Brian Ashcroft: Parallels are all too Depressing

PEOPLE were getting edgy. Very serious people. The debtor countries wanted financial support. The risk of default was increasing. But the main creditor and its banks were reluctant to accept reduced payments.

In an attempt to deal with the crisis policymakers devised a plan to restructure the obligations of the main debtor. A new overarching funding facility was proposed. And there was stress on fiscal austerity to restore and maintain confidence in the long-term fiscal stability of the sovereigns.

But the problem was not resolved. Economic conditions deteriorated in the debtor countries and unemployment rose considerably. There was a fear of contagion to other countries including the main creditor and beyond.

Sound familiar? Yes, it is. But this is 1929 not the eurozone and the world economy in 2011. In 1929 the main debtor country, ironically, was Germany and the main creditor was the US. The new funding facility in 1929-30 was the Bank of International Settlements. In the eurozone we have the European Financial Stability Fund which will become in 2012 the European Stability Mechanism.

We know what happened after 1929. The global economy slid into the Great Depression. In the major economies, output first began to fall in Germany from the first quarter of 1928, then stabilised before dropping again from the third quarter of 1929. Then in the US a major downturn commenced from the third quarter of 1929, heralded by the Wall Street crash in the autumn. The UK and France followed, with output falling from the first and second quarters of 1930, respectively.

Contagion was reinforced by the Gold Standard. With currencies pegged to gold, exchange rates were effectively fixed. Hence, a downturn in demand in one country, particularly the US, lowered imports from the other countries.

In the 1920s, the US was enjoying steady growth but the stock market there was booming until the speculative bubble burst. As asset prices fell, people scrambled to pay off, or defaulted on, their debts and the demand for goods and services fell, spreading effects worldwide through the trade contagion route.

There followed successive waves of banking panics, so that by the trough of the recession in 1933, one-fifth of the banks in existence in the US at the start of 1930 had failed. The banking closures reduced the money supply.

A mistaken policy response to the fear in the markets that the US might leave the Gold Standard, like Britain in September 1931, led to the Fed tightening the money supply further and raising interest rates. Demand for goods and services fell even more. By the trough of the Depression, US industrial production had fallen by 47 per cent, German and French production by 42 per cent and 31 per cent, respectively and British production by 16 per cent. The smaller fall in British output was in part a reflection of an already weak economy, following the return to the Gold Standard in 1925.

Is it about to happen again? Christine Lagarde, head of the International Monetary Fund, certainly fears the possibility. In mid-December, she raised the spectre of a 1930s-style economic and political morass. However, the parallel with the Great Depression is not directly apposite to the world economy today. The crisis of 2008 is the better comparison. In 2008, the world was faced with a banking and a potential debt deflation crisis of such magnitude that without the co-ordinated monetary and fiscal policy intervention that occurred it is likely that we would have experienced Great Depression II. Rather it is in the eurozone where the parallel with 1930s seems more appropriate.

The speculative financial bubble that burst in 2008 had a particular incidence in the eurozone. Governments in the periphery were able to borrow at near-German rates because the financial markets believed that peripheral country sovereign bonds had the backing of the eurozone authorities. This resulted in major flows of capital from the centre – especially German and French banks – to the periphery.

A crisis was precipitated when these flows suddenly stopped, due in part to the wider consequences of the credit crunch and as many of the investments went bad e.g. commercial property and housing investments in Spain and Ireland.

This led to a rapid rise in public debt as some of the periphery countries bailed out their banks, and spent more and taxed less in the recession mainly through indirect “automatic stabiliser” effects – e.g. increased unemployment benefit payments.

The fixed exchange rate regime within the zone is similar to the Gold Standard in that internal economic adjustments to country balance of payments imbalance must occur through internal price and wage changes. But in one respect it is worse because the burden of adjustment is expected to fall only on those countries in the periphery that are running current account deficits.

Germany, with its large current account surplus, stands aloof. The pain that is being borne by Greece, Ireland, Italy, Portugal and Spain is that much greater because of it. And this heightens the risk of greater output losses, larger budget deficits, greater borrowing than expected, higher bond yields and default. Added to this are the emphasis on fiscal austerity, and the European Central Bank’s focus on a tight money policy, fearing rising inflation more than the risk of recession, while refusing to act directly as a lender of last resort to the beleaguered sovereigns in the periphery. All of this resonates strongly with the 1930s.

As we enter 2012 it does not appear that the eurozone has put in place policies that adequately deal with the financing needs of the peripheral sovereigns. Agreement and rapid implementation of a full fiscal union, with financial risk pooling, Eurobonds and the ECB acting as a full lender of last resort would reassure the financial markets.

The present agreement will not satisfy the markets. And it is not simply high levels of sovereign debt that are causing high bond yields, because such a relationship is only evident in the eurozone. Hence, the risk of major sovereign and European bank defaults remains within the eurozone and with that a 1930s-style economic and political morass.

What of the UK and Scotland? While I would strongly criticise the UK government for its fiscal austerity programme, there are several positives that will help protect us to some degree from contagion if there is a euro catastrophe.

First, we have a flexible exchange rate. Second, our banks are better capitalised than their counterparts in the eurozone. Third, we have our own central bank that is operating a much looser monetary policy than the ECB and could go a lot further. For example, a “cheap money” policy that pushes real interest rates below zero and so overcomes the stultifying effect on monetary policy of what economists call the “zero bound on nominal rates”. To implement this would require a relaxation, or increase, in the inflation target for several years. But extreme times require extreme measures.

And Scotland can, in addition, take some comfort from its experience in the recent recession. GDP dropped by less than the UK, although employment fell more. While the public sector acted as a buffer, we relied less on it for protection during the downturn than the North-east of England, Wales, Northern Ireland, West Midlands and East Midlands. This was in part because manufacturing while contracting held up much better than the sector in many other parts of the UK.

Small comfort I know. But we may need to clutch at as many straws as we can find.

• Brian Ashcroft is emeritus professor of economics at the University of Strathclyde.