Lecture 5: The disintegration of the world economy
1914 to 1939 AD
1
From heights of 1913, world economy
essentially flat-lines over the next forty
years…but with a lot of variation in between.
Constitutes only documented disintegration of
the world economy; using variation to ascribe
causal effects.
What we will explore in this lecture is the trauma
induced by WWI, the slow recovery post-WWI,
and the Great Depression.
Introduction
The alignment of powers during the “first
industrialized war”
World War I
World War I
4
World War I
5
Concurrently, US firms displace Europeans in
LA; “greatest business proposition of all time”.
Japanese firms (sided with Entente) do the same
in E/SE Asia: Japanese real exports from 1913 to
1918 more than double.
Signals rising stature of Japan as the industrial
power of East Asia.
World War I
With the close of WWI, these trade flows
become very important for two reasons:
1.) Loss of market share not easily regained;
blocks a source of desperately needed
forex reserves for European nations.
2.) Creation of massive levels of indebtedness;
allied debt = $220 billion (real) USD;
half owed to the US (1/3 of US GDP)
World War I
Apart from trade, WWI also results in strong
supply responses:
1.) Increase in global commodity capacity in
response to high prices;
2.) Increase in European industrial capacity in
response to “total war”;
3.) Increase in periphery industrial capacity in
World War I
Finally, big political effects of WWI:
1.) Creation of new nation-states (AustriaHungary; Russian Empire, Irish Free State);
2.) Rise of organized labor (and potential
nominal wage rigidity);
3.) Russian revolution in 1917 generates a 99.9%
World War I
1920s spent dealing with supply & demand
shocks of WWI and—for most countries—
getting back to the pre-war Belle Epoque.
But they were faced with new set of constraints:
1.) Inflated price levels (differences matter)
2.) Declining commodity & industrial prices
3.) Lost access to foreign markets
4.) Calls for protection
The 1920s
Early 1920s saw attempts to normalize
commercial, financial, and political relations:
establishment of the BIS and League of Nations.
But the most significant attempt was the return of
the gold standard inspired by Genoa conference
of 1922 and initiated by the UK in 1925.
Gold standard as a matter of national
The 1920s
The 1920s
12
However, the gold standard unwittingly spelled
disaster.
First for the British who pegged at the pre-war
parity of 4.86 USD per GBP; GDP decline of
5% in first year…
And finally for all nations (90%) which
subsequently joined once the Great Depression
(GD) emerged in the US.
The 1920s
The course of the GD
The course of the GD
The course of the GD
The course of the GD
The course of the GD
What set off the decline in US output after 1929?
Popular impression: Black Tuesday, 1929.
Monetarist interpretation: GD a consequence of
the Fed’s tight monetary policy in 1928/9 and role
of bank failures and effects on money supply.
Others interpret the GD as a credit boom gone
wrong: as prices fall, debts fixed in nominal
The causes of the GD
Regardless, output contracts in the US by 30%.
Big effects for economies close to the US, above
all Canada (which matches the US one for one).
But as we saw, a wide range of nations
experience a synchronized decline in GDP, not
just those in geographic proximity to the US.
What then explains the Great Depression’s
transmission across the globe?
The causes of the GD
The gold standard and its system of fixed
exchange rates seems to be a likely suspect.
But why? Fixed exchange rates thought to have
beneficial effects on trade and investment.
Need to consider role of policy responses to GD
and constraints imposed by the gold standard.
Next, develop a model linking policies and GS
with performance of the global macroeconomy.
The causes of the GD
Foreign exchange (forex) markets governed by
the uncovered interest parity (UIP) condition,
 E$/e fc  E$/ fc
i$  i *  

E$/ fc


 , or

domestic dollar return = expected foreign dollar return.
We assume that nominal interest rates (i$ and i*)
The transmission of the GD
This can also be seen graphically as:
For: i$  0.05, i*  0.03, and E$/e fc  1.20  E$/ fc  1.1764
The transmission of the GD
Any decline in the foreign return makes foreign
assets/deposits less attractive to investors.
If the domestic return remains unchanged, an
arbitrage opportunity emerges.
Traders will dump the foreign currency until the
dollar (the home currency) has appreciated to the
The transmission of the GD
We also need to know about the goods market.
To simplify the analysis we will assume:
1.) Two countries: home and the US
2.) An asterisk (*) denotes US variables
3.) In the short run, home and US price levels
The transmission of the GD
4.) Government spending (G) is fixed at some
constant level, but subject to change.
5.) Conditions in the US economy, output (Y*)
and interest rates (i*), are exogenous to home.
In any EQ: supply (Y) must equal demand…
The transmission of the GD
In this set-up, a fall in the home interest rate
generates two responses in aggregate demand:
1.) Marginal investment projects become more
attractive, so that I is stimulated and Y increases.
2.) The home currency depreciates (or the value
of the nominal exchange rate (E) increases), so
The transmission of the GD
The IS curve
is simply
combinations
of Y and i
The transmission of the GD
Finally, need to know about the money market;
to simplify the analysis, we assume:
1.) Prices are still fixed.
2.) Money supply is exogenously determined by
the central bank while money demand increases
with income, for any given interest rate.
The transmission of the GD
M
 L(i )Y
P
real
real
money
supply
The transmission of the GD
money
demand
The LM curve is simply the combinations of Y and i
The transmission of the GD
Putting it all together…
The transmission of the GD
What is the point of all this?
Allows us to see how the GS transmitted the
GD from the US to the rest of the world due to:
1.) The increase in US interest rates as money
supply contracted (first the Fed; then banks fail).
3.) The decrease in US demand for the rest of the
world’s products as income fell (and protectionist
barriers rose).
The transmission of the GD
1.) The increase in US interest rates as the money
supply contracted.
The transmission of the GD
2.) The decrease in US demand for the rest of the
world’s products as income fell & barriers rose.
The transmission of the GD
Both developments put upwards pressure on the
value of (home’s) nominal exchange rate.
Countries could have abandoned the GS.
But given their choice not to, countries could
have increased G and shifted the IS curve to the
right or could have decreased the money supply
and shifted the LM curve to the left.
The transmission of the GD
The transmission of the GD
Enough with theory, did events actually play out
along these lines?
That is, did countries that maintained fixed
exchange rates suffer greater losses in output?
And if so, what were the mechanisms?
Best to think in terms of interactions among price
declines, nominal wage rigidity, productivity, and
international competitiveness.
The transmission of the GD
Countries that
experienced the largest
devaluations from
1929 experienced
The transmission of the GD
Defending the GS
implied reducing the
money supply.
Over time, prices
decline as well.
The transmission of the GD
And this change in real
wages should have big
effects
The transmission of the GD
The transmission of the GD
One of the most obvious consequences was on
trade: as incomes plummeted, import demand
matched it (at least) one-for-one.
A vicious cycle and one not helped by changes in
commercial policy; global trade withers by about
60% from 1929 to 1933.
Dislocation of GD also initiates
The consequences of the GD
Period from 1914 to 1939 witnessed the
disintegration of the global economy.
And 1939 did not even mark the worst of it as
GD unleashed forces which were to take the
world to the brink of annihilation.
Thus, no matter how far technology progresses
Conclusion