Exchange Rates, Recessions and Depressions

Many economists (for example, the specialists Barry Eichengreen and Peter Temin) tend to identify the gold standard as the chief culprit for transmitting depression around the world in 1929 and during the early thirties. In a recent book (“Lords of Finance”), Liaquat Ahamed blame the leading central bankers of the era (Strong, Schacht, Norman Montagu and Moreau from U.S., Germany, U.K. and France) for major economic policy mistakes before and after 1929, particularly the decision to take the world back onto the gold standard after the First World War.

Moreover, the key to economic revival in the 30’s was – in the opinion of many economic historians – the decision of the major countries to abandon the gold standard, including the UK in 1931, with a major devaluation of the currency, and the US in 1933, also with a major devaluation under Roosevelt.

When Milton Friedman convinced the world to adopt freely floating exchange rates in the seventies, the major argument in favor of flexible rates was precisely the independence of monetary policy for each country, as opposed to the previous Bretton Woods system of fixed exchange rates, adopted after the Second World War, as well as the gold standard of the twenties.

However, the reality of the foreign exchange markets since then proved that this was not entirely true – and consequently negative economic growth shocks continued to be transmitted internationally, starting with the recessions in 1974-75 and 1982-83, and naturally reaching this major dramatic international situation in the last two years, with the possibility of a great world recession in 2009 and eventually a long depression.

Therefore, either under the gold standard in 1929 or under floating rates in 2009, the world is facing tragic unemployment and negative economic growth in many countries, big and small, including the major G7 economies and the BRICs. As a matter of fact, at this point in time it is difficult to try to guess the duration and the size of this new recession or depression.

After the end of the gold standard, the thirties were characterized by so-called “beggar-thy-neighbor” exchange rate policies. We have already mentioned UK and US, but it is interesting to point out that emerging countries such as Brazil did the same in the thirties. In all three cases, by the way, such devaluation policies had a great success curing domestic depression and unemployment, by shifting demand away from imports onto

domestically produced goods and boosting exports to gain market shares  by “competitive” devaluations.

Brazil was one of the first countries to recover economic growth in the thirties. As a matter of fact, the industrialization process of Brazil started during the thirties through import substitution due to devaluations as well as some unorthodox “Keynesian” policies of burning thousands of coffee bags to protect the price of coffee, which had fallen intensely in 1929/1930. Certainly, some economic advisors of the Lula Government will call his attention to the fact that, paradoxically, the 1929 crisis generated growth opportunities through industrialization via import substitution which lasted from 1930 to 1980.

In other words, in addition to printing money, increasing government spending and reducing taxes, economic policy makers are well aware of the power of devaluation of the currency as far as generating demand through export expansion and import substitution, as well as capital flows through direct investments and external credit.

It is true that economists discuss all the time the effectiveness of monetary policy (because of the liquidity trap), of fiscal policy (because of the deficit financing crowding-out problem) and of devaluations (because of the difference between nominal and real devaluations, due to inflation increases).

The logic of the present exchange rate system leaves to the private markets the decision to establish the level of currency rates through supply and demand. But the world economic situation is so dramatic that one should not rule out a much greater intervention from Governments in foreign exchange markets. Ben Bernanke and Cristina Romer – from the Obama Government – know very well the importance of the 1933 devaluation for the US and this is very clear in their academic articles about the Great Depression.

An additional factor is 2009 in contrast to 1929 is of course the presence of China as a major player in international markets. Furthermore, the Chinese exchange rate system does not fit very well under freely floating rates; on the contrary, it is more similar to Bretton Woods with fixed-but-adjustable exchange rates. Or perhaps – to be precise – it is a typical and lonely beggar-thy-neighbor policy in a world of floating rates.

Either using the words “beggar thy neighbor” or not, the fact is that one may expect countries such as the United States, United Kingdom, China, Brazil and others. to consider the possibility of becoming more active as far as exchange rates are concerned, in order to become more competitive and help economic revival (and additionally, in some cases, bringing some useful inflationary pressures). By the way, just as printing money is being used intensely to reduce deflationary pressures in major countries – irrespective of fears of inflationary consequences in the future – exactly the same is true for devaluations.

The problem with exchange rates is that for n currencies there are only n-1 exchange rates. All n countries at the same time cannot devalue. This suggests that – after the gold standard of the 20s, the competitive exchange depreciations of the 30s, the Bretton Woods system of the 50s and 60s, and the freely floating exchange rates of the last four decades – something could be done in order to find a new framework.

With or without an international supervision from an IMF-type organization, we are certainly going to see in the next few months and years beggar-thy-neighbor policies adapted to the modern times: The name is dirty floating.

The dirty floating will be a natural economic policy response to the negative external shocks.

One can imagine, however, in order to avoid a chaotic competitive situation, an international organism such as the IMF writing reports and eventually contributing funds for individual countries in order to support their currency policy decisions.

8 Responses to "Exchange Rates, Recessions and Depressions"

  1. Anonymous   February 27, 2009 at 12:54 pm

    Are you suggesting that the best choice -thoug politically unnatainable -for the world economy is returning to a hard pegs system like gold standard?Another point: your analisys above forgot the capital movements side of the issue.

  2. RGBx   February 27, 2009 at 1:50 pm

    I’ve always seen the inherent power of the Brasilian culture and politics. Where Argentina strived to be european, Brasil found it’s power and identity in its liberty from europe, may I even suggest “like the USofA”. Brasil is not a third world country. Independent, proud, and having resources that are intellectual and cutting edge in the environmental issues Brasil should be respected and listened to and not put into a corner of the world as if they were a distant cousin. Brasil may be one of the most stable economies we have. It is a nice example of a comeback kid.

  3. sage   February 27, 2009 at 4:53 pm

    rgbx, you are 100% correct. Most analysts & elites in the anglo-saxon/north atlantic world have an inherent ‘grapes are sour’/death wish attitude toward this euro tropical civilization which developed in the new world & encompassing peoples of all races & religions. could never figure it out & have now stopped trying to. let them wallow in their own misery!people forget that paul volker’s high interest rates of the early 1980’s killed the brasilian economy. it was at that time where east & central european countries are today – large foreign currency debts & declining local exchange rates. the difference however, brasil’s borrowings were used to fund infrastructure vs home mortgages & consumer spending as in East Central Europe.Brasil learned it’s lesson well & has a good chance to come out of this crisis further strengthened

  4. Anonymous   February 27, 2009 at 5:47 pm

    I strongly disagree with the two previos comments. They are off topic also.Brazil is not a melting pot society. It is an extemely elititist one. You can see this in an economic angle: the distribution of income is one of the more inequal of the world, and one the worst in Latin America.I am not so sure of the inmetiate future of Brazil if this crisis continues. Why? See the high short term debt, the nearly nil fiscal margin (govrnmt spending is quite high; fiscal deficits were high even during the last years) , investment in infraestructura and education is very low, GDP growth was poor during the last 5 or 10 or 20 years (by any standar, Brazil history or rest of Latin America perfomance), and so on.I suspect that Brazilian economic beauty is in the eyes of the internacional financial community beholder. Or should I say pockets?

  5. sage   February 27, 2009 at 11:09 pm

    ‘anonymous’, nowhere in the 2 above posts were mentioned anything about Brazil’s society or income distribution. you are also confusing race/ethnicity (not being a melting pot)w/ socio/economic (elitist) variables. the post only talked about a country encompassing peoples of all races & religions.your economic analysis of Brazil could very well be mistaken for ‘developed’ countries the us, britain, italy, ireland, spain, etc. etc.i suspect you are a spanish speaking monkey (not english speaking because of your bad spelling & grammar), who just showed the negative ‘grapes are sour’/death wish bias toward brazil, which i mentioned in the post above.

    • Anonymous   March 1, 2009 at 3:47 pm

      I’am a brazilian monkey (not english speaking).

    • Anonymous   March 6, 2009 at 8:34 am

      “Brazil is not a thirld world country”. Repeat 100 times and it may become reality.”Brazil only has a 6% black population”. Repeat 100 times and it may become reality.”Brazil is nuclear armed”. Repeat 100 times and it may become reality.If only illusions were reality.Given the fragmented nature of its society, technological dependance, and null capacity to project power, Brazil still has a long way to go before it can sit in the table.

  6. Anonymous   February 28, 2009 at 11:00 am

    Lemgruber says “Many economists (for example, the specialists Barry Eichengreen and Peter Temin) tend to identify the gold standard as the chief culprit for transmitting depression around the world in 1929 and during the early thirties. In a recent book (“Lords of Finance”), Liaquat Ahamed blame the leading central bankers of the era (Strong, Schacht, Norman Montagu and Moreau from U.S., Germany, U.K. and France) for major economic policy mistakes before and after 1929, particularly the decision to take the world back onto the gold standard after the First World War. Moreover, the key to economic revival in the 30’s was – in the opinion of many economic historians – the decision of the major countries to abandon the gold standard, including the UK in 1931, with a major devaluation of the currency, and the US in 1933, also with a major devaluation under Roosevelt.” And he continues with M. Friedman crusade in favor of floating exchange rates.Interesting.He notes that “many economists”, Einchengreen, and Temin blame on Gold Standard. And Liaquat Ahamed blame central banks. But it seems that the truth (?) is “in the opinion of many economic historians”.And who are these “economics historians”? NO NAMES!!!!! Quite difficult to understand such strategy of argumentation.