Euro zone must look to UK in 1920s and 1930s
WHAT HAPPENS if a large, high-income economy, burdened with high levels of debt and an overvalued, fixed exchange rate, attempts to lower the debt and regain competitiveness? This question is of current relevance, since this is the challenge confronting Italy and Spain.
Yet, as a chapter in the International Monetary Fund’s latest World Economic Outlook demonstrates, a relevant historical experience exists: that of the UK between the two world wars. This proves that the interaction between attempts at “internal devaluations” and the dynamics of debt are potentially lethal.
Moreover, the plight of Italy and Spain is, in many ways, worse than the UK’s was. The latter, after all, could go off the gold standard; exit from the euro zone is far harder. Again, the UK had a central bank able and willing to reduce interest rates. The European Central Bank may not be able and willing to do the same for Italy and Spain.
The UK emerged from the first World War with public debt of 140 per cent of gross domestic product and prices more than double the prewar level. The government resolved both to return to the gold standard at the prewar parity, which it did in 1925, and to pay off the public debt, to preserve creditworthiness. Here was a country fit for the Tea Party.
To achieve its objectives, the UK implemented tight fiscal and monetary policies. The primary fiscal surplus (before interest payments) was kept near 7 per cent of GDP throughout the 1920s. This was, in turn, accomplished by the “Geddes Axe”, after a commission chaired by Sir Eric Geddes. This recommended slashing government spending in precisely the way today’s believers in “expansionary austerity” recommend.
Meanwhile, the Bank of England raised interest rates to 7 per cent in 1920. The aim of this was to support the return to the prewar parity. Coupled with the consequent deflation, the result was extraordinarily high real interest rates. This, then, was how the self-righteous fools in the British establishment greeted the hapless survivors of the hellish war.
So how did this commitment to fiscal famine and monetary necrophilia work? Badly. In 1938, real output was hardly above the level of 1918, with growth averaging 0.5 per cent a year. This was not just because of the Depression. Real output in 1928 was also lower than in 1918. Exports were persistently weak and unemployment persistently elevated. High unemployment was the mechanism for driving nominal and real wages down. But wages are never just another price. The aim was to break organised labour. These policies resulted in the general strike of 1926. They spread a bitterness that lasted decades after the second World War.
Quite apart from their huge economic and social costs, these policies failed in their own terms. The country went off gold, for good, in 1931. Worse, public debt did not fall. By 1930, debt had reached 170 per cent of GDP. By 1933, it had reached 190 per cent of GDP. (These numbers put the panic over today’s far lower ratios in perspective.) In fact, the UK did not return to its pre-first World War debt ratios until 1990.
Why was the UK unsuccessful in lowering the ratio of debt to GDP? Briefly, growth was too low and interest rates too high. As a result, even a huge primary fiscal surplus could not constrain the debt ratio.