Britain 1931: An Austerity Episode in Deflationary Times

Columbia Business School dean, former chairman of George W. Bush's Council of Economic Advisers and Mitt Romney economic adviser Glenn Hubbard has a sort of executive summary of a Republican "growth agenda" in the Financial Times. Why now? Who knows? Maybe he's on summer break. Still, if there's anything new in it, I missed it: The need to make "structural adjustments," which means "reducing transfer spending" (that's mostly entitlements) and generally rethinking the tax code, and undergoing "gradual fiscal consolidation" (translation: reducing the size of the government). Hubbard dismisses "many in Washington [who] argue that an emphasis on the long term is misplaced, that we should focus on near-term 'stimulus' and can confront long-term problems later." (By pinning this notion on Washington, he ignores the fact that such thoughts have dawned on many souls, including many economists, in many places -- that it's not just political hackery at work: It's most of his colleagues.) Why the need to act now? Hubbard insists that that fiscal overhang, mostly from Medicare and Medicaid, contributed to the crisis -- the "bias" for housing, presumably from the mortgage deduction -- and that if you take care of longer-term "transfer spending" problems, you can attack short-term problems like growth and jobs. And lastly, "ad hoc responses to the crisis exacerbated policy uncertainty, weakening the recovery."

Why get into a cat fight over this, particularly the last point, which speaks to gridlock in Congress? It is worth noting, however, how larded up this short op-ed is with jargon, euphemism, qualifiers and declarations of faux facts. Hubbard's absolutely certain, for instance, that many of our economic woes rise from the fact that consumers and businesses are convinced that the fiscal overhang will "some day" raise their tax burdens, "discouraging investment, and limiting productivity growth." Really? This is a version of a rational-expectations hypothesis that has been pummeled of late more than a piñata. But OK, it's a political document in the midst of a presidential campaign. What is revealing, however, is how Hubbard uses "austerity" as a kind of threat: either cut deeply immediately, or our woes will continue to deepen.

We have been here before. Much is made of Franklin Roosevelt's decision in the late '30s to try to balance the budget, thus inadvertently launching a second depression in 1938. But an even more revealing sequence of events occurred in Great Britain earlier in the '30s. My source for this is A.J.P. Taylor's wonderful English History: 1914-1945 published by Oxford University Press in 1965. When the 1929 stock market crash occurred in America, its effects soon swept Britain and Europe, particularly as U.S. investment dollars evaporated. Britain actually fared better than most, despite structural problems: Its all-important exports fell dramatically, but imports did as well, cushioning the blow. Unemployment, which had been a chronic problem in the '20s, surged, but not to the levels of the U.S. or Germany. In fact, the crisis came not over the economy itself but over the budget.

In 1929 Britain had elected a Labour government under Ramsay MacDonald and Chancellor of the Exchequer Philip Snowden. Despite his Labour pedigree, Snowden was intensely orthodox; on fiscal matters, including balanced budgets and the gold standard, he was not all that far from longtime Bank of England head Montagu Norman. (Taylor on Norman: "In particular, Montagu Norman regarded unemployment with the fatalistic resignation which Jellicoe [British naval chief, World War I] had shown toward German submarines in April 1917. 'We have done nothing. There is nothing to do.'") For his part, MacDonald was not a finance person and tended to go along. In 1931, the government ordered two reports drawn up on the budget, one led by Lord Macmillan, with John Maynard Keynes on the committee; the other by former Prudential Insurance chairman Sir George May and manned by businessmen. The Macmillan committee had all kinds of novel (and, at the time, strange) ideas that would matter later, but, as Taylor recounts, in discussing the situation, it revealed that Britain had run a balance-of-payments shortfall for years -- indeed, since 1822. This stirred a tempest. "They [the government] were alarmed at the prospect that Great Britain was not paying her way in the world and easily confused the alleged deficit in the international balance with the budget deficit, though of course the two had nothing in common."

Nonetheless, Snowden was determined to balance the budget, helped by the May report, which Keynes called "the most foolish document I ever had the misfortune to read." The committee urged draconian cuts, particularly in unemployment relief, and higher taxes -- this in a period of intense deflation. Then, as the government left for holiday in August 1931, the crisis spread. The banks told MacDonald, who rushed back from his holiday, there was a run on the pound, caused by widespread foreigners selling sterling. The impression they left was that this had something to do with the budget and unemployment -- that it was a run on Britain. In fact, it had more to do with the City, eager to retain its role as an international finance center, taking short-term deposits of foreign money, then lending long-term in Central Europe, mostly Germany. As tensions between France and Germany spiked in 1931, French depositors yanked their short-term money; meanwhile Central Europe was collapsing, putting the loans underwater. In short, the crisis had little to do with Britain as a nation and everything to do with failures of the City banks.

A few, like Keynes, saw through this, but the Labour government did not. Salvation could come only with a balanced budget. Taylor: "The bankers, and most other people, believed that it [the budget] must be balanced mainly by reducing government expenditures -- 'waste' as it was usually called, not by increasing taxation. They believed also that the gravest 'waste,' crying out for reduction, was on unemployment relief. ... Behind this financial judgment, there was an unconscious moral judgment: the unemployed, living on the dole, were felt to be somehow unemployed through their own fault." Some businessmen, writes Taylor, "went further." Cutting relief would break "rigidities, and open the way for a general reduction of wages, thus helping industry. Faced with a crisis, the responsible authorities fled back to the antiquated prejudices and practices which they had been unwittingly abandoning in easier times. Renewed class war seemed to them the only way out."

The end of the story? Rank-and-file Labour opposition mounted, the Cabinet split, and the government fell, only to re-form as a coalition headed by MacDonald. The Snowden budget did pass, after bitter debate and minor reductions in its most extreme aspects, supported by Liberals and Conservatives, with Labour rejecting it. Hello austerity. Meanwhile, the run on the pound continued, despite support from New York and Paris; it accelerated with Labour opposition to the budget, which alarmed the markets. On Sept. 19, the Bank of England reported that its foreign credits were exhausted. Two days later, Britain went off the gold standard, which turned out to be a good thing, with the pound devaluing by a quarter and essentially providing some inadvertent stimulus. In fact, going off the gold standard, for all the doom and gloom, proved to be among the best strategies to deal with deflation. Taylor concludes the episode: "A few days before, a managed currency had seemed as wicked as family planning. Now, like contraception, it became commonplace. This was the end of an age." Or perhaps not.

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Robert Teitelman is editor in chief of The Deal magazine.