Lecture on chapter 10 The era of political economy: from the minimal state to the Welfare State in the 20th century

Topics discussed today The changing role of the state in the modern economy. The impact of the Great Depression ( ) on economic thinking about macroeconomics. A tale of different policy responses to the economic crisis in 1929 and A market failure theory of the Welfare State. The socialist experiment failed- but why?

First decades of the 20 th century: Economic orthodoxy rules The economy was seen as a self-equilibrating system in which shocks were neutralized by strong wage and price flexibility. Budget balance was a priority. Self-help rather than government assistance in situations of unemployment & sick leave. Monetary policy should serve the aim of defending the fixed (gold standard) exchange rate.

1920s: Europe was not well prepared for the Great Depression The restoration of the gold standard in the early 1920s was costly for UK and Scandinavia which opted for pre-1914 gold parities leading to overvalued currencies and high unemployment and international reserve (gold) losses. France and US sterilized gold inflows. Rules of the game were violated. Remember that in a fixed exchange rate system deviations from PPP* can only be corrected by price and wage level adjustments, but these adjustments were very slow. Germany turned from reckless spending and hyperinflation to austerity policies when the bill of foreign lending and war reparations had to be paid. *PPP =purchasing power parity means that 1 unit of the domestic currency buys the same basket of goods at home as in the foreign nation when exchanged at the prevailing exchange rate.

Policy responses to Great Depression made things worse Great Depression was preceded by asset price bubbles and subsequent wealth destruction lowerered consumption and added to an autonomous negative consumption shock in USA. Banking crisis was not met by strong enough ’lender of last resort’ policy. Deflation implied high real interest rates which brought investment to a standstill. (Slide 4) Protectionist response accelerated the fall in trade. (Slide 5)

Real interest rates had strong impact on investment: the US case. Source: C. Romer (2009), ‘What Ended the Great Depression?’, Journal of Economic History 52:4, pp

The Contracting Spiral of World Trade: Total Imports of 75 Countries ($ millions) NB! Current prices! Source: C.Kindleberger (1986), ‘History of the World Economy in the Twentieth Century, Vol. 4’, UC Press

1930s: The long farewell to orthodoxy The dogmatic Gold Standard commitment was abandoned less by conviction, more of necessity first in UK and Scandinavia. Monetary policy was henceforward influenced by domestic policy aims. Modern macro-economics was in a formative phase scientifically but had little or no impact on economic policies. Initial (unintended) budget deficits were often met by increased taxes or spending cuts.

Quotation of Chairman Ben To understand the Great Depression is the Holy Grail of macroeconomics. Not only did the Depression give birth to macroeconomics as a distinct field of study, but also… the experience of the 1930s continues to influence macroeconomists’ beliefs, policy recommendations, and research agendas. And, practicalities aside, finding an explanation for the worldwide economic collapse of the 1930s remains a fascinating intellectual challenge. - Ben Bernanke (2000), Essays on the Great Depression

Exchange rate policy mattered The differential pattern of recovery was determined by exchange rate choices. Stubborn Gold Standard commitment (in France, Netherlands, Belgium) prolonged crisis. Economies who were bold enough (or forced) to break the ’golden fetters’ in 1931 (Scandinavia,UK) started recovery in Was it a ’beggar-thy-neighbour’ policy?

No more ’golden fetters’! Source: B. Eichengreen (ed.) Elusive Stability, Essays in the History of International Finance, , Cambridge: Cambridge University Press, 1990

Money is not neutral! Christina Romer, a Berkeley economic historian and until recently an economic adviser to President Obama, made a counter-factual analysis of the impact of the monetary policy in the 1930s. Unexpected inflow of gold was not sterilized and resulted in a fast increase in money supply which had an expansionary effect. Source: C. Romer (2009), ‘What Ended the Great Depression?’, Journal of Economic History 52:4, pp

Germany: the ascent to power of Adolf Hitler was not inevitable! Germany was trapped by war reparations, a huge foreign debt and a commitment to orthodox economic policies. Capital controls introduced in 1931 opened up a possibility of expansionary domestic monetary policy but… Policy makers opted for continued austerity policy: unemployment and the Nazi vote increased. Had Germany followed UK and Scandinavia in devaluing in 1931 Hitler might have been sent back to where he belonged: lunatic fringe politics.

NSDAP (the Nazi party) rides the unemployment wave

Putting European growth into perspective Real GDP Growth EuropeUSACanadaJapan Source: Feinstein et al, ‘The World Economy Between the Wars’, 1997, p. 9

The Great Depression and the 2008/09 crisis in Europe Great DepressionPresent crisis Quarters of negative growth: Industrial output: -25 to -30%. First year: - 8 %. GDP: -5% to -10%. GDP first year: -5%. World trade : -25% World trade first year: -7%. Unemployment: 15-25%. Quarters of negative growth: Industrial output: -10 to -15 %. First year:-10 to -15%. GDP: -5% GDP first year: -5%. World trade: -38%. World trade first year:- 38%. Unemployment: 8-12%

Policy responses in Europe Great DepressionPresent crisis Banking crises not contained. Money supply response limited by gold standard discipline until 1931 or later for gold bloc nations. Initial budget deficits were met by attempts to restore budget balance through spending cuts or tax increases. Discretionay spending and automatic stablizers: weak. Increase in public debt: small Banking crises contained by vigorous lender of last resort lending and nationalization of insolvent banks. Strong automatic stablizers as well as increase in discretionary spending. Budget deficits as a share of GDP: 5-12 % of which half discretionary. Public debt/GDP increases by percentage points.

New classical economics got it wrong! Quick, decisive and co-ordinated policy response, expansionary monetary and fiscal policy, probably made what could become a new Great Depression ’only’ to a Great Recession. As a consequence the protectionist backlash was constrained compared to the Great D. But the rescue plan comes with a cost: high public debt but lower than at the end of the World Wars, as a share of GDP.

The end of the minimal state. The new role of the state in the 20th century European economy is linked to the rise of democracy which made domestic policy concerns relatively more important, the increase in income per head which increased demand for welfare related services, the increase in life expectancy the demand for better education to match increasingly sophisticated technology. Traditional (non welfare) public spending remained a constant share of GDP

Power to the people!

What the Welfare State is about Inter-temporal smoothing of consumption possibilities over ’event states’ (unemployment, sick leave) and life-cycle (child care, education, employment, pension) Redistribution of income from rich to poor? Yes, but not as much as people want to/fear to believe. The big issue: why don’t markets, say, private insurance/savings solve these problems?

Inter-temporal redistribution over household’s life-cycle

The Welfare State is a response to market failures QuestionAnswer 1.Can private insurance solve the problem of negative income shocks due to unemployment and sick-leave? 2.Can capital markets solve the life-cycle smoothing of consumption for all? 3.Will private savings for old age be sufficient? 4.Why is schooling compulsory? 5.Why is redistribution not left to private charities? 1.Adverse selection would create a situation of incomplete coverage. 2.Banks do not lend without collateral or against the uncertain future income flows. 3.Time-inconsistent preferences will generate innsufficient private pension saving. Paternalism. 4.Externalities in education. 5.Conditional altruism and co-ordination problems.

The evolution of public spending

The uses of public spending in 2000

The socialist experiment Russia was an overachiever in the period but at intolerable human costs. The post 1945 socialist bloc had initial income and political rights levels similar to Spain and Portugal. Both democracy and income growth were retarded in the socialist bloc. Why did the socialist bloc fail to catch up in the Golden Age?

Limits to technology transfer The socialist bloc was initially blocked from using some best practice technology by Cold War strategic restrictions to technology transfer. The technological isolation was partly self- imposed and also linked to a change in trade pattern away from technological leading edge economies. Foreign investments often carried new technologies but were not welcomed since private property was not tolerated.

Central planning failures Central planning tended to waste resources because managers exploited exclusive knowledge to extract excess investment resources from central planning office. Lack of democracy led to high investment bias at the expense of consumption, compare China today. Investment ratio 5 to 10 percentage points higher in socialist bloc economies but growth rates only half that of eonomies at comparable initial income levels.

The growth failure of the socialist bloc Next graph shows the GDP per capita in Spain, Italy and the average for the Socialist bloc. Spain and the Socialist bloc started at the same income level and were both relatively closed economies, but Spain opened up in the 1960s. Italy is postwar Europe’s growth success – until the late 1990s but had a dismal growth record in the fascist Interwar era.

GDP per capita in Italy, Spain, and the Socialist bloc (EE+USSR), 1990 constant $.

Karl Marx’s trap Karl Marx, an icon of socialist bloc nations, famously argued that economic systems survive only if they can generate economic growth (known as ’developing the productive forces’). The socialist economies failed in that respect as well as permitting political freedom and independent trade unions. When the people was permitted to vote with their feet around 1990, they did. The rest is history.

Summary The minimal state was not able to cope with the systematic market failures and gave away to the mixed Welfare State economy in which, on average per cent of GDP, is re-allocated in political processes. The socialist experiment failed because it did produce neither the goods nor the liberties of the mixed economies.

Acknowledgements If not otherwise stated graphs and tables are taken from the textbook or are own estimates. Slides 6 and 12 from C. Romer, What Ended the great Depression?, Journal of Economic History, 52(4), ,1992. Charles Kindleberger is the originator of the graph on slide 7. Graphs on slide 11 from Barry Eichengreen, Elusive Stability, Essays in the History of International Finance , Cambridge University Press Slides 20 and 24 from Angus Maddison, Dynamic Forces in Capitalist Development, Oxford University Press, 1991.