HISTORY LESSONS FOR A WORLD OUT OF BALANCE / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

History lessons for a world out of balance

By John Plender

Published: November 11 2010 20:46

The prevailing rhetoric about currency wars smacks of the 1930s, when a sauve qui peut mentality marred international monetary relations. What are the lessons of that beggar-thy-neighbour period for Group of 20 policymakers meeting at a time of renewed uncertainty in sovereign debt markets?

While the world has so far avoided the extreme loss of output experienced in the Great Depression, history suggests, among other things, that competitive devaluations and capital controls are the inevitable consequence of surplus countries failing to take any responsibility for global payments imbalances.


The 1930s gold standard was a fixed exchange rate system in which deficit countries were required to adjust by way of deflation rather than devaluation. Surplus countries, in contrast, incurred no penalty for accumulating gold. The chief surplus countries were the US and France, while counterpart deficits were run by countries such as the UK, Germany and Italy.


Come the Depression, the US and French failure to adopt expansionist policies forced deficit countries to contract. The contraction was exacerbated by surplus countries’ refusal to offer emergency financial help when banks failed. Britain went off the gold standard in September 1931, while Germany saw Hitler’s rise to power.


Barry Eichengreen, a leading expert on the gold standard, argues that far from being the stabilising influence it was perceived to be, the gold standard was itself the main threat to financial stability and prosperity between the wars. While World Bank president Robert Zoellick, in his call on this page for gold to be given a new role in the monetary system, was not advocating a return to the gold standard as such, Mr Eichengreen’s verdict suggests even a move to use gold as a reference point could be risky.


Another important lesson was that deficit countries outperformed surplus countries. This was because abandoning the gold standard liberated them to pursue expansionary policies; and the sooner this happened the better. Britain’s real growth in gross domestic product averaged 3.1 per cent from 1931 to 1938, whereas France, which stuck to the gold bloc until 1936, showed minus 1.6 per cent over the same period.


Yet for eurozone countries such as Greece, this lesson is tantalising because the European monetary union is a much tougher discipline than the gold standard, with no provision for exit from the single currency. Greece and other southern European countries that run counterpart deficits to Germany’s surplus are now being forced to deflate, while Germany resolutely places the burden of adjustment on southern Europe. External devaluation is ruled out, while internal devaluation, in Greece’s case, cannot include a debt write-down until the European Union works out how to implement last month’s vague agreement to change the rules of the monetary union. The irony is that Greece is in a position similar to that of Germany in the early 1930s, where cutting costs makes the debt load heavier.


The lessons of the 1930s are also relevant to the Chinese currency peg to the dollar. In the early 1930s China was on a silver standard. This had been in use since the country’s experiment with paper currency collapsed as a result of inflation and civil war in the late 14th century. When the US Treasury moved in 1934 to help American silver producers by buying silver to boost the price, China’s currency rose in value, leading to an outflow of silver and savage domestic deflation.


China went off silver in 1935. Its new paper currency then became the vehicle for one of history’s greatest hyperinflations as the country struggled to finance the war with Japan. The monthly inflation rate at its peak reached 2,178 per cent. This paved the way for the communist takeover. While most western economists believe an appreciation of the renminbi would be in China’s interest, some cite this precedent to suggest external pressure for currency appreciation can be destabilising. Steve Hanke of Johns Hopkins University even argues that if Beijing caves in to demands on the renmimbi, a Chinese upheaval and a world disaster will ensue.


China was not helped, incidentally, by its lack of exchange controls when its currency was under pressure. Yet the 1930s experience of capital controls, now back in vogue, suggests they are not always effective. Such was the degree of regulatory arbitrage and smuggling in foreign exchange that Germany and Italy introduced the death penalty for violations.


A final lesson concerns the failure of the 1933 London World Economic Conference to address the Depression. Mr Eichengreen argues that the inability to find a co-operative response stemmed from the lack of a shared diagnosis. That resonates across the decades. Expectations of Seoul should not be pitched too high.


The writer is an FT columnist


Copyright The Financial Times Limited 2010