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 (1929-35) on
economic thinking about macroeconomics.
• A tale of different policy responses to the
economic crisis in 1929 and 2008.
• A market failure theory of the Welfare State.
• The socialist experiment failed- but why?
First decades of the 20th 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. 757-784
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 1932.
• Was it a ’beggar-thy-neighbour’ policy?
No more ’golden fetters’!
Source: B. Eichengreen (ed.) Elusive Stability, Essays in the History of International Finance,
1919-1939, 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. 757-784
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
Europe
USA
Canada
Japan
1890-1994
1.8
1.8
2.0
2.9
1890-1913
1.4
2.0
2.8
1.4
1913-1950
0.9
1.4
1.4
0.9
1950-1973
4.0
2.9
2.9
8.0
1973-1994
1.7
1.4
1.4
2.8
Source: Feinstein et al, ‘The World Economy Between the
Wars’, 1997, p. 9
The Great Depression and the 2008/09
crisis in Europe
Great Depression
Present crisis
• Quarters of negative growth:
13-15.
• 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:
3- 5.
• 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 Depression
Present 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
10-30 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
Question
Answer
• 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 1920-1990
• Russia was an overachiever in the 1920-40
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 selfimposed 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 $.
18000
16000
14000
12000
10000
spain
EE and former USSR
8000
Italy
6000
4000
2000
0
1950
1955
1960
1965
1970
1975
1980
1985
1990
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 40-50 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), 757-784,1992.
• 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 1919-1939,
Cambridge University Press 1990.
• Slides 20 and 24 from Angus Maddison, Dynamic Forces in
Capitalist Development, Oxford University Press, 1991.