Is it 1936 already?!?!?

Well that didn’t take long.  I have to admit that when I made this prediction eight days ago I didn’t really expect it to happen so fast:

The great irony of the Depression period is that by 1936 things had gotten so bad that even the French had to devalue.  The French had helped cause the Depression by their obsessive hoarding of gold, and their refusal to help out the weaker countries.  In other words, in monetary terms France was the Germany of the 1930s.  When you see doubts raised about countries like Finland and Austria, you really have to wonder if even the German debt is truly safe.

I still think the policy elite are slightly less pigheaded than in the 1930s, so I doubt things will go that far.  But it would be a lot simpler if they recognized reality right now, instead of dragging out the pain.

First a bit of background.  In the late 1920s and the early 1930s the Bank of France hoarded vast quantities of gold.  This raised the value of gold, which meant deflation (once the US and Britain stopped offsetting the French hoarding after October 1929.)  An international financial crisis ensued, with one country after another leaving the gold standard.  Britain in 1931, the US in 1933, etc.  At first France got off lightly, as their currency had been undervalued on the eve of the Depression.  But by 1936 the deflation in France was so bad that even they had to devalue.  In each case countries didn’t begin recovering until they had left the gold standard.

In the modern world things seem to move much faster than during the long agonizing 1931-36 collapse of the gold standard.  Today German bonds were hit hard:

The debt crisis that began more than two years ago now risks engulfing Germany. The Markit iTraxx SovX Western Europe Index of credit-default swaps on 15 governments rose to an all- time high as Germany failed to find buyers for 35 percent of the bonds offered at an auction.

Germany is of course the France of the 21st century.

It’s now quite possible that the Fed may have to move toward NGDP targeting before they would have liked.  The Fed cannot allow another collapse of NGDP like we saw in 2009.  The cost in terms of banking distress, worsening public finances, international discord and mass unemployment is simply too great to contemplate.  I have no doubt that Ben Bernanke of all people understands this.

Perhaps the Europeans will come together and do something dramatic in the next few days.  But if not, the Fed must be prepared to hold an emergency meeting and do whatever it takes.  To quote David Beckworth:

Also, if a nominal GDP level target is explicit and widely understood it would actually serve to mitigate the effects of financial shocks.  If the public understood the Fed would always close return nominal GDP to its trend path, public expectations would be better anchored and thus be less susceptible to wide swings.  That means velocity (i.e. real money demand) would be more stable.  For these reasons, it is reasonable to conclude that had the Fed been targeting nominal GDP during the 2008-2009 financial crisis, the outcome would have been far milder.  And for the same reasons, the Fed should be targeting nominal GDP now given the looming financial threat coming from the Eurozone crisis.

It’s Bernanke’s moment of truth.

PS.  Also check out Beckworth’s post showing the non-German NGDP in the eurozone.  And people wonder why the eurozone is having a sovereign debt crisis.

HT:  Joe2


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24 Responses to “Is it 1936 already?!?!?”

  1. Gravatar of dwb dwb
    23. November 2011 at 09:31

    theres hope…never underestimate the ability of the ECB and Europeans to contradict themselves. The next few weeks are critical. Germany seems to think its immune, but in reality if the Euro breaks the combined weight of a deep recession (the rest of Europe will IMO devalue wrt Germany, crushing that export machine) and the ensuing bank bailouts will crush German finances. Suddenly they will look very, ahem, Irish and Spanish. The irony, of course, it’s they will need Bundesbank QE. why oh why do they have re-re-re-learn the lessons of the 30s the hard way.

  2. Gravatar of Joe2 Joe2
    23. November 2011 at 10:56

    DWB Says:
    “Suddenly they will look very, ahem, Irish and Spanish.”

    It amazes me how utterly complacent and stupid the German position has been.

    Germany is NOT out of the woods in any shape of form. They have a debt level of 80%ish and the only reason the market has treated them as the anchor is because of their export machine potential and the annual deficit if a little better.. running a primary surplus.

    If markets pick up on the idea the German export machine is done like a dinner they will be in the same position as France and the soft core having to meet austerity targets with an unsuited monetary policy. Their collapse could be spectacular.

    Meanwhile the ECB president talks about the ECB’s success at taming inflation. Lord almighty.

  3. Gravatar of Benjamin Cole Benjamin Cole
    23. November 2011 at 12:50

    I will say it out loud again: The purpose of a macroeconomic policy should be to promote prosperity. That includes the policies of central banks.

    If we can have prospeorti with inflation, or without inflation, fine. But prosperity comes first.

    If we can only have prosperity with some inflation, than that is the best course.

    Inflation is just an expansion of an index, some nominal coordinates. Big whoop.

    Crickey, you would think Satan and Baal are in league with 4 percent inflation, judging from the economics profession today. Aside from Market Monetarists, they have lost their marbles.

  4. Gravatar of Benjamin Cole Benjamin Cole
    23. November 2011 at 12:52

    Boy, Eurozone stocks off 60 percent from 2000. Is austerity working?

  5. Gravatar of W. Peden W. Peden
    23. November 2011 at 13:08

    Benjamin Cole,

    Without a doubt, austerity in the Eurozone is achieving the goal of preventing hyperinflation.

  6. Gravatar of Doc Merlin Doc Merlin
    23. November 2011 at 13:39

    Um, what austerity? Everyone keeps talking about austerity, but I haven’t really seen any…. just tax increases.

  7. Gravatar of Cthorm Cthorm
    23. November 2011 at 13:48

    Doc –

    Austerity? Iceland.

  8. Gravatar of W. Peden W. Peden
    23. November 2011 at 13:50

    Doc Merlin,

    If you pay taxes, tax increases certainly make life more austere. Maybe it doesn’t fit some use of the word ‘austerity’, but severe deficit cuts via tax increases is austerity in a very important sense.

  9. Gravatar of Steve Steve
    23. November 2011 at 14:03

    Scott,

    You strike me as very overoptimistic. Green shoots in China? Fed moving closer to NGDP targeting? Not what I’m seeing…

    I guess it doesn’t concern you that the Fed wants banks to stress their loans against -8% RGDP and 13% unemployment. To me that means the end of bank lending. Plus I see no evidence that the Bertank has the courage to implement NGDP targeting, nor a belief that the problems are monetary rather than structural. Just recently he blamed Congress.

    Bernanke faces a very perverse political payoff matrix. He can sit on his hands and watch -8% RGDP, and everyone will blame Congress, the rich, the poor, the Greeks, the Italians, and the French. The he can resume complaining about 2% inflation when the economy tries to bounce from 30% below NGDP trend.

    OR, he can level target NGDP, resume QE, and get tons of political flack when headline inflation rises to 4 or 5 percent just in time for his renomination in 2013. He will lose his job in 2013.

    Which do you think he will choose? You believe in EMH, right? What’s the market telling you?

  10. Gravatar of Lars Christensen Lars Christensen
    23. November 2011 at 14:10

    Scott, the situation here in Europe is deeply depressing. Our policy makers have understood absolutely nothing and seem bend on repeating the mistakes of 1930s. I guess if you ask an ECB policy makers he/she would know nothing of 1931? Or the German default of 1932…

  11. Gravatar of ssumner ssumner
    23. November 2011 at 14:39

    dwb, Yes, there’s always hope.

    Joe2, The “taming inflation” stuff is beginning to sound like a sick joke. Thanks for the tip.

    Ben, Prosperity? What a novel idea? I don’t think all those serious thinkers in the eurozone would be interested in such a simple idea. It sounds to easy. Life is tough, and if not they’ll make it tough.

    Steve, You said;

    “You strike me as very overoptimistic. Green shoots in China? Fed moving closer to NGDP targeting? Not what I’m seeing… ”

    I think you misread me. I see China slowing, my point was that at least the government there understands that growth is priority number one. I think I said sliver of hope.

    And my point about the US wasn’t optimistic either. It was that things might get so bad that the Fed is forced to do NGDP targeting. That’s not exactly a happy forecast.

    You asked:

    “Which do you think he will choose? You believe in EMH, right? What’s the market telling you?”

    The US stock market obviously isn’t pricing in negative 8% RGDP, I’d say closer to 1% to 2%.

    But the stress test is a good point, do you have a link?

    Lars, Unfortunately you are right (and also prophetic.)

  12. Gravatar of Bonnie Bonnie
    23. November 2011 at 15:06

    You are right, the crisis hit Germany fast. Do you suppose it might have something to do with the CDS issue out there? There really isn’t a reliable way to insure the debt anymore, after what they did to holders of Greek bonds.

    Also, I’m a novice and I don’t really understand that NGDP graph. How is it so high in Germany vs. the rest of euro zone when they all share the same currency? It is it a situation where the non-German members have far less real growth, so they can’t fill in the income gap? How is this different than how the Fed looks at things when some states might be doing well while others are hitting the skids? Would the Fed react (assuming it wasn’t as messed up as it is now) in that situation?

  13. Gravatar of Cthorm Cthorm
    23. November 2011 at 15:38

    Scott,

    Here is a link to a Bloomberg article on the Fed Stress Test…

    http://www.businessweek.com/news/2011-11-23/fed-seeks-to-bolster-confidence-in-banks-with-stress-tests.html

    Seems to me like their concern is just about capital levels if the Euro situation gets even worse. I’m not exactly sure how you model out the ‘stress’ of a monetary union dissolving. In Euro terms, how do you price assets in new Francs, Deutsche-marks, Lira, Pesos, and Drachma? If I was a currency trader I’d be buying long dated options on the Zloty and Swedish/Danish/Norwegian Krona.

    A bit of an aside, but it’s interesting watching the Euro decline so slowly against the Dollar in recent weeks. Its paradoxical: the more the ECB digs in to tight money policies, the stronger the Euro is in the short term. But the more they dig in, the deeper the cracks in the Euro get and the higher the likelihood the whole thing just collapses.

  14. Gravatar of John John
    23. November 2011 at 16:01

    Scott,

    Bernanke will fail your moment of truth. No one has enough faith to do what you think needs to be done (massive money printing) or do what I think needs to be done (stop making any purchases and unwinding their current holdings). He’ll do something in the mushy middle that is politically acceptable but won’t work.

  15. Gravatar of John John
    23. November 2011 at 16:01

    Scott,

    Bernanke will fail your moment of truth. No one has enough faith to do what you think needs to be done (NDGP targeting) or do what I think needs to be done (stop making any purchases and unwinding their current holdings). He’ll do something in the mushy middle that is politically acceptable but won’t work.

  16. Gravatar of Federico S Federico S
    23. November 2011 at 20:59

    Scott, I don’t want to detract from your overall point that things may be moving faster in the eurozone than most people thought, but just to put things into context it’s worth noting that bund auctions are weak every now and then. This auction was a bit worse in terms of bid-to-cover ratio, I’ll agree with that. More telling, however, is that yields in Germany have begun to rise when European peripheral spreads rise (last week this was happening), suggesting that markets are no longer treating bunds as a risk free asset. File that under policymaker failure to recognize market predictions.

  17. Gravatar of Russ Anderson Russ Anderson
    24. November 2011 at 07:42

    Scott wrote “And my point about the US wasn’t optimistic either. It was that things might get so bad that the Fed is forced to do NGDP targeting. That’s not exactly a happy forecast.” But your middle sentence is still too optimistic. You’ve read Herbert Hoover’s memoirs. How bad did things have to get for him to admit that abandoning the gold standard was a good thing?

    The point is that even with 25% unemployment and 1/3 drop in GDP and a collapse of the banking industry AND the benefit of hindsight (writing it in the late 1940′s early 50′s) Herbert Hoover STILL was arguing for the gold standard. He learned NOTHING from the Great Depression disaster. There was no “so bad” point to force him to change.

    As you know, even after FDR took over getting off the gold standard was still a zig-zag course, with many within FDR’s own administration fighting against it. And even when the loosening resulted in economic growth in 1934-35 it simply set the stage for the disastrous budget balancing/tightening in 1936-37. My point is even after reaching the “so bad” point (for most people) it was still an uphill battle to get rid of the gold standard.

    A couple years of 9% unemployment hasn’t been enough to teach the tight money hawks a lesson. All Bernanke has shown is he will do just enough to keep the stock market from imploding, keep GDP slightly growing, that’s it. No return to trend line. No pushing down the unemployment rate. Why would one expect a German/European monetary implosion to change that?

  18. Gravatar of Phil Perspective Phil Perspective
    24. November 2011 at 08:41

    Steve:
    The Ben Bernank’s term isn’t up until January 31, 2014. A quick use of Teh Google would have gotten you the correct answer. And does The Ben Bernank really want to preside over the destruction of the world? Isn’t keeping the world from imploding worth taking some political heat?

  19. Gravatar of Phil Perspective Phil Perspective
    24. November 2011 at 08:45

    The cost in terms of banking distress, worsening public finances, international discord and mass unemployment is simply too great to contemplate. I have no doubt that Ben Bernanke of all people understands this.

    Does he? The Princeton economist named Ben Bernanke sure did. The Federal Reserve Chief named Ben Bernanke certainly doesn’t!!

  20. Gravatar of Thomas M. cole Thomas M. cole
    24. November 2011 at 16:13

    I would differ in the reason the gold standard was abandoned in the early 1930′s. The central banks of Europe and the US wanted to print vast quantities of paper money, and the gold standard was in the way of doing so.

    To somehow imagine that Government has any idea what is going on, when all of the Euro and the Dollar are outsourced to central banks is, well, non sense to me. World money powers set the agenda, not the people, or the pundents.

    Did not the most brilliant and highly decorated economists, working at the Fed, simply walk us into this current debacle? Indeed they did. So why would any person of moderate common sense think the Fed could actually care about higher sovereign debt. This is what the Fed lives for. Are we all blind? Of course the Fed wants more debt, more spending, and more taxes to pay the interest to itself and it’s owners.

    The Fed monitors GSE’s. Yet the Fed encouraged Fannie and Freddie to loan out at a 75/1 ratio and sell them as MBS. Is this what you call oversight?

    The Fed drove the US and Europe into the ditch, and now is only a little afraid that some nation might say boo to the interest payments. The vile little man behind the curtin would be revealed, like when Iceland told the centrals to shove off. They got offered new terms or a lawsuit in the World Court. This is only loan sharking on a world scale.

    You know it, I know it. But academia pretends in public, there is some exact set of ratios, which if reached, would solve the debt problems. The only real solution is to eliminate the centrals by force.

    How is it possible for academic economists, to have any faith at all in the Fed? If not for grants and status. The Fed is obviously and clearly working for itself, it’s owners and it’s fellow centrals.

    And this endless debate on Bernanke doing the right thing or not. Rubbish. Ben does what is best for Fed bond holders period.

    Note, that even though the Fed is highly insulated from attacks, Ben made time to visit returning troops, telling them,” the Fed will make jobs for them.” ( Nov, 17, 2011 at Fort Hood, Texas)

    This shows the Fed truly at work protecting itself from the only real threat it might ever face. An angry, armed, military trained force, in country.

    All this high brow discourse ignores the centrals true roll. Academia seeks to aggrandize itself by speaking in financial tongues, when a plain, common sense look at the Fed, reveals the hand of Marx. Come on, face facts. The Fed works for itself, we the people are sheep.

    Accomplice academia; Is not a noble sight.

    T.M. Cole 200yearsofcentralbanks.com

  21. Gravatar of ssumner ssumner
    25. November 2011 at 08:10

    Bonnie, The Fed and ECB should target the overall average performance, and by that criterion they both should ease.

    Cthorm, Yes, I also find that ironic.

    John, I do not favor “massive money printing.”

    Federico, This was anything but a typical bund auction. Yields soared in the secondary markets, which tells us all we need to know.

    Russ, You said;

    “All Bernanke has shown is he will do just enough to keep the stock market from imploding, keep GDP slightly growing, that’s it. No return to trend line. No pushing down the unemployment rate. Why would one expect a German/European monetary implosion to change that?”

    I don’t, another 2008-like event would cause the stock market to implode.

    Phil, We’ll see.

    Thomas, You said;

    “I would differ in the reason the gold standard was abandoned in the early 1930’s. The central banks of Europe and the US wanted to print vast quantities of paper money, and the gold standard was in the way of doing so.”

    Sure, but why did they suddenly want to do this? Presumably the sharp deflation and high unemployment had something to do with this sudden urge to print money.

  22. Gravatar of dwb dwb
    26. November 2011 at 08:31

    1936 is interesting for a lot of reasons. I’ve been thinking lately that it is no coincidence that under a too-low inflation targeting (ECB) regime or under sub-par nominal income growth financial crisis are more frequent. What if the great moderation was really about higher inflation/nominal income?
    My understanding is that the focus of most Fed “simulations” on “stability” of various policies is on the standard deviation of RDGP output (what I have in mind is akin to the Ball 1999 paper cited earlier – VAR model + policy and stdev is measured).
    Many economists seem to believe the Euro crisis and the housing crisis were random one-off events.
    What-if not (I do not believe in coincidences)? Under the gold standard financial crises were more frequent phenomena. The way I think about it is that there is a much higher probability of a negative shock of sufficient size as to require deleveraging. (Or when balance of payments adjustments are required). Put another way, the amount of capital a bank needs to hold is a function of the trend and volatility of assets; a bank needs to hold more capital with lower trend growth and higher asset volatility. If there is a negative shock that is expected to permanently lower the trend, then the bank will be forced to deleverage. If there is excess savings (e.g. for a net exporter) this process is probably less severe than if there is a savings deficit (net importer) because there is a natural source of capital replenishment.
    The higher risk of financial crises both lower the trend and raise the volatility of output, requiring more bank capital. I do not believe that the Fed models accurately account for “financial crises” and the deleveraging effect. The effects of a negative shock to nominal income are not linear since debt is denominated in nominal terms.
    I realize nothing new under the sun here; there are various reasons why the FOMC thinks 1.75% is the optimal inflation rate, these arguments among them. I think instead it’s not 1.75% inflation, its 1.75% nominal income as a floor, that’s necessary to prevent a financial crisis.
    I know these points has been made here before… I just am just lamenting and it seems like a point worth hammering home over and over as the Euro crumbles: it’s not just about the trend or the Phillips curve – poor nominal income growth is a recipe for a financial crisis because debt is in nominal terms. Poor nominal income growth leads to higher volatility of output (isn’t this one of the lessons of the gold standard?) because financial crises (deleveraging) become more frequent events. Poor nominal income growth makes balance-of-payments adjustments painful (because they likely require deflation).
    I think there is a false sense of comfort that the economy has “bottomed out.” Another significant shock would require yet another round of higher unemployment and deleveraging and potential bank failures. Yes, things can get far worse.

  23. Gravatar of Scott Sumner Scott Sumner
    27. November 2011 at 12:32

    dwb, Very good point. I plan to post something on the euro crisis relatively soon.

  24. Gravatar of TheMoneyIllusion » Monetary regimes in your review mirror may be closer than they appear. TheMoneyIllusion » Monetary regimes in your review mirror may be closer than they appear.
    30. November 2011 at 15:21

    [...] of commenters were skeptical last week when I said this: It’s now quite possible that the Fed may have to move toward NGDP targeting before they would [...]

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