Like “ignorant and illiterate depositors in times of panic”

There were three basic problems during the Great Contraction of 1929-33.  People hoarded currency, people hoarded gold, and central banks hoarded gold.  Because currency was backed by gold, the hoarding of currency created a derived demand for gold.  So the bottom line is that people and central bank hoarded gold.  This raised the value of gold, and lowered price levels all over the world.

In mid-1931 people began to fear devaluations; first in Germany, then Britain, then America.  This led people to hoard gold.  Unfortunately, this also led other central banks to hoard massive quantities of gold.  The French were the biggest hoarders.  In one sense this is understandable; they saw the value of their sterling reserves decline after Britain devalued, and did want the same to happen when the US devalued.  So they sold dollars and bought gold.

But there was one big problem with the French policy.  They were on the gold standard.  Hoarding gold increased the value of gold, causing deflation.  It dragged down all the economies still tied to gold, including France itself.  They loaded up their lifeboat with gold bars, and it sank their economy.

A few days ago stock markets soared on news that China was not planning on abandoning the purchase of euro assets.  But todays’ news is not so rosy:

June 1 (Bloomberg) — Wall Street’s foreign-exchange strategists say central bankers are showing growing reluctance toward holding euros as Europe’s debt crisis undermines confidence in the region’s single currency.

The euro weakened 2.4 percent against the dollar last week even after China’s State Administration of Foreign Exchange, which manages the country’s $2.4 trillion of reserves, denied speculation that it was diversifying away from European bonds. The 20 percent depreciation from last year’s peak in November has demonstrated the limits of the euro as a reserve currency to rival the dollar as well as the European Central Bank’s ability to defend its legal tender.

A net 105 billion euros ($129 billion) flowed out of the region’s fixed-income markets on an annualized basis in the first three months of the year, signaling a “broad shift” in appetite for euro-denominated assets, according to Nomura Holdings Inc. The region attracted a net 225 billion euros from foreign debt investors in 2009.

“It’s clearly the case that there’s been an element of foreign central banks slowing down their euro purchases,” said Jens Nordvig, a managing director for foreign-exchange research at Nomura in New York. “The institutional framework is being questioned, the credibility of the ECB is being questioned, and all that uncertainty is really fueling an asset allocation shift away from the euro zone.”

.   .   .

The euro fell as much as 1.6 percent against the dollar to $1.2111 today in London, the lowest since April 14, 2006. It depreciated as much as 2.3 percent to 109.77 yen. The Financial Times reported last week without saying where it got the information that Chinese officials have been meeting with foreign bankers to review holdings of euro-zone debt.

Think of it this way:

The euro in 2010 = the US$ in 1931.

The US$ in 2010 = gold in 1931

China is in the position of France.  If they don’t sell of their euros, they risk a capital loss.  If they exchange euros for dollars, they strengthen the dollar and thus their own currency–which puts more deflationary pressure on the dollar bloc.  France gave a higher priority to avoiding capital losses in their reserves, than to high unemployment.  As a result, gold appreciated and the French economy deteriorated further, with no recovery until they left the gold standard in 1936.  Penny wise and pound foolish.

After Britain left the gold standard, Paul Einzig argued that European central bankers had not acted as public-minded economic policymakers, but rather had substituted gold for foreign exchange reserves much as “ignorant and illiterate depositors do in times of panic.”  Let’s hope the world’s central bankers don’t re-enact this 1931 scenario in 2010.

There is, of course, one major difference between 1931 and today.  In 1931 the Fed had no ability to print gold.  So it was not easy for a single central bank, no matter how large, to prevent the value of gold from rising.  Today, however, there is one central bank that does have the ability to print unlimited quantities of dollars.  And it’s not the PBOC.  Although I would hope the Chinese will behave responsibly, the real responsibility for any dollar-zone deflation would lie much closer to home.

If only we had an expert on 1931 in charge of the Fed!  Seriously, despite my frequent criticism of Bernanke, one reason that I have never forecast the worst case scenario is that, despite everything that has happened I just don’t see him allowing things to get much worse.  He knows exactly what happened in 1931, and indeed shares my view of those events.   I hope I am not being naive.

One other point.  The EMH says that you should never say “the euro is falling” but instead say “the euro has fallen.”  Asset prices have near-zero momentum.  Thus the Chinese have no scientific basis for converting euros into dollars.  The (expected) damage from a weak euro has already been done, already been incorporated into the current price of their euro assets.  I know that sounds counterintuitive, but do you really think central bank portfolio managers are smarter than the bond market?

Slightly off topic; this extremely discouraging NYT article contains one sentence that seems very misleading:

The bond purchases were only the latest of a series of extraordinary moves that Mr. Trichet has pursued to stabilize the European banking system. Since the beginning of the financial crisis, the central bank has been essentially keeping banks afloat by providing almost unlimited loans at 1 percent interest.

Let’s not forget that “the” financial crisis began in September 2008, and in the worst part of the financial crisis the ECB maintained a roughly 4% policy rate, not 1%.  That’s how we got into this mess.  I understand that the author meant the latest part of the financial crisis, related to Greece, but this kind of sloppy writing creates the impression that the ECB is blameless, when in fact it is primarily responsible for the fall in NGDP that underlies much (but not all) of the European debt crisis.  I’d hate to see these central bank blunders airbrushed out of the history books.

HT:  Marcus




8 Responses to “Like “ignorant and illiterate depositors in times of panic””

  1. Gravatar of Will Ambrosini Will Ambrosini
    1. June 2010 at 17:44

    Is “They loaded up their lifeboat with gold bars, and it sank their economy.” original to you? I like it.

  2. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    1. June 2010 at 23:29

    “Penny wise and pound foolish.”

    I’d actually like to see a list of such views as concerns Political Economy. Quoting Burke again:

    “* Mere parsimony is not economy. Expense, and great expense, may be an essential part in true economy.

    * Economy is a distributive virtue, and consists not in saving but selection. Parsimony requires no providence, no sagacity, no powers of combination, no comparison, no judgment.”

  3. Gravatar of scott sumner scott sumner
    2. June 2010 at 04:29

    Will, Thanks. Whenever I think I have a new idea, I always find someone else was there first. My Depression project is called “The Midas Curse”—later I found out that Temin already used the term.

    Don, Those are very good quotations.

  4. Gravatar of Ted Ted
    2. June 2010 at 12:47

    I think in the end China will convert some of their euros into dollars. Regardless of whatever the EMH says, everyone always thinks they are smarter than everybody else.

    On the failures of the Fed and the ECB, I don’t know enough about governance of these central banks and their organizational structure, but I have to assume there is some type of institutional constraint here. I could easily say that these central bankers are just idiots, but that’s a rather unsatisfying story, particularly since I know Bernanke is neither stupid nor ignorant. I also suspect the people on the ECB board are not morons. My assumption is there has to be some institutional (or political, particularly for the ECB) constraints. Maybe the members of the Federal Reserve are too conservative constraining Bernanke (which I think is probably somewhat true), but is that also true of the ECB? Maybe current structure and governance doesn’t allow it to credibly and effectively execute its desired policies? I don’t know. Perhaps the best “crisis reform” would be a careful study of the institutional structure of the Federal Reserve and the ECB to discover what exactly is going on and how to reform these institutional constraints to enable more effective monetary policy in times of crises and shocks. Perhaps more academics on the boards would solve the trick also.

    Now, for something slightly off-topic, but since you brought up gold, devaluation, and the Great Depression I have a somewhat related question for you (since you generously respond to comments on your blog). This is something I was wondering about a few days ago and since you brought up gold and devaluation I thought I’d just ask your opinion. Do you believe that expansionary monetary policy was possible under the gold standard constrain in the US? Or do you believe the gold standard constraint was too strong and that it would have been impossible for the Fed to increase the money supply enough without losing credibility in the US commitment to the gold standard prompting speculative attacks on the currency? Now, I think it seem somewhat plausible that Federal Reserve officials may have believed that, but do you think it was a reasonable belief to have? I know Barry Eichengreen (and I believe Peter Temin), have suggested that indeed speculative attacks would have occurred.

    I don’t particularly think a first-generation attack would have been a likely outcome (of course, maybe we should ask your good friend Krugman since this would be his area of expertise!) . On a casual glance of the data it seems to me that given any reasonable amount of open-market operations the amount of gold stock would still be large enough that it should have been sufficient to assuage any concerns about devaluation, ruling out a first-generation currency crisis. A second-generation crisis seems somewhat more plausible, but I’m still not convinced. Given the same fundamental reasons for ruling out a first-generation attack, combined with the known gold-committed mentality of the time among bankers, I don’t think it would have been reasonable for investors to assume other investors were contemplating an attack thus avoiding the whole self-fufilling game. I suspect that second-generation crisis story would have been more plausible after the UKs devaluation, but if expansionary policy had begun during the banking panics of the fall of 1930 the risk would have been significantly less (and I’m not even convinced it still couldn’t be done after the UKs devaluation for the reasons I listed before). Also, wouldn’t the expansionary policy improve economic fundamentals thus even seemingly strengthening the U.S. commitment to the gold standard, since then, what incentive would they have to devalue? Also, if I remember correctly, the Fed did engage in a $1 billion open market operation in 1932 and I don’t recall any signs of shifts in expectations suggesting a possible devaluation (though I haven’t studied the details of this sufficiently to comment really). I see this story applying more to smaller economies, as it did in Hungary, Austria and Belgium, but not someone like the US.

    Of course, I’m not a prestigious economist or historian like Barry Eichengreen or Peter Temin so I could be completely wrong here (in fact, I’m not even in college yet so what do I know!), thus I’m curious on what you think.

  5. Gravatar of scott sumner scott sumner
    3. June 2010 at 10:20

    Ted, I mostly agree. I think that it’s not enough to be smart, you have to be really smart. It seems to me that the smartest economists have the best understanding of the role monetary policy can play in determining AD. I also think that political pressure plays a role, as you suggest. But that’s not the only problem.

    The question on the Great Depression is difficult. The honest answer is that no one knows. The Fed certainly could have done more early on. And I think that would have prevented a depression. Even in 1932 they could have done more than they did, but there is some question about how much gold they would have lost. Even if they didn’t lose all their gold, once it fell below their comfort level it became a constraint on their behavior. So then the question is how low is too low? Given what we know about the severity of the Depression, they should have been much more agreessive, and if they had been more aggresssive then I think the odds are thet we would have avoided an outright depression.

  6. Gravatar of marcus nunes marcus nunes
    3. June 2010 at 15:52

    A “who´s the bigger hawk” competition:

  7. Gravatar of marcus nunes marcus nunes
    3. June 2010 at 18:31

    A “who´s the bigger hawk” competition:

  8. Gravatar of ssumner ssumner
    4. June 2010 at 05:58

    Marcus, Thanks. Basically these guys oppose level targeting. Indeed thier policy view sare even a bit tight for rate targeting, as core inflation is expected to stay around 1%.

    What is their model? I doubt they have one.

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