Academic journal article Brookings Papers on Economic Activity

When the North Last Headed South: Revisiting the 1930s

Academic journal article Brookings Papers on Economic Activity

When the North Last Headed South: Revisiting the 1930s

Article excerpt

ABSTRACT The U.S. recession of 2007-09 is unique in the post-World War II experience in the broad company it kept. Activity contracted around the world, with the advanced economies of the North experiencing declines in spending more typical of the developing economies of the South for the first time since the 1930s. This paper examines the role of policy in fostering recovery in that earlier decade. With nominal short-term interest rates already near zero, monetary policy in most countries took the unconventional step of delinking currencies from the gold standard. However, analysis of a sample that includes developing countries shows that this was not as universally effective as often claimed, perhaps because the exit from gold was uncoordinated in time, scale, and scope and, in many countries, failed to bring about a substantial depreciation against the dollar. Fiscal policy was also active--most countries sharply increased government spending--but was prone to reversals that may have undermined confidence. Countries that more consistently kept spending high tended to recover more quickly.

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The financial and economic dislocations of the past two years have been sharp and widespread. Yet there is ample precedent for such crises--and for the economic adjustment that follows to be wrenching. Among the advanced economies, those earlier crises occurred either before World War II or in open economies that were out of sync with the global cycle. (1) Crashes and severe contractions have been more common in emerging market economies. In the current episode, however, activity collapsed in unison in developed and developing countries around the world. Indeed, the rarity of current circumstances is why we rely on an event three-quarters of a century old, the Great Depression, as the main comparator. (2)

Given the importance of that precedent in understanding the current contraction, it is useful to cast a sharp focus on the role that policy actions played in shaping recovery in the 1930s. Unconventional monetary policy action has been called (Svensson 2003) a "foolproof way" of preventing deflation, especially in an open economy that can generate additional demand through depreciation of its currency. But when the global pie is shrinking, such action may be less effective. In the 1930s, moving off the gold standard bought fiscal authorities in many countries more space for stimulus because their central banks had room on their balance sheets to purchase more government securities and to generate additional income. It also allowed each country to devalue relative to gold. (3) Those actions, however, were mostly uncoordinated in time, scale, and scope. As a consequence, the record of success among countries abandoning the gold standard, both in avoiding a severe contraction and in speeding the recovery, is quite mixed. The 1930s also saw massive increases in government spending in many countries, but fiscal authorities were prone to reverse themselves. As a result, some of the direct benefits of that spending were offset by harmful effects stemming from its volatility.

I. The Appropriate Precedent

The Business Cycle Dating Committee of the National Bureau of Economic Research has put the peak of the current U.S. cycle at the end of 2007. There is no equivalent formalism at the world level, but indicators for most other countries started turning down about six months later, consistent with the view that the United States led the way down. Robert Barro and Jose Ursua (2008) have demonstrated that occasional large, adverse shocks hit national economies without the reason for those shocks always being clear. The current episode is particularly unusual because so many economies around the world contracted simultaneously.

Table 1 provides a historical perspective on the rarity of events like those of recent years, by documenting changes in real exports during past systemic crises from 1890 to today, for samples ranging from 35 to 111 countries. …

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