Great, Greater, Greatest – Three Finnish Depressions

Brad DeLong has suggested that we rename the Great Recession the GreatER Depression in Europe as the crisis in terms of real GDP lose now is bigger in Europe than it was it during the Great Depression.

Surely it is a very simplified measure just to look at the development in the level of real GDP and surely the present socio-economic situation in Europe cannot be compared directly to the economic hardship during the 1930s. That said, I do believe that there are important lessons to be learned by comparing the two periods.

In my post from Friday – Italy’s Greater Depression – Eerie memories of the 1930s – I inspired by the recent political unrest in Italy compared the development in real GDP in Italy during the recent crisis with the development in the 1920s and 1930s.

The graph in that blog post showed two things. First, Italy’s real GDP lose in the recent crisis has been bigger than during 1930s and second that monetary easing (a 41% devaluation) brought Italy out of the crisis in 1936.

I have been asked if I could do a similar graph on Finland. I have done so – but I have also added the a third Finnish “Depression” and that is the crisis in the early 1990s related to the collapse of the Soviet Union and the Nordic banking crisis. The graph below shows the three periods.

Three Finnish Depressions

(Sources: Angus Maddison’s “Dynamic Forces in Capitalist Development” and IMF, 2014 is IMF forecast)

The difference between monetary tightening and monetary easing

The most interesting story in the graph undoubtedly is the difference in the monetary response during the 1930s and during the present crisis.

In October 1931 the Finnish government decided to follow the example of the other Nordic countries and the UK and give up (or officially suspend) the gold standard.

The economic impact was significant and is very clearly illustrate in the graph (look at the blue line from year 2-3).

We have nearly imitate take off. I am not claiming the devaluation was the only driver of this economic recovery, but it surely looks like monetary easing played a very significant part in the Finnish economic recovery from 1931-32.

Contrary to this during the recent crisis we obviously saw a monetary policy response in 2009 from the ECB – remember Finland is now a euro zone country – which helped start a moderate recovery. However, that recovery really never took off and was ended abruptly in 2011 (year 3 in the graph) when the ECB decided to hike interest rate twice.

So here is the paradox – in 1931 two years into the crisis and with a real GDP lose of around 5% compared to 1929 the Finnish government decided to implement significant monetary easing by devaluing the Markka.

In 2011 three  years into the present crisis and a similar output lose as in 1931 the ECB decided to hike interest rates! Hence, the policy response was exactly the opposite of what the Nordic countries (and Britain) did in 1931.

The difference between monetary easing and monetary tightening is very clear in the graph. After 1931 the Finnish economy recovered nicely, while the Finnish economy has fallen deeper into crisis after the ECB’s rate hikes in 2011 (lately “helped” by the Ukrainian-Russian crisis).

Just to make it clear – I am not claiming that the only thing import here is monetary policy (even though I think it nearly is) and surely structural factors (for example the “disappearance” of Nokia in recent years and serious labour market problems) and maybe also fiscal policy (for example higher defense spending in the late-1930s) played role, but I think it is hard to get around the fact that the devaluation of 1931 did a lot of good for the Finnish economy, while the ECB 2011’s rate hikes have hit the Finnish economy harder than is normally acknowledged (particularly in Finland).

Finland: The present crisis is The Greatest Depression

Concluding, in terms of real GDP lose the present crisis is a GreatER Depression than the Great Depression of the 1930s. However, it is not just greater – in fact it is the GreatEST Depression and the output lose now is bigger than during the otherwise very long and deep crisis of the 1990s.

The policy conclusions should be clear…

PS this is what the New York Times wrote on October 13 1931) about the Finnish decision to suspend the gold standard:

“The decision of taken under dramatic circumstances…foreign rates of exchange immediately soared about 25 per cent”

And the impact on the Finnish economy was correctly “forecasted” in the article:

“In commercial circles it is expected that the suspension (of the gold standard) will greatly stimulate industries and exports.”

HT Vladimir

Related post:
Currency union and asymmetrical supply shocks – the case of Finland

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Bennett McCallum told “my” Kuroda story a decade ago

From to time I will make an argument and then later realize that it really wasn’t my own independently thought out argument, but rather a “reproduction” of something I once read. Often it would be Milton Friedman who has been my inspiration, however, Friedman is certainly not my only inspiration.

Another economist who undoubtedly have had quite a bit of an influence on my thinking is Bennett McCallum and guess what – it turns out that the argument that I was making in my latest post on the “Kuroda recovery” is very similar to the type of argument Bennett made in a number of papers around a decade ago about how to get Japan out of the deflationary trap. Bennett has kindly pointed this out to me. I know Bennett’s work on Japan quite well, but when I was writing my post yesterday I didn’t realize how close my thinking was to Bennett’s arguments.

I therefore think it is appropriate to touch on some of Bennett’s main conclusions and how they relate to the situation in Japan today.

I my previous post I argued that easing of monetary policy in Japan would primarily work through an increase in domestic demand – contrary to the general perception that monetary easing would primarily boost exports through a depreciation of the yen. Bennett told the exact same story a decade ago in his paper “Japanese Monetary Policy, 1991–2001″ (and a number of other papers).

While I used general historical observations to make my argument Bennett in his 2003 paper uses a formal model. His model is a variation of an open economy DSGE model calibrated for the Japanese economy originally developed with Edward Nelson.

In his paper Bennett simulates a shock to inflation expectations – from -1% inflation to +1% inflation. Hence, this is not very different from the actual shock we are presently seeing in Japan. However, while the “Kuroda-shock” is a direct shock to the money base in Bennett’s example the exchange rate is used as the policy instrument.  However, this is not really important for the results in the model (as far as I can see at least…).

In Bennett’s model the Bank of Japan is buying foreign assets to weaken the yen to increase inflation expectations. According to the general perception this should lead to an marked improvement Japanese net exports. However, take a look at what conclusion Bennett reaches:

The variable on whose response we shall focus is the home country’s— i.e., Japan’s—net export balance in real terms….we see that the upward jump in the target inflation rate (π), which occurs in period 1, does indeed induce an exchange-rate depreciation rate that remains positive for over two years. Inflation, not surprisingly, rises and stays above its initial value for over two years, then oscillates and settles down at a new steady state rate of 0.005 (in relation to its starting value). Quite surprisingly, p responds more strongly than s so the real exchange rate appreciates. As expected, however, real output rises strongly for two years.

Most importantly, the real (Japanese) export balance is so affected by the two-year increase in real output that it turns negative and stays negative for almost two years.

Hence, Bennett’s simulations shows the same result as i postulated in my previous post – that monetary easing even if it leads to a substantial weakening of the yen will primarily boost domestic demand. In fact it is likely that after a few quarters the boost to domestic demand will lead to higher import growth than export growth and hence the net impact on the Japanese trade balance is likely to be negative.

Said, in another way there is no beggar-thy-neighbor-effect. In fact is anything monetary easing in Japan is likely to boost exports to Japan rather than the opposite.

I am sure that Bennett’s papers also in the future will inspire me to write blog posts on different topics as anybody who follow my blog knows it has done in the past – even when I don’t realize myself to begin with. Until then I suggest to my readers that you take a look at Bennett’s 2003 paper. It will teach you quite a bit about what is happening in Japan a decade after Bennett wrote the paper.

Fiscal devaluation – a terrible idea that will never work

Maybe I am ignorant, but until recently I had never heard of the concept “fiscal devaluation” (at least not that term), but I fear it could be an idea that could have considerable political appeal, but as I understand the idea it smells of protectionism and the idea is based on a mis-diagnosing the reasons for the present crisis – particularly in the euro zone.

What is a “fiscal devaluation”?

The idea behind fiscal devaluations is that a nation can improve it’s competitiveness by basically “twisting” taxes by cutting payroll taxes and finance it by increasing VAT.

The idea is not new. Already back in 1931 John Maynard Keynes suggested a VAT style tariff on all imported goods plus a uniform subsidy on all exports. In 2011 the idea was re-introduced by Gita Gopinath, Emmanuel Farhi and Oleg Itskhoki in their paper “Fiscal Devaluations”.

I will not go through the paper (and it the idea I want to discuss rather than the specific paper), but rather discuss why I find the idea terrible and why I think it will not achieve any of the results suggested by it’s proponents.

Fiscal devaluation is protectionism

The first thing that came to my mind when I heard the description of a fiscal devaluation was that this is basically a typically 1930s style protectionist idea: Tax imports and subsidies exports. Anybody who have studied economics should know that protectionism is extremely negative for everybody and such protectionist ideas will lower the economic welfare of the country that introduces the protectionist measures and of other countries. Only fools advocate protectionism.

Furthermore, I am completely unaware of any countries that came out of the Great Depression through a fiscal devaluation, but I know of many countries that tried. This is an idea that have been tried before and failed before. So why try it again? However, I can easily find numerous examples of countries that have undertaken proper (monetary) devaluations and have succeed. The UK and the “Sterling bloc” in 1931, the US in 1933, Sweden in 1992 and Argentina in 2002. The list is much longer…

The point is that a fiscal devaluation is negative sum game – it hurts everybody – while a monetary devaluation is a positive sum game if the world is caught in a quasi-deflationary environment as has been the case for the last 4-5 years. As I have stress before a monetary devaluation is not a hostile act – a fiscal devaluation certainly is.

Mis-diagnosing the problem

A key problem for the Fiscal devaluationists in my view is that they mis-diagnose the problem in for example South Europe as a problem of competitiveness rather than a problem of weak domestic demand. In that sense it is paradoxical that origin of the idea comes from Keynes.

It might of course be that South Europe has a competitiveness problem in the sense that the real exchange rate is “overvalued”. However, competitiveness does not determine aggregate demand. The real exchange rate determines the composition of aggregate demand, but not the aggregate demand. Aggregate demand is determined by monetary policy. And the lack of aggregate demand is Greece’s (and the other PIIGS’) real problem. The euro crisis is not a competitiveness problem, but a NGDP crisis.

Countries with fixed exchange rates or countries – like Spain or Portugal – that are in currency unions are not able to ease monetary policy as the have “outsourced” their monetary policy – in the case of Spain and Portugal to the ECB. A fiscal devaluation is unable to ease monetary policy – at the most it can only “twist” demand from domestic demand to exports (…there is a small aber dabei – see PPS below). In that sense a fiscal devaluation is mercantilist idea – an idea that exports in some way is “better” than domestic demand.

However, artificially twisting demand from domestic demand reduces the international division of labour. It might be that Keynes or the average German policy maker think that is a great idea, but Adam Smith and David Ricardo are spinning in their graves.

There is only one way out of a quasi-deflationary trap – monetary easing

For countries caught in a quasi-deflationary trap – as the South European countries – a fiscal devaluation might temporarily improve external balances, but it will not do anything about the deflationary pressures. There are only two options for these countries – either they leave the euro or the ECB ease monetary conditions.

Lower taxes is great for long-run growth – twisting taxes is mostly a waste of time

Finally I would like to stress that I in no way is arguing against lowering payroll taxes. However, the purpose of lowering payroll taxes should not be to increase export, but to remove a tax wedge that lowers employment. Lower payroll taxes very likely will increase the level of potential GDP (but not impact nominal GDP). Furthermore, I doubt that higher VAT would be beneficial to any country in the world. Even worse if the central bank – like the ECB – targets headline CPI-inflation then higher VAT rates will temporarily increase headline inflation and that could trigger a monetary tightening. If you think that is alarmist – then just think about what happened when a number of euro zone countries started to increase indirect taxes in 2010-11 at the same time oil prices spiked. The ECB hiked interest rates twice in 2011!

Reading recommendation for policy makers

Concluding, fiscal devaluation is a terrible idea and we should call it what it is – protectionism – and any policy maker out there who is tempted by these ideas should carefully study the experience of the 1930s. The best way to learn about the serious welfare cost of this sort of ideas is to read Doug Irwin’s excellent little book Trade Policy Disaster.

In his book Doug clearly shows that fiscal devaluation style measures never worked but helped escalate trade wars while proper monetary devaluations helped countries like the US, the UK and Sweden get out of the Great Depression.

You could also read Chapter 10 in Larry White’s great book Clashes of Economic Ideas. In that chapter Larry explains the disaster that was economic policy in India in the first 4-5 decades after Indian independence in 1947. India of course pursued (and to a large extent still do) the kind of policies that the fiscal devaluationistists advocate. The result of course was decades of lacklustre growth.

So before policy makers are tempted by protectionist ideas packaged in modern New Keynesian models they should study history and then they should realize that “fiscal devaluation” is terrible idea that will never work.

PS Maybe it is not a surprise that the French government – yes the government that introduced a 75% marginal income tax (!) – find a fiscal devaluation attractive.

PPS I write above that improving competitiveness cannot ease monetary conditions. That is not entirely right as anybody who knows Hume’s traditional price-specie-flow mechanism would acknowledge, but that is at best a very indirect channel and is very unlikely to be very powerful. In fact there has been a quite drastic improvement in external balance in some of the PIIGS, but none of these economies are exactly booming.

Update: Doug Irwin tells me that Joan Robinson used to called ideas like a fiscal devaluation “Silly clever”.  I think it is an excellent term – from time to time you will see economic papers that are overly mathematical and complex that come up with answers that are a result of certain (random?) model assumptions that gives anti-economic results. I am afraid silly clever has become fashionable and certain academic economists.

Update 2: My friend David Glasner just wrote a blog post addressing a similar topic – competitive devaluations – we reach very similar conclusions. I love David’s Ralph Hawtrey quote on competitive devaluation – it is very similar to what I argue above.

Is monetary easing (devaluation) a hostile act?

One of the great things about blogging is that people comment on your posts and thereby challenge your views and at the same time create new ideas for blog posts. Therefore I want to thank commentator Max for the following response to my previous post:

“I don’t think exchange rate intervention is a good idea for a large country. For one thing, it’s a hostile act given that other countries have exactly the same issue. And it can’t work without their cooperation, since they have the power to undo the intervention.” 

Let me start out by saying that Max is wrong on both accounts, but I would also acknowledge that both views are more or less the “consensus” view of devaluations and my view – which is based on the monetary approach to balance of payments and exchange rates – is the minority view. Let me address the two issues separately.

Is monetary easing a hostile act?

In his comment Max describes a devaluation as a hostile act towards other countries. This is a very common view and it is often said that it is a reflection of a beggar-thy-neighbour policy for a country to devalue its currency. I have two comments on that.

First, if a devaluation is a hostile act then all forms of monetary easing are hostile acts as any form of monetary easing is likely to lead to a weakening of the currency. Let’s for example assume that the Federal Reserve tomorrow announced that it would buy unlimited amounts of US equities and it would continue to do so until US nominal GDP had increased 15%. I am pretty sure that would lead to a massive weakening of the US dollar. In fact we can basically define monetary easing as a situation where the supply of the currency is increased relative to the demand for the currency. Said, in another way if the currency weakens it is a pretty good indication that monetary conditions are getting easier.

Second, I have often argued that the impact of a devaluation does not primarily work through an improvement in the country’s competitiveness. In fact the purpose of the devaluation should be to increase prices (and wages) and hence nominal GDP. An increase in prices and wages can hardly be said to be an improvement of competitiveness. It is correct that if prices and wages are sticky then you might get an initial real depreciation of the currency, however that impact is not really important compared to the monetary impact. Hence, a devaluation will lead to an increase in the money supply (that is how you engineer the devaluation) and likely also to an increase in money-velocity as inflation expectations increase. Empirically that is much more important than any possible competitiveness effect.

A good example of how the monetary effect dominates the competitiveness effect: the Argentine devaluation in 2002 actually led to a deterioration of the Argentine trade balance and what really was the driver of the recovery was the sharp pickup in domestic demand due to an increase in the money supply and money-velocity rather than an improvement in exports. See my previous comment on the episode here. When the US gave up the gold standard in 1933 the story was the same – the monetary effect strongly dominated the competitiveness effect.

Yet another example of the monetary effect of a devaluation dominating the competitiveness effect is Denmark and Sweden in 2008-9. It is a common misunderstanding that Sweden grew stronger than Denmark in 2008-9 because a sharp depreciation of the Swedish krona led to a massive improvement in competitiveness. It is correct that Swedish competitiveness was improved due to the weakening of the krona, but this was not the main reason for Sweden’s relatively fast recovery from the crisis. The real reason was that Sweden did not see any substantial decline in money-velocity and the Swedish money supply grew relatively steadily through the crisis.

Looking at Swedish exports in 2008-9 it is very hard to spot any advantage from the depreciation of the krona. In fact Swedish exports did more or less as badly as Danish exports in 2008-9 despite the fact that the Danish krone did not depreciate due to Denmark’s fixed exchange rate regime. However, looking at domestic demand there was a much sharper contraction in Danish private consumption and investment than was the case in Sweden. This difference can easily be explained by the sharp monetary contraction in Denmark in 2008-9 (both a drop in M and V).

Furthermore, let’s assume that the Federal Reserve announced massive intervention in the FX market to weaken the US dollar and the result was a sharp increase in US nominal GDP. Would the rest of the world be worse off? I doubt it. Yes, the likely impact would be that for example German exports would get under pressure as the euro would strengthen dramatically against the dollar. However, nothing would stop the ECB from also undertaking monetary easing to counteract the strengthening of the euro. This is what somebody calls “competitive devaluations” or even “currency war”. However, in a deflationary environment such “currency war” should be welcomed as it basically would be a competition to print money. Hence, the “net result” of currency war would not be any change in competitiveness, but an increase in the global money supply (and global money-velocity) and hence in global nominal GDP. Who would be against that and in a situation where the global economy continues to contract and as such a currency war like that would be very welcomed news. In fact we can not really talk about a “war” as it would be mutually beneficial. So I say please bring on the currency war!

Is global monetary cooperation needed? No, but…

This brings us to Max’s second argument: “And it can’t work without their cooperation, since they have the power to undo the intervention.

This is obviously related to the discussion above. Max seems to think a devaluation will not work if it is met by “competitive devaluations” from all other countries. As I have argued above this is completely wrong. It would work as the devaluation will increase the money supply and money-velocity even if the devaluation has no impact on competitiveness at all. As a result there is no need for international monetary cooperation. In fact healthy competition among currencies is exactly what we need. In fact every time the major nations of the world have gotten together to agree on realigning exchange rates it has had major negative consequences.

However, there is one argument for international coordination that I think is extremely important and that is the need for cooperation to avoid “competitive protectionism”. The problem is that most global policy makers perceive devaluations in the same way as Max. They see devaluations as hostile acts and therefore these policy makers might react to devaluations by introducing trade tariffs and other protectionist measures. This is what happened in the 1930s where especially the (foolish) countries which maintained the gold standard reacted by introducing trade tariffs against for example the UK and the Scandinavian countries, which early on gave up the gold standard.

Unfortunately Mitt Romney seems to think as Max

Republican presidential hopeful Mitt Romney has said that his first act as US president would be to slap tariffs on China for being a “currency manipulator”. Here is what Romney recently said:

“If I’m president, I will label China a currency manipulator and apply tariffs” wherever needed “to stop them from unfair trade practices”

The discussion above should show clearly that Romney’s comments on China’s currency policy is economically meaningless – or rather extremely dangerous. Imagine what would be the impact on the US economy if China tomorrow announced a 40% (just to pick a number) revaluation of the yuan. To engineer this the People’s Bank of China would have to cause a sharp contraction in the Chinese money supply and money-velocity. The result would undoubtedly throw China into a massive recession – or more likely a depression. You can only wonder what that would do to US exports to China and to US employment. Obviously this would be massively negative for the US economy.

Furthermore, a sharp appreciation of the yuan would effectively be a massive negative supply shock to the US economy as US import prices would skyrocket. Given the present (wrongful) thinking of the Federal Reserve, that might even trigger monetary tightening as US inflation would pick up. In other words the US might face stagflation and I am pretty sure that Romney would have no friends left on Wall Street if that where to happen and he would certainly not be reelected in four years.

I hope that Romney has some economic advisors that realize the insanity of forcing China to a massive appreciation of the yuan. Unfortunately I do not have high hope that there is an understanding of these issues in today’s Republican Party – as it was the case in 1930 when two Republican lawmakers Senator Reed Smoot and Representative Willis C. Hawley sponsored the draconian and very damaging Smoot-Hawley tariff act.

Finally, thanks to Max for your comments. I hope you appreciate that I do not think that you would like the same kind of protectionist policies as Mitt Romney, but I do think that when we get it wrong on the monetary impact of devaluations we might end up with the kind of policy response that Mitt Romney is suggesting. And no, this is no endorsement of President Obama – I think my readers fully understand that. Furthermore to Max, I do appreciate your comments even though I disagree on this exact topic.

PS if you want to learn more about the policy dynamics that led to Smoot-Hawley you should have a look at Doug Irwin’s great little book “Peddling Protectionism: Smoot-Hawley and the Great Depression”.

Update: Scott Sumner has a similar discussion of the effects of devaluation.

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