In Wednesday’s Financial Times, Nicholas Crafts, Professor of Economics at Warwick University, writes a superb op-ed “Fiscal stimulus is not our only option” explaining how an easy money policy worked for England in the 1930s, generating a 20% increase in real GDP between 1933 and 1937 despite fiscal retrenchment. The op-ed summarizes a report (Delivering growth while reducing deficits: Lessons from the 1930s) just published by the Centre Forum, a liberal think tank based in London.
Here is the opening paragraph:
The lessons of the 1930s are not well understood but are important. Britain enjoyed a strong recovery from the depression, with growth exceeding 3 per cent in each year between 1933 and 1937, despite a double-dip recession in 1932 and continuing turmoil in the international economy. Until 1936, growth owed nothing to rearmament. Indeed, as now, in the early 1930s the government was engaged in fiscal consolidation at a time of very precarious public finances, while from mid-1932 short-term interest rates were close to zero and could not be cut to deliver monetary stimulus. The parallels with today are clear, but today’s policymakers are unaware of the successful economic policy that revived growth. How did they pull this off 80 years ago – and could we do the same?
Crafts answers his question — correctly! — in the affirmative.
Uneasy Money 
Clearly, private expenditures–consumption and investment rose. The question is did bank credit rise? What financed the increase in private expenditure–hoarded money or increased bank lending?
The lessons for the US or UK today is not clear at all. Households and firms in the UK and US are heavily leveraged (even though in the US, firms hold lots of cash and have a good liquidity profile) and taking on more debt is not appealing.
The bottomline is that ultimately some sector is expanding its balance sheet for the economy to grow. If fiscal stimulus is ruled out, then we need the private sectors to lever up or trade surplus to expand (which in turn means other countries levering up).
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The history lesson in that paper is great.
I’m struggling with the arguments about price level targeting. Surely the MPC *has* proven beyond reasonable doubt its ability to raise the CPI and at least hit the inflation target, whilst at the ZLB. I guess you could argue the gilt market is still not convinced, based on the breakeven rates.
If the MPC does have that credibility, why is a price level target better than a growth rate target?
Surely the main thing that has been demonstrated by the last two years of inflation targeting in the UK is that inflation is simply the wrong target?
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He also said, “The chances for success would be greater if planning regulations were relaxed and we would once again envisage building 300,000 houses in a year, but that is politically too difficult.”
We probably don’t need the kinds of housing that they were fortunate enough to build then, but new definitions of ownership in housing would really help now. Many people would love to get out from under the roofs of others and into modular housing components readily put together in short order. Municipalities could put together grids (underground electrical and a variety of plumbing alternatives?) which could be rented to those who buy the needed components, and sell those components when they are ready to move. Manufacturing could increase and lots of lives be made a lot easier.
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Good blog.
BTW, and I hope someone in the Market Monetarism world picks this up: The last three reports on CPI, PPI and unit labor costs are all down.
Down.
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David,
Craft writes: “This worked through reducing real interest rates as the expected rate of inflation rose relative to nominal interest rates.”
Real rates were on the order of +12% going into 1933. To say real rates were, “falling” after 1933, as Craft does, is a severe understatement. The effect of removing the binding constraint on the path of future monetary policy (gold) was dramatic: real rates plunged by over twelve percentage points.
How does the Craft analogy apply to today? Real rates are currently negative 2% or so, not positive 12%. Were the Fed to take them down a fraction of the 30’s experience — say, 5% — would give us real rates of -7%. The sign on real rates matters. At -7%, the Fed would have a difficult, if not impossible, task quelling inflation without throwing the economy back into recession with a spike in real rates.
Actors in the economy make plans based on future policy. If you tell them, “we’ll have strongly negative real rates and then jack them up six-ten percentage points when inflation reaches our ceiling,” don’t be surprised if they shy away from spending/investment.
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srini, You can’t infer causality from accounting identities. If economic growth starts then balance sheets will expand along with the economy.
Britmouse, Not sure I get your question. Which growth rate are you referring to?
Becky, I don’t think that any one sector is crucial to a recovery, but clearly housing in the US has not been making any contribution to the recovery, in contrast to most upturns in which housing expands more rapidly than the rest of the economy.
Benjamin, Thanks. Good point. I am a bit overwhelmed now, so it will have to be someone else.
David, Most market monetarists are arguing in favor of short term NGDP target of 7-8% to make up for the shortfall in NGDP growth since 2008. That might translate into inflation of 3-6%, so that would be close to what you are suggesting. Under the gold standard, there was actually a fair amount of variability in year to year inflation (deflation) rates but there was confidence in long-term price stability. So I think the trick for monetary policy is to commit to a long-run level. The problem with that is that the price level is sensitive to supply shocks. That’s why in principle, the price level target should be a wage level. As Benjamin points out, money wages are barely rising.
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David I’m not sure where you get your info from but it seems that rates were not 12% in 1933:
http://www.measuringworth.com/datasets/interestrates/result.php
I am, however, in agreement about the importance of low rates. Keynes influenced policymakers into abandoning the gold standard and pursuing low long and short term rates in the 1930s, which is what produced the real growth.
Monetarists have this weird idea that low rates are a ‘sign’ of tight monetary policy, which simply makes no sense to me as low rates are the target rather than the indicator.
I note this here:
http://unlearningeconomics.wordpress.com/2011/11/16/keynes-figured-it-all-out-a-while-ago/
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David,
I’m still not clear on how you get from -6% real rates in year one to +2% real rates in year three without tanking the economy. Or how you get inflation up to 6% while promising to make it fall to 2% soon after.
Are you thinking linear? The cpi goes 6%,4%,2%? Fine, what will be the real interest rate in year two needed to produce that slowdown in inflation? -2%? 0? 2%? If its 2%, then I’d wager actors would foresee that level in year one, and they wouldn’t produce the inflation to begin with. If its -2% or 0%, I see no reason why inflation would decelerate so quickly!
You can produce excess inflation, or you promise to quickly extinguish it, but I have a very hard time believing you can do both.
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Unlearningecon, I think your question is directed to David Pearson, I was assuming that he was adding something like 8% deflation to 4% nominal interest rate. But that’s just a guess. The nominal interest rate is ambiguous, because it can be both an indicator and a target. What matters is where the nominal interest rate stands relative to expectations. Hawtrey understood that. If Keynes did not, it was a retrogression.
David I am saying that the low real rate is a reflection of very pessimistic expectations. Once the economy starts to recover and profit expectations recover as well, real rates will rise and nominal rates will follow along. If nominal rates rise along with real rates, the economy won’t tank.
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