[Fun and clear history story as much as anything else]
http://www.ft.com/cms/s/0/8c1da3da-60f1-11de-aa12-00144feabdc0.html?nclick_check=1
June 24 2009 Financial Times
Lessons from the Jazz Age for creditor nations By James Macdonald
If John Maynard Keynes were reborn today, I am sure he would be gratified to discover that his economic theories were being so widely applied. Yet, while Keynes might conclude that people had learnt the lessons of the 1930s, I doubt that he would be so sanguine about the lessons of the 1920s.
After the first world war, the US found itself transformed from a debtor into the world's largest creditor. It had extensive claims on its wartime allies in the form of war loans. Britain and France, in turn, had large claims on Germany for reparations. To satisfy these claims, a large westward flow of money was required. The amounts involved were substantial, representing more than 100 per cent of German gross domestic product and 15 per cent of American GDP.
The problem was: how was the money to be found? What was needed was for Germany to generate a current-account surplus -- offset by an American deficit of a similar magnitude. Given their relative sizes, a German surplus of 5 per cent of GDP offset by an American deficit of less than 1 per cent would have sufficed.
The normal rules of the gold standard should have helped the process. The economic and political frailty of Europe after the war led to large-scale inflows of gold into the US. Left to themselves, these flows should have raised prices in America and lowered them in Europe.
Writing in 1921, Keynes put his finger on the nub of the issue. "Ultimately ... there must be a readjustment of the balance of exports and imports. America must buy more and sell less. Either American prices must rise faster than European (which they will if the Federal Reserve Board allows the gold influx to produce its natural consequences), or failing this, the same result must be brought about by a further depreciation of the European exchanges."
Keynes could already see that none of this was likely to occur, so he predicted that "America will not carry through to a conclusion the collection of Allied debt, any more than the Allies will carry through the collection of their present reparation demands". He was right. The US did not wish to reduce its trade surplus with Europe; and neither Britain nor France wished to boost the exports of Germany, a trade rival.
The US responded not by allowing the workings of the gold standard to raise prices but by sterilising gold inflows -- selling securities -- to hold prices down. Just in case this was not sufficient, it imposed tariffs that further disadvantaged European exports.
In the absence of adjustment to trade flows, there was only one other way to avoid default: America had to lend the Weimar Republic the money. Between 1924 and 1928, the American private sector was happy to oblige, lending Germany more than double the amount needed for reparations. Rather than shrinking, Germany's foreign debt grew.
In hindsight, the situation was obviously unsustainable, and even at the time many people realised this. In 1928, John Foster Dulles, the future secretary of state, summed the matter up for an American audience in terms that could be transferred almost word for word to our present situation: "As long as we have a national policy of promoting exports [and] of a full collection of debts ... so long must we finance our exports very largely through the medium of loaning foreigners the money to pay for them." However, like the Chinese of today, most Americans refused to see the connection between the repayment of their loans and the underlying global imbalances.
In 1928, the music stopped. The American stock market boom sucked money away from Europe and into securities loans at juicy interest rates. Deprived of credit, Germany lost its ability to service its debt. The pretence that international debts were worth the paper that they were written on limped on for a while. But in 1931, Germany stopped paying reparations, and Britain and France stopped paying their war debts. The imbalances that the world had been unwilling to resolve through trade flows were resolved instead through default and protectionism.
Now, as then, the laws of economic gravity will eventually bring about a resolution to our current global imbalances. Let us hope that historical short-sightedness does not lead to a repeat of the 1930s outcome.
The writer is the author of A Free Nation Deep in Debt: The Financial Roots of Democracy and is a strategic adviser to the Hanseatic Group
Copyright The Financial Times Limited 2009