as speciﬁed in equation 27 from 1932Q3 (for the brief period between 1931Q3 and 1932Q2 this simulation follows the policy rule in

23 Regime 2).

The first counterfactual is perhaps unrealistic, though it’s certainly the case that Britain experienced some significant misfortune during the financial crisis of 1931. First of all the day the German banking system closed on 13th July was the same day the MacMillan Committee report was published exposing Britain’s exposure to German debt and short-run debt in general. Then almost simultaneous to the announcement of new credits at the start of August the May committee report was published highlighting the need for further budget cuts. Therefore it is certainly possible to envisage Britain having battled longer on the gold standard than it did. On the other hand Howson (1975) points out the precarious position of the balance of payments in September 1931 and suggests Britain would having exited the gold standard by 1932 at the latest. The second counterfactual regime, of a shadow peg exchange rate regime was discussed by officials following the exit from gold, although initially this encountered the serious problem of a complete lack of foreign exchange reserves that might be needed to maintain a new parity (Howson 1975). Nevertheless by early 1932 confidence in the British economy had returned and the value of sterling was appreciating significantly. This allowed Britain to build-up enough foreign currency to repay credits borrowed in the midst of the crisis the previous summer. This counterfactual is of interest as it provides a non-activist policy regime against which to compare the more interventionist approach ultimately adopted in the Managed Economy strategy. Finally, the third regime of the Managed Economy sees the adoption of a target price level aiming for a return to the price-level of 1929 and a target depreciation for the nominal exchange rate of around 30% as suggested by Crafts (2013). Since this is the policy that was adopted, this counterfactual simulation should match the data most closely.

4.2 A Well Managed Economy

Our interest lies in the divergence of the regimes after 1931Q3 in Figure 4. Up until this time all three counterfactual simulations follow an identical path as they maintain the gold standard policy rule. The first divergence occurs in 1931Q3 and it is highly significant, the gold standard simulation (Regime 1) suggests that rather than the economy stabilizing after a loss of 6% of output, the output loss doubles and the trough of output occurs in 1932Q3 in Panel A. In contrast both the shadow peg (Regime 2) and the Managed Economy (Regime 3) counter- factuals see output not only stabilize but also rise slightly before the recovery is choked off by the restrictive policies pursued during this period including the high Bank Rate seen in panel C. There is also a significant difference in the GDP Deflator in Panel B. Maintenance of the gold standard regime sees no end to deflationary expectations and the trough in the GDP De- flator only occurs in 1935. In contrast both the Regime 2 and Regime 3 simulations see output stabilize, the shadow peg by 1933Q1 and the Managed Economy by 1932Q3. It is perhaps significant that there is a divergence between these simulations and the data which actually

24 shows a much more rapid stabilization of the price level than the model predicts. This could be due to the limitations of the model but equally potentially because rather than a fixed peg regime during 1931Q3-1932Q3 there was potentially more intervention by the authorities in this time period. This is highlighted by the fact that the exchange rate dropped to a low of $3.23 in December 1931 before steadily rising to $3.75 by April. The build up of foreign exchange reserves that allowed the early repayment of credits suggest the principle mechanisms behind exchange rate intervention and smoothing may have been in force long before the announcement of the Exchange Equalization Account in April (Nevin 1955). Nevertheless the path of the exchange rate broadly matches that of the data in Panel D 2. The early period sees two phases of depreciation, the first following the exit from the gold standard up to April 1932 when the dollar value of sterling fell from $4.86 to $3.75, then a second phase of depreciation between April 1932 to December 1932 between which the value of sterling fell from $3.75 to $3.27. Therefore the shadow peg regime assumes the initial depreciation to $3.75 after which there is no further exchange rate intervention. The Managed Economy simulation captures the second phase of depreciation up to 1932Q4. Finally, this was a period when there was a lower bound on interest rates in both the US for the Federal Funds Rate, upon which the world interest in Panel F is based, and in Britain where in both Regimes 2 and 3 interest rates hit the lower bound of 2% from 1932Q3. Amid continued fiscal orthodoxy Britain needed alternative means to stimulate the economy. As is shown by the data in Figure 1 the initial exit from the gold standard did create expectations of inflation, at least based upon the rise in stocks and share prices after 1931Q3. However the activist Managed Economy strategy, price level target and active exchange rate intervention provided a greater boost to inflation expectations after implementation in 1932Q3. This is witnessed not only in the more robust recovery of the GDP Deflator but also in the much sharper fall in the ex post real interest rate from 1932Q4 compared to the drop experienced on the shadow peg counterfactual (Figure 4, Panel E). Interestingly the gold standard counterfactual also sees a drop in the real interest rate due to the fact both world trade and the world price level began to recover from 1932Q4. Once again the gold standard simulation matches closely the path of the real interest rate in France during this period which did see a significant reduction due to the recovery in the world price level at this time though in France, and under the gold standard simulation here, real interest rates never turn(ed) negative 3

2The data for the nominal exchange rate are taken from Thomas et al (2010) which is provided at annual frequency, this has been interpolated here but it remains an area of signiﬁcant interest to obtain a high frequency index of the Effective Exchange Rate for the interwar years 3It must be added that the recovery in the world price is treated as entirely exogenous. Given the size of the British and US economies, their recoveries after exit from gold, in 1932Q3 and 1933Q2 respectively, occur contemporaneously with the slowdown and reversal of the fall in world prices. Therefore had Britain not exited the gold standard the world deﬂation may well have gone on longer and been more protracted.

25 4.3 Fiscal Multipliers - Could Lloyd George have done it?

Ahead of the 1929 general election Lloyd pledged public works schemes aimed at reducing unemployment via an increase in government spending of £100m which would be maintained for three years. A £100m rise in government spending in 1929 would have been 23% of the governments expenditure and just over 2% of nominal GDP. In comparison the US stimulus package of 2009 was 5.5% of GDP and 27% of the federal budget. The First New Deal package of FDR in 1933 was worth around 5.9% of US GDP and around 1.65 times the level of government revenues (Rueters 2009). Rather than the actual size of government stimulus packages much recent debate and research has focused on fiscal multipliers to gauge the potential effectiveness of these packages and help inform decisions by policy makers. In particular the key conclusion of this recent literature is that fiscal multipliers are highly non-linear and depend upon key country characteristics and the existing state of the economy. Key characteristics of the economy include: the exchange rate regime, the debt to GDP ratio, trade openness and country size whereas key states of the economy include the position of the output gap, whether interest rates are at their zero lower bound and the health of financial markets. This is a topic of great interest but existing research has largely only analysed how the size of the multiplier varies when considering any one of these states or country characteristics at a given time. Of significant interest is the analysis of how these various country characteristics interact with each other and how much weight policy makers should place upon each e.g. if a country has a liquidity trap, large negative output gap, a fixed exchange rate regime and is relatively closed to trade, all factors pointing towards a high multiplier, could these factors be negated by any single factor such as a high debt to GDP ratio? This is of vital importance in answering the question of whether Lloyd George could have done it. In 1929 Britain was on a fixed exchange rate regime and had significant labour market slack with historically high unemployment rates, however the country was open to trade despite significant protectionist barriers already in existence in other countries. Britain also had a high debt to GDP ratio with interest payments taking up a significant proportion of the governments budget. Therefore we would like to use the DSGE model for interwar Britain to estimate how large the multiplier may have been at different time periods given the circumstances facing policy makers at any given time.

Non-linear government spending multipliers

As a preliminary analysis of fiscal policy in interwar Britain we estimate the size of the government spending multiplier under several different scenarios. To begin with we simulate a 1% shock to government spending and vary the policy rule in the model between either a fixed exchange rate regime such as the gold standard or a floating exchange rate regime with a generic Taylor-rule guiding monetary policy. Along a second dimension we also consider whether the

26 government has high or low debt to GDP ratio. These four alternative regime combinations will allow us to gauge whether the multiplier varies in response to a change in the debt to GDP ratio or a different exchange rate regime. The results are presented in Table 3 and are of some interest 4. Firstly, the overall size of all the estimated multipliers are positive suggesting some beneficial short-run effects of discretionary government spending on output. Secondly, the estimated multipliers are virtually identical regardless of whether we assume the government has a high or a low debt to GDP ratio 5. A third observation is that the estimated multipliers are larger under the Taylor-rule than under the gold standard fixed exchange rate regime, this is somewhat counter-intuitive and does not match recent empirical evidence that the multiplier is larger under fixed exchange rate regimes. It is of significant interest however that although we vary the steady-state debt to GDP ratio to estimate the multiplier in each scenario the debt to GDP itself does not significantly affect the governments ability to issue debt to fund the 1% of GDP government spending shock. Had Lloyd George in fact increased government spending between 1929 and 1931 it may have been the case that the government would have had to conduct deep austerity measures soon afterwards. This scenario would have been similar to the experiences of OECD countries after the stimulus measures passed in much of the OECD in 2009/10 were quickly replaced by austerity measures to stabilize debt to GDP ratios. Therefore to analyze this issue further we introduce a “debt constraint” in the governments fiscal rule by

varying parameter γb from its default value of 0.2 to a high value of 0.8. We repeat the simulation of 1% government spending shock and again calculate the multiplier from the impulse response functions of the DSGE model. By introducing a debt constraint into the fiscal rule there is no significant change in the government spending multiplier after 4 quarters, however after 8 quarters the results are significantly different, under the gold standard policy rule the multiplier drops to zero and under the floating exchange rate Taylor rule the multiplier drops significantly below zero. This baseline analysis of the size of the government spending multiplier predicted by the model highlights the non-linearity of the government spending multiplier and the importance of both the exchange rate regime, debt to GDP ratios and potential debt constraints in determining the effectiveness of government spending in stabilizing the economy. It remains as an extension to this analysis to analyse the impact of other characteristics in the model presented; firstly to also consider the effect of introducing a lower bound on interest rates, secondly to consider the potential affects a risk premium shock if discretionary fiscal policy is conducted in unfavorable market conditions and finally to add a complete discussion of the potential affects of Lloyd George’s proposed public works programme in 1929 as well as the effect of rearmament expenditure on the economy after 1935. In 1929 Lloyd George wanted

4To calculate the multiplier we simulate the 1 per cent of GDP shock to government spending and take the ratio of the sum of coefﬁcients from the impulse response functions of output and government spending. In equation 60 government spending is expressed as a proportion of output so that there is no need to convert the ratio of impulse responses functions any further (see Owyang et al (2013). 5We vary the debt to GDP ratio by assuming a different steady-state debt to GDP ratio in the model. A “low” debt to GDP ratio implies the steady state debt to GDP ratio is 50%, a “high” debt to GDP assumes the debt to GDP ratio is 150%

27 to implement a £100m increase in spending for three consecutive years. Under the assumption that Lloyd George could have ﬁnanced the proposed public works scheme via the issuing of domestic debt our model predicts a multiplier of 0.5 after 4 quarters and 0.61 after 8 quarters. Crafts and Mills (2013) estimate a government spending multiplier of 0.8 during this period and suggest this could have reduced unemployment by little more than 200,000; our estimates suggest even this estimate of the reduction in unemployment from the proposed public works programme may not be conservative enough.

4.4 Further Research

Whilst the simulation results are both intuitive and encouraging there are several areas for improvement and further research. Firstly, some characteristics of the simulations results suggest room for improvement. The shock of the 1926 General Strike shows slightly too much persistence, the pre-1929 boom is not fully captured by the model, the GDP Deﬂator shows too much of a drop in comparison to the data. Furthermore, one key part of the analysis the simulation results do not yet include is the news shocks of rearmament expenditure announcements after 1935 as document by Crafts and Mills (2013). The size of these shocks should prove signiﬁcant enough to alter the performance of the simulation after 1935. The contribution of consumption, investment, government spending and exports to the growth of gross output in the Regime 3 simulation are found in Figure 5. These show the importance of the shock to exports in the onset of the recession and also the importance of domestic demand in the initial recovery. However, it is expected that shocks to government spending via the announcement of the start of rearmament spending from March 1935 should play a much greater role between 1935 and 1938.

In addition there are still several areas the model can be improved to better match the structure of the interwar British economy. The first of these is the widespread acknowledgement of a problem of wage rigidity in interwar Britain. The divergence between nominal wages and prices in the post-WWI period, where wages were relatively rigid while prices decreased, led to a rise in real wages. It was argued by many that this had significantly increased firms costs reducing profit margins and reducing the incentive to invest. This aspect of the data is not yet included in the model and is a clear area for improvement. A second area for improvement is in the structure of the government sector. This could for example be enhanced to include a more complete tax structure (such as income and consumption taxes). A third way to improve the model would be to allow for the inclusion of two much more distinct sectors in the economy to replicate the “old staple industries” and “new staple industries” documented in the literature of this era of British economic history, perhaps through the inclusion of a tradable and non-tradable sector in the economy. This would potentially lead on to the fourth and fifth additions to the model which would be to include unemployment and benefit payments. A sixth and significant addition to the

28 model would also be to more closely model the gold standard system via the inclusion of money demand, money supply and gold reserves. Seventh, it would add to completeness of the model to include the rise in trade barriers in the world economy and in Britain from February 1932, although this policy change does not seem to have any immediate effect on expectations in the data in Figure 1. Nevertheless the model as outlined in section three has enough complexity to replicate the main macroeconomic shocks and subsequent policy regime changes Britain experienced in the interwar years; particularly the “Foolproof Way” of escape from a liquidity trap in the second half of 1932. Finally, further research is still required to consider how applicable the Managed Economy strategy really was after June 1932. One potential avenue of investigation would be to run the model several time for different weights on the parameters in the Managed Economy strategy rule to systematically uncover which weights on the rule see the simulation ﬁt the data most closely.

5 Conclusion

We have used a DSGE model calibrated for the interwar British economy to analyze the success of the Managed Economy strategy adopted by British policy makers after the forced exit from the gold standard in September 1931. Simulation results from a counterfactual analysis suggest the activist policy of exchange rate intervention in combination with a price-level target con- tributed significantly to Britain’s relatively robust return to growth starting in September 1932. In particular the creation of expectations of inflation via a credible exchange rate depreciation allowed real interest rates to drop to zero or below thus stimulating private consumption and investment whilst interest rates were at their historic lower bound of 2% and world trade was yet to recover. In contrast counterfactual evidence suggests Britain’s recovery would have been less robust had Britain simply adopted a shadow peg regime after September 1931, a second counterfactual simulation with Britain remaining on the gold standard estimates that Britain would have experienced further deflation and severe economic strain similar to that of other economies remaining on gold after 1933. Finally, we have estimated the size of the government spending multiplier under alternative economic conditions including fixed and floating exchange rates and high and low debt to GDP ratios. The estimated multiplier between 0.5 and 0.61 suggesting significant crowding out of private spending and relatively little chance of Lloyd George’s proposed public works scheme having the desired affect on unemployment between 1929 and 1931. Nevertheless, the overall results of the model suggest that economies experiencing severe difficulties due the presence of deflation, large output losses, a liquidity trap, and little or no fiscal space can, and perhaps should, use unconventional means to stimulate the economy via expectations management and other unorthodox policies.

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32 Appendix

Table 1: Model Parameters

Parameter Value Description β 0.99 Discount factor α 0.3 Share of capital in domestic production sc 0.83 Consumption share si 0.09 Investment share sg 0.105 Government share sm 0.237 Import share sx 0.202 Export share sva 0.763 Value added share in gross output sd 0.763 Domestic input share in gross output σ 1.1 Inverse intertemporal elasticity of substitution ψ 0.04 Elasticity of risk premium wrt foreign assets κ 0.25 Elasticity of exports wrt the exchange rate h 0.8 Consumption habits ω¯b 0.25 Share of rule of thumb price adjusters θ 0.75 Share of ﬁrms with sticky prices µ 0.35 Inverse of labour supply elasticity ρ 2 Elasticity of substitution between domestic and foreign inputs ν 0.65 Elasticity of risk premium wrt foreign investor risk aversion δ 0.025 Rate of depreciation δa 1 Curvature of the capacity utilization cost function δs 4 Second derivative of investment adjustment costs ω¯c 0.4 Share of rule of thumb consumers ω¯n 0.8 Share of rule of thumb employment I K 0.03 Capital law of motion φ∗ 1.016 Law of motion for net foreign assets R∗ 1.01 World gross nominal interest rate By∗ 0.033 Net foreign asset to value added ratio R 1.042 Domestic gross nominal interest rate By 1.5 Government debt-to-value added ratio

33 Table 2: Model Parameters

Parameter Value Description

γg 0.1 Government expenditure smoothing in the fiscal rule γs 0.5 Primary surplus coefficient in the fiscal rule γb 0.2 Government debt coefficient in the fiscal rule γr 0.85 Interest rate smoothing in Taylor-rule γp 0.1 Interest rate - weight on price level target γs 0.1 Interest rate - weight on exchange rate target γ∆p 0.75 Interest rate - weight on price level smoothing γ∆s 0.75 Interest rate - weight on exchange rate smoothing ρa 0.5 Persistence of technology shock ρc 0.793 Persistence of preference shock ρi 0.793 Persistence of investment shock ρn 0.178 Persistence of labour supply shock ρr 0.0 Persistence of monetary shock ρg 0.75 Persistence of fiscal policy shock ρφ 0.75 Persistence of country risk premium shock ∗ ρφ 0.75 Persistence of foreign investor risk aversion shock ∗ ρm 0.5 Persistence of world trade shock ∗ ρπ 0.347 Persistence of world inflation shock ∗ ρr 0.0 Persistence of world interest rate shock

Table 3: Government Spending Multiplier Estimates

Regime 4 Quarters 8 Quarters Gold Standard - High Debt 0.50 0.61 Taylor Rule - High Debt 0.67 1.04 Gold Standard - Low Debt 0.51 0.59 Taylor Rule - Low Debt 0.68 1.07 Gold Standard - High Debt - DC 0.63 0.05 Taylor Rule - High Debt - DC 0.76 -0.678 Gold Standard - Low Debt - DC 0.66 -0.09 Taylor Rule - Low Debt - DC 0.83 -0.87 NB. DC implies the economy is “Debt Constrained”

34 Figure 1: Turning Points

Source: See main text (Data, Calibration and Simulation). NB. Shaded areas represent time between exit from the gold standard (1931M9) and implementation of Managed Economy strategy (1932M6)

35 Figure 2: UK Bank Rate 1694-2014

Source: Thomas et al (2010)

Figure 3: Interwar Britain DSGE Model Overview

36 Figure 4: Simulation Results

37 Figure 5: Contributions to the Growth Rate of Gross Output - Managed Economy Simulation