There Are Monetary Echoes From the 1930s Too

I have been on the road for the past few (and next ten) days, in part because of Spring Festival, so I haven’t been able to post as much as I normally do, but I was asked to write an article for a Chinese magazine, which I recently finished, on comparisons between today and the beginning of the 1930s. As the recognition grows around the world of the similarities between China in 2008 and the US in 1929, it is worth considering why the Great Depression in the US was so severe and what lessons China should draw from it. I and a few others have discussed one of the similarities so many times and in so many different places that I think by now the whole issue of the trade impact of US overcapacity in the 1920s and 1930s and how it relates to China today is pretty widely recognized.

But there is more. I just finished rereading Barry Eichengreen’s Golden Fetters, a book on monetary conditions in the 1920s and 1930s (and in my opinion one of the great books of financial history). One of the points he makes – in fact it is probably the main point of the book – is the way currency policies (i.e. adherence to the gold standard) sharply constrained the ability of policymakers to deal effectively with the monetary consequences of the 1929-31 crisis. It wasn’t until various affected countries escaped from their monetary handcuffs and rejected gold that monetary policy became flexible enough to permit them to loosen sufficiently to counteract the banking collapse that accompanied the crisis. Eichengreen makes the point often and forcefully that there was a strong positive correlation between the speed with which countries went off the gold standard and the mildness of the subsequent economic crisis.

As an aside I would add my impressionistic sense that countries that ran large balance of payments surpluses (most obviously the US, but there were others too) were in the strongest position to hang on to gold, and so were the last to go off gold. They were also the ones most harmed by the 1930s crisis. I am not sure if this is primarily because of the monetary straitjacket or because most countries with strong balance of payments positions were also countries with large trade surpluses, and so they suffered most from a contraction in global demand and a collapse in international trade, but I suspect that the two are very closely linked.

Let me summarize my view of the key conditions in the 1920s and 1930s that shed light on current conditions. Besides the standard impact of the 1929 crash on consumer confidence, domestic consumption, and the cost of capital, economists generally speak of two factors that compounded the difficulties facing the US economy:

1. The first I have discussed many times. Throughout the 1920s, the US created significant industrial overcapacity, which it was able to export even as massive foreign borrowing in the US markets financed those exports. However just when the 1929 crash caused US consumption to decline, it also eliminated foreign financing for the trade deficit countries. As international trade collapsed – especially after the US tried to force the adjustment abroad by the passage of import tariffs – domestic demand was not nearly high enough to absorb everything US factories produced, and the US was forced to resolve its overcapacity problem domestically. It could have done so by increasing domestic government demand, as Keynes advised, but although the US was in a very strong position fiscally, it failed to take advantage of this strength and barely expanded government spending. This ensured that overcapacity would not be resolved by rising government demand but rather by factory closings and rising unemployment. Of course the passage of Smoot-Hawley and other mercantilist acts, by inviting retaliation, made the process much more difficult.
2. To make matters worse, excess money expansion caused by the massive accumulation of reserves in the 1920s had led to over-investment and risky lending. The stock market crash set off the process of deleveraging that always signals the end of a liquidity boom, and banks, financing companies and securities firms saw their balance sheets contract. When the Federal Reserve failed to accommodate the sudden collapse in money supply as banks cut lending in response to the crisis, the resulting money contraction in the US converted a sharp economic slowdown into a disaster. According to Milton Friedman (and I think most other economists) this was the biggest policy blunder that ensured that the crisis would be so devastating.

Compared to the US in 1929 China fares better on some measures, but not all. The first and most obvious is the scale of China’s overcapacity problem. China’s trade surplus, the cleanest measure of overcapacity, is of the same magnitude as that of the US in 1929 – roughly 0.5% of global GDP – but its economy is less than one-fifth the relative size of the US in 1929. Resolving the overcapacity problem will be much more difficult for China, especially if the world descends into trade friction and if international trade contracts. For that reason China must be at the forefront of trade liberalization and avoid the mistake the US made in 1930 of trying to increase its export competitiveness and reduce domestic demand for foreign goods. In that direction lays trade friction, which would have a devastating impact on Chinese businesses.

Perhaps not nearly as strong as the US in 1930, China is nonetheless in a reasonably strong position fiscally – although municipal reliance on land sales for revenues, contingent liabilities in the banking system and in provincial and municipal borrowing, and overall lack of transparency, make it difficult to judge. More importantly, however, there is widespread recognition among policymakers, unlike in the 1930s, that rapid and forceful fiscal expansion is key to creating new demand. Unfortunately it is not yet clear exactly how aggressively the Chinese government will expand fiscally and whether it will do so fast enough to replace declining US and European imports.

The second point may be the more important. Like the US in the 1920s China experienced a huge run-up in central bank reserves and, as the inevitable counterpart, low interest rates and excessive money supply growth. When this happens the financial system often responds by taking on excessive credit risk and over-investing. Given the complexity of the China’s formal and informal banking systems and the lack of transparency, it is difficult to know how vulnerable the banking sector is, but it is clearly something about which to worry. Warren Buffett once quipped that you can never know who is swimming naked until the tide goes down. The tide is receding and we are about to see how many naked bankers there are.

How the PBoC will respond to any signs of sharp money contraction is probably the most important question to answer and also the most difficult. On the optimists’ side the mistakes made by the US central bank in the 1930s have been so widely discussed that there is no question that Chinese policymakers understand the risk. The PBoC will undoubtedly do all in their power to counteract any monetary or credit contraction.

But things are not so easy. In the 1930s as long as the US was on the gold standard, it had limited flexibility in dealing with domestic monetary management. This is one of Eichengreen’s key points. Once the US got off the gold standard in 1933 it was able to pursue a wholly independent monetary policy, but its failure to counteract the initial credit contraction was a blunder with huge implications, and one from which it was only able to recover after tremendous pain. Certainly the PBoC would not make the same choice this time around, would it?

But can it choose differently? Unfortunately the PBoC is not as free to manage domestic monetary policy as the Fed was after 1933 because its primary obligation is to manage the foreign exchange value of the currency. This means that a crucial aspect of monetary policy in China is determined largely by net inflows or outflows on the trade and capital account.

The PBoC has other tools: most importantly its influence on credit creation (I am skeptical about the usefulness of open market operations) which it can expand partly by reducing the minimum reserve requirement for banks and partly by moral suasion within the banking system, but I am not sure how effective this is likely to be. Remember that much of the credit expansion from previous years seems to have migrated off the balance sheets of commercial banks (including into the informal sector) when the PBoC tried to constrain credit growth. In my opinion when underlying monetary conditions are consistent with rapid credit expansion there, is little the regulators can do to prevent this from happening. At best they can decide whether it happens in the regulated parts of the system or whether it simply migrates to other areas.

The reverse is also likely to be true. Attempts by the PBoC and other policy-makers to force banks to expand credit may result in higher loan growth reported on bank balance sheets, but overall credit growth within the economy is likely to be much less. If the underlying money supply is consistent with contracting credit, the system will most likely see contracting credit (and I am saying nothing about the possibility that much of the formal credit expansion reported by the banks will consist of empty lending into future NPLs).

With international trade falling, it is probably only a question of time before China’s trade surplus begins to shrink sharply (although a number of commentators who I respect a lot, including Brad Setser, might disagree with me on this), and as I wrote last week there is mounting evidence that some of the hot money that poured into China one year ago is now starting to leave. This suggests that China may begin to see rapid contraction of foreign currency holdings and, with it, a contracting domestic money supply.

This may be the biggest unexpected risk China faces. We must remember that as long as the main task of monetary policy is to set the value of the RMB in foreign currency terms, the PBoC has limited ability to manage the domestic money supply. If net outflows are large in 2009, the PBoC may be forced to preside over a monetary contraction, and this would be exacerbated if there were problems in the banking system that caused formal and informal banks to cut lending. This would undoubtedly worsen China’s difficult economic adjustment to the problem of overcapacity. It is vitally important that Chinese policymakers recognize the monetary constraints under which they work and prepare contingency plans. China can learn a lot from the mistakes of US policy in the 1930s.

By the way whenever I say that money outflows could become a problem for China, inevitably someone rushes in to pour scorn on the idea that China is vulnerable to a 1997-style Asian crisis. I agree it isn’t, and I will repeat (again) that this is not and never has been the point of my concern about hot money outflows. China does not have a currency mismatch risk worth bothering about. The reason to worry about hot money outflow is that it has a domestic monetary impact.