How Depressions End: Lesson from Interwar Britain∗ George, Chouliarakis Chairman of the Council of Economic Advisers, Greece The University of Manchester y Tadeusz, Gwiazdowski The University of Manchesterz April 2015 PRELIMINARY VERSION: Please do not quote or circulate.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 gov- ernment 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 unconven- tional 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, yArthur Lewis Building, 3rd Floor, School of Social Sciences, The University of Manchester, Manchester, M13 9PL. E-mail address:[email protected] zAddress 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 persis- tent 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 com- mit 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 in- vestment 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 con- sider 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 eas- ing (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 con- cept 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 in- flationary 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 es- cape 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.