Saturday, 3 November 2012

The Transformation of Policy Between the Wars

Immediately after the First World War, the government's aim for policy was to get the economy back to the 'normality' experienced prior to 1914. This sort of thing included the government playing a limited role in the economy, more integration with the world economy and restoration of the gold standard, free trade and a balance budget.

Initially these three final points are achieved. The budget is eventually balanced, albeit a higher budget than previous years due to the increase social spending and maintenance of the national debt. During the 1920's the policy of free trade is also pretty much restored. Britain gets back on the gold standard in 1925 at the rate of £1 = $4.86. Germany and France both rejoin the gold standard at a similar time, along with most other leading economies. Why did we return to the gold standard you may ask? Well, firstly it helped achieve the restoration of pre-war 'normality'. Also, it aimed to try and stabilise the currency which would in turn help out trade. Another feature of the gold standard was to allow the monetary system to function on its own. What I mean by this, is that if the country runs a payments surplus then gold will flow into the country, interest rates will be decreased so wages and prices will fall. This will in turn cure the surplus. It also works the opposite way for a payments deficit. A final point is that the gold standard was a means of stopping politicians from meddling with the money supply!

However, pre 1914 the gold standard worked but after the war and during the 1920's it just didn't. There is a list of potential reasons for this:

  • Why the gold standard worked pre-1914:
    • It was developed gradually over time.
    • Capital and labour was freely moving.
    • The central bank could use interest rates to protect the currency, independent of the government. 
    • London was still a financial centre.

  • What changed in the 20's?
    • There was a rush to return to the gold standard.
    • More protectionism and less migration due to barriers.
    • Central banks were under pressure from politicians.
    • Paris and New York now competing against London as financial centres. 

Mr. Keynes pops up again in this debate. He pointed out that British prices had risen faster than the US', so starting at the same £1 = $4.86 rate would be an overvaluation of the pound. Although this shouldn't have matter because the gold standard should re-adjust prices, Keynes doubted it would work. He thought it would have bad domestic effects including interest rates needing to be kept at 4.5-4.5% and due to this borrowing would become expensive and investment would suffer.

The world slump is the next chronological step in the economic history of Britain. The recession of 1929 - 1931 started because of the Wall Street Crash in the US. This meant massive balance of payments problems. In 1931 came the European Banking Crisis and so in Autumn of that year Britain was forced off of the gold standard. This was first portrayed as a temporary change, but gradually the realisation came about that it was for good. Interest rates were cut to 2% to encourage borrowing and investment which would boost the economy again! Amazingly, there was a recovery. GDP rose as investment rose and Britain actually now compared well with other global economies. It would be easy to say all of this was because of the gold standard, but it isn't true as many other factors were also contributing to the recovery of the British economy. What the slump did cause, however, is the abandonment of free trade between 1931 and 1932. 

Keynes had the idea that investment from the government was something that was necessary for the economy. But, the treasury wasn't in agreement with this theory. They believed it would unsettle foreign investors and worsen the national debt. Keynes thought that there was no point in cutting wages because demand and consumption would suffer. What was needed was public investment which would boost the economy via the multiplier effect. The treasury argued it would be inflationary and any more borrowing would get out of control. The only time borrowing was allowed was in a one-off circumstance for rearmament!

Thanks for reading again guys, that'll be it for economic history for a while... I promise! Haha.


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