Alpha Creditor Revaluations in the 1930s versus the 2010s
I am trying to make sense of the revaluation talk that surrounds the Sino-American trade relationship. Here are some thoughts on the issue. Your comments are appreciated.
In the 1920s, the United States was the Alpha Creditor having taken on a huge manufacturing role after Europe’s collapse during the First World War. At the time, exchange rates were fixed. And the US pegged its currency to gold at $20 per ounce. The British had pegged their currency to the U.S. dollar at the pre-war rate of $4.86 to the pound despite a needed re-valuation of the U.S. currency to reflect inflation/productivity differences. The market rate was $3.50. Murray Rothbard describes this in his book “A History of Money and Banking in the United States” which I quoted at length last Spring. Here is the crucial passage:
Great Britain might well have been able to return to the original form of gold standard at a new, realistic, depreciated parity of $3.50 to the pound. But it was not willing to do so. For the British dream was to restore, even more glowingly than before, British financial preeminence, and if it depreciated the pound by 30 percent, it would thereby acknowledge that the dollar, not the pound, was the world financial center. This it was fiercely unwilling to do; for restoration of dominance, for the saving of financial face, it would return at the good old $4.86 or bust in the attempt. And bust it almost did. For to insist on returning to gold at $4.86, even on the new, vitiated, gold-exchange basis, was to mean that the pound would be absurdly expensive in relation to the dollar and other currencies, and would therefore mean that at current inflated price levels, Britain’s exports—its economic lifeline— would be severely crippled, and a general depression would ensue. And indeed, Britain suffered a severe depression in her export industries—particularly coal and textiles—throughout the 1920s. If she insisted on returning at the overvalued $4.86, there was only one hope for keeping her exports competitive in price: a massive domestic deflation to lower price and wage levels. While a severe deflation is difficult at best, Britain now found it impossible, for the new system of national unemployment insurance and the new-found strength of trade unions made wage-cutting politically unthinkable.
But if Britain would not or could not make her exports competitive by returning to gold at a depreciated par or by deflating at home, there was a third alternative which it could pursue, and which indeed marked the key to the British international economic policy of the 1920s: it could induce or force other countries to inflate, or themselves to return to gold at overvalued pars; in short, if it could not clean up its own economic mess, it could contrive to impose messes upon everyone else. If it did not do so, it would see inflating Britain lose gold to the United States, France, and other “hard-money” countries, as indeed happened during the 1920s; only by contriving for other countries, especially the U.S., to inflate also, could it check the loss of gold and therefore halt the collapse of the whole jerry-built international monetary structure.
In this past decade the Chinese have occupied the position as Alpha creditor with an undervalued currency, with the US playing the role of the British. The difference this time around is that the US is not as concerned with the chest-pounding significance of a strong dollar. It is the Chinese who refuse to revalue. And as in the 1920s, the Chinese are therefore hoovering up foreign reserves – now denominated in depreciating U.S. dollars instead of gold.
But, just as in the 1920s, the Alpha Creditor today has been running an extremely loose monetary policy to maintain the peg. This effectively robs savers and creates asset bubbles and industrial overcapacity (See Michael Pettis’ article on this). When the Great Depression was ushered in as a severe recession, the result was an asset bubble collapse, revelation of malinvestment and industrial overcapacity as well as Depression in the U.S. We then witnessed a relative devaluation, not a revaluation of the US dollar. Why should we expect any different?
Based on comments and my own thoughts, I will update this post over the coming hours.
Update: Here are some more thoughts and questions. In my view, current account imbalances were at the centre of both the economic travails of the 1930s and of the ones in the 1970s. I see the parallel today as more akin to the 1930s than the 1970s. But here are some thoughts on that episode.
In the 1960s, the US had an overvalued currency that caused it to lose gold reserves, precipitating the end of the Bretton Woods currency regime. As the US dollar depreciated, the result was stagflation in the US. While Japan and Germany also suffered inflation due to the oil price shocks, inflation was not embedded in either country as it was in countries with depreciating currencies and relatively lower productivity gains like the US and the UK.
As regards the 1930s, my sense is that most observers falsely equate the US of today with the US of the 1930s. Since, the current account imbalances were the major source of the political tension, which both exacerbated the downturn and created a Depression, it makes sense to put those imbalances at the centre of any analysis of likely outcomes today. Thinking about imbalances makes one appreciate China’s role in this day as akin to the US role in the 1930s. I see the US role today as more akin to the British role of the 1930s.
In the 1920s, Britain already had a relatively high unemployment rate which only fell to 10.6 in 1927 before rising to 22.5 percent in 1932. Is this what could happen to US unemployment rates if we have a second financial crisis? One difference between now and then is that we have had a much greater monetary and fiscal stimulus than in the early 1930s to the point where I believe a technical recovery has already been underway for almost a year. Does that make 2010 more akin to 1931 or to 1937 regarding the political economy? And, does that make any difference regarding the appropriate economic policy response?
Update II: Thinking about China as the US equivalent again, the main difference today is that the loose monetary policy that China has followed has been self-imposed where the US opted for a loose policy before 1929 but were tighter afterward. In my view, the US desire to maintain the gold standard, a tighter monetary and fiscal policy produced deflation where in China, the looser fiscal and monetary policy has produced inflation, overcapacity and malinvestment.
The question for China is: what happens if the developed world double dips or if China faces a protectionist backlash? The right policy would be to fight these deflationary threats by increasing the social safety net and further biasing economic policy in favour of domestic consumption.
Moreover, Asians have already re-constituted their economic systems around a more regional approach than before the credit crunch with China at the centre. The Chinese should deepen their regional ties and promote this de-coupling in order to break away from a deflationary West.
I suspect that unless we see the Chinese current account surplus fall, protectionism is likely.
Update III: One point I forgot to make originally has to do with internal devaluation. You notice in Rothbard’s text he says "there was only one hope for keeping her exports competitive in price: a massive domestic deflation to lower price and wage levels." With Britain’s exchange rates fixed against its major trading partners and competitors, internal devaluation or forcing other countries to inflate is the only way it could remain competitive. This is the problem that Greece, Ireland, Spain and Portugal face within the Eurozone. That’s why Edward Hugh often talks about lagging productivity gains in southern Europe and the need to rectify this via internal devaluation. However, if the Eurozone induced a competitive currency devaluation by inflating the money supply, at a minimum, the southern Europeans would fare better in relation to non-Eurozone countries. But, Germany would be the largest beneficiary of such a tactic.