PRINCETON – Britain’s policy of fiscal consolidation, recently announced by Chancellor of the Exchequer George Osborne, sent shock waves around the world. Osborne argued that Britain was on the brink: that there was no alternative to his policy if the country was to avoid a massive crisis of confidence.
Other countries, such as Greece, needed to have a full-blown crisis in order to prompt such adjustment measures, whereas Britain was acting prudently and preemptively. If Britain, with a relatively low share of public debt to GDP (64.6%) is worried, the implication is that many other countries should be much more concerned.
But drastic attempts at fiscal consolidation immediately evoke memories of the Great Depression. Andrew Mellon, the United States Treasury Secretary at the time, talked about liquidating workers, farmers, stocks, and real estate in order “to purge the rottenness out of the system.” In Britain back then, Philip Snowden, a small man with a narrow, pinched face, who needed a cane to walk, seemed to want to remake the British economy in his physical image.
Given these historical analogies, a slew of heavyweight Keynesian critics are warning that the world is about to repeat all the disasters caused by bad fiscal policy in the 1930’s. But this interpretation of the Great Depression, common though it is, is misguided.
In the first place, the critics get their history wrong. US President Herbert Hoover’s administration did not initially respond to the depression by emphasizing the need for fiscal austerity. On the contrary, Hoover and other figures argued in a perfectly modern, Keynesian fashion that large-scale public-works programs were needed to pull the economy out of the trough.
Moreover, today’s Keynesians ignore the urgency behind the depression-era concern with balanced budgets. When the Hoover administration did swing to fiscal tightening, it was responding to pressures from the capital and foreign-exchange markets, which in turn were responding to the crises in Latin America and Central Europe, where public finances had been a major part of the problem.
Beginning in September 1931, the markets became nervous about the US, causing large outflows from American banks – and thus from the dollar. The Depression had rendered capital markets incapable of absorbing large quantities of government (or, indeed, any other) debt. As a result, fiscal consolidation appeared to be the only way to restore confidence.
Great Britain in 1931 already grasped this logic. Snowden was worried that any attempt by the British government to borrow would fail, which would constitute an “admission of national bankruptcy.” That September, concerns about public debt and the British government’s ability to enforce austerity led to a run on the pound. Rather than trying to mount a last-ditch defense of the fixed exchange rate, the government, at the suggestion of the Bank of England, agreed to abandon the gold standard and devalue the pound.
A third problem with the conventional Keynesian interpretation is that the balanced-budget approach during the Great Depression did actually work. It calmed markets, and Britain’s departure from the gold standard freed monetary policy from its previous constraints, and allowed a monetary stabilization. The country was no longer subject to imported deflation via the fixed exchange rate.
But an equally important part of the recovery process was that Britain had left gold with a more or less balanced budget. That was why monetary policy could be managed with greater flexibility. The balanced budget thus allowed Britain to have a strong recovery, ensuring that the 1930’s were a much better decade for the British economy than the 1920’s had been.
Finally, those who view the Great Depression as fundamentally a product of tight fiscal policies and “Treasury orthodoxy” overlook the much greater culpability of a fixed exchange-rate regime for the transmission of bad monetary policy, and thus for fueling the contraction.
The major question today should be whether the failure of capital markets (and the implications for government debt) after 2007 has been as severe as during the Great Depression. At the moment, there has not been widespread revulsion against all government debt, and some countries today clearly have better access than others to capital markets, enabling them to finance their deficits externally.
The debate about room for fiscal maneuver in practice soon becomes a debate about whether countries that have easily financed debt in the past can automatically continue to do so. We are still in the last stages of a bubble in government debt that arose in the first stage of the financial crisis from the “flight to security” of US Treasuries. When that bubble collapses, it will hit not just the weaker countries – the equivalent of sub-prime mortgages – but also stronger creditors.
In the Great Depression, one of the big surprises was the devastating abruptness with which markets turned on the US. In the late summer of 1931, the dollar, alongside the French franc, appeared to be the strongest currency in the international system. That precedent should serve as a warning of how vulnerable governments and their finances can rapidly become, and of how fiscal policy can stand in the way of a monetary approach oriented toward stability.
Greece in the spring of 2010 sent a wake-up call to Great Britain. The British response should prompt other industrial economies, above all the US, to tackle their long-term fiscal weaknesses.