Policy Papers

History and the financial crisis

Martin Daunton |

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Executive Summary

  • The Bretton Woods institutions were agreed in 1944-8, to a large extent to try and avoid the bitter experiences of the 1930s: economic depression, currency and trade wars, unemployment and war.
  • In 1944, differing lessons from history were drawn about the reasons for the Great Depression - and the disputes over how to frame post-war institutions were heavily informed by competing British and American interpretations of those reasons.
  • Those disputes over whether the burden of economic adjustment should be shared between debtor and creditor countries, over exchange rate policy and over the balance between free trade and full employment, are paralleled today.
  • Whereas the United States was the major creditor nation in 1944, it is now arguably the major debtor nation: a shift which has left it employing many of the arguments it opposed in 1944.
  • The institutions which were set up to prevent protectionism have, so far, generally succeeded; trade remains more open than ever before. Governments have been less concerned about the impact of domestic policies on international trade.
  • The experience of the WTO and its failure to negotiate a successful round of trade liberalisation suggests that, as with the attempt to set up the ITO in 1947-8, trying to deal with a wide agenda and a large number of participants can be less successful than focussing on more defined and limited aims.
  • Today's institutions were set up in specific circumstances, during a relatively managed transition from sterling to the dollar as the major reserve currency and as a result of agreement between two unequal partners: Britain and America. These circumstances no longer exist.
  • There is not an obvious alternative leading reserve currency to the dollar; and while China is the alternative candidate for international leadership on the economy, both its policies and willingness to lead are uncertain.
  • History can show us how different politicians and commentators are using the past for their own ends; highlight how different countries' positions are coloured by national historical memory; and help us recognise the problems old institutions can face when confronted with new problems.


In 1944, Henry Morgenthau, US Secretary of the Treasury, opened the Bretton Woods conference on post-war monetary relations with a warning to the delegates of 44 countries. His words were based on the bitter experience of the 1930s: 'We saw the worldwide depression of the 1930s. We saw currency disorders develop and spread from land to land, destroying the basis for international trade and international investment and even international faith. In their wake, we saw unemployment and wretchedness - idle tools, wasted wealth. We saw their victims fall prey, in places, to demagogues and dictators. We saw bewilderment and bitterness become the breeders of fascism, and, finally, of war.'

He and the other delegates at the conference, and the officials who had discussed the reform of the world's economy since 1941, were drawing lessons from the Great Depression that they would apply to the post-war world. The problem was that they drew different lessons. Today's politicians and economists also seek to apply the lessons of the Great Depression of the 1930s to the great recession of the present, and to apply the lessons of Bretton Woods to current debates. At the G20, constant reference was made to the 1930s and 1944.

Historians need to warn against the use of inappropriate analogies; to show where history is being drafted in to support particular policies; and to highlight where the experience of the past differs fundamentally from the present.

Reparations versus integration?

The presiding genius at Bretton Woods was John Maynard Keynes who put forward his scheme for an international clearing union in 1941; after much discussion with Morgenthau's assistant secretary of the Treasury Harry Dexter White, it resulted in the agreement of 1944. Although Morgenthau and White agreed with Keynes on some of the lessons of the Great Depression, they also had deep disagreements about other lessons.

Keynes participated at the Versailles peace conference at the end of the First World War, and exploded onto the international stage with his famous book, The Economic Consequences of the Peace. He warned that disaster would follow from the imposition of reparations on Germany. The result, he feared, would be bitter resentment and disordering of international finances.

In 1944, Keynes's lesson from history was that the Germans should not be treated punitively. Instead they should be integrated into the world economy - and Cordell Hull, the US Secretary of State agreed. Hull was the reincarnation of Richard Cobden, the great leader of the Anti-Corn Law League and creator of the Peace Society. By linking nations together in trade, peace would be assured.

Morgenthau disagreed. In his view, Hull's continued reliance on trade agreements to make peace was derided as being 'like hunting an elephant in the jungle with a fly swatter'. Morgenthau wished to destroy the capacity of Germany to wage war: the 'Morgenthau plan' proposed splitting Germany into separate states, closing down heavy industry and returning it to a pastoral economy. A US Treasury memorandum called this the 'Program to Prevent Germany from Starting World War III' and was presented by Roosevelt to Churchill in September 1944, shortly after Bretton Woods and without Hull's knowledge.

Although Churchill initially condemned the plan, he was eventually converted by the thought that Britain would secure German export markets. This policy of limiting German recovery was pursued by the US occupying army until July 1947, when it was decided that 'an orderly, prosperous Europe requires the economic contributions of a stable and productive Germany'. Apparent agreement on the need for international economic institutions to reduce post-war conflict masked deep divisions over how best to deal with the defeated nations and to create the conditions for a lasting peace.

Deficit versus creditor countries

Keynes and White disagreed deeply on another lesson of the Great Depression. Keynes argued that the lesson of the post-war settlement was that the burden of adjustment should not fall on countries such as Britain which had massive trade deficits, but should also be borne by the surplus countries - above all the United States.

At the end of the First World War, Britain had lost a large part of its export markets and experienced inflation so that its costs were out of line with those in the US. To regain export markets, it needed to become more competitive and, since it could not devalue its currency given the decision to return to the gold standard, it had to reduce costs by slashing spending, raising interest rates to defend the value of the pound, and attacking wages.

In The Economic Consequences of Mr Churchill, Keynes warned that the result would be disaster - an outbreak of warfare between capital and labour, and mass unemployment through reduction in consumption. His warnings seemed to come to pass with the general strike of 1926, mass unemployment, and a slide into economic nationalism. On this reading of events, recovery after the Second World War required the creditor nation - the USA - to adjust as well as the deficit countries to prevent all the burdens falling on struggling economies which would provoke a nationalistic or communist backlash.

Morgenthau and White were equally adamant that the US should not be forced to act as the creditor nation. In their view, British industrialists and politicians in the 1920s vacillated in the face of high costs after the First World War. British wages should have been forced down and costs adjusted to the gold standard. The British government had not stood up to the power of unions; they had not cut taxes or restored free-market incentives; they had spent too much on welfare, preventing wages from adjusting (in effect, falling).

Instead, the British government came off the gold standard in 1931 - allowing the value of the pound to drop, pricing imports out of the domestic market and making British exports more competitive. Britain had laid the ground for currency warfare which led to economic disaster. If anyone was at fault, it was Britain - which was now demanding to be allowed to escape the pain of adjustment a second time.

These two perspectives were fought out at Bretton Woods - with Morgenthau and White winning the battle so that creditor nations would not need to adjust by ensuring that they did not accumulate massive surpluses.

Keynes wanted an international bank to produce its own money or Bancor to provide liquidity for trade, and to allow deficit countries to have an overdraft facility, much as a private individual would from Barclays. If a country was in persistent credit - as was the US - it would pay a penalty and ultimately hand over its surplus in full.

White rejected such as approach as a sanction for profligacy: why would any deficit country do anything to adjust its international trade position? And the production of Bancor would be inflationary. The American proposal was a stabilisation fund into which each member country paid a quota upon which it could draw; it could not create money itself. Further, sanctions on creditor countries were rejected or ineffective. White and the US Treasury had largely won over Keynes and the British Treasury.

In 1944, two different lessons were taken from the history of the interwar period by the British (deficit) and the Americans (surplus). We are now seeing a very similar debate - with an ironic twist. American and Britain are both now deficit nations and China, Germany and Japan are surplus countries. Without action to rectify these imbalances, they pose serious dangers to the world economy.

Tim Geithner (US Secretary of the Treasury) is taking on the mantle of Keynes - and the Chinese and Germans are following White and Morgenthau. Geithner suggested that countries with a deficit or surplus of 4% of GDP should take corrective action: notably, the US' deficit is about 3% of GDP, whereas China and Germany's surpluses are 6% and 5%. The figures are not a target, and there is no sanction or automatic mechanism as proposed by Keynes: at the G20, there was only a promise to be virtuous sometime in the future.

Currency wars

The debate over global imbalances is closely linked with the belief that we are now witnessing currency wars.

One reason for China's large surplus, in US eyes, is that the Chinese government deliberately undervalues the Renminbi to boost its exports. In response, other Asian countries hold down their own currencies. Beijing counters that the real problem is the American failure to reduce costs and balance the books - just as the Americans complained about Britain after the war. Furthermore, the Chinese accuse Washington of manipulating the currency through Quantitative Easing - pumping money into the economy, weakening the dollar and making American goods cheaper.

This game of tit-for-tat has serious implications. Could it spill over into trade wars, as in the 1930s? There is considerable concern that these difficulties could create a new financial crisis and protectionism. The participants at Bretton Woods recognised that competitive devaluation played a major role in the Great Depression; countries followed each other to ever lower exchange rates in order to secure export markets and to price imports out of the domestic economy. Currency wars led to trade wars and to depression: the stakes are very high. The current debates turn to history for lessons - which, as we might expect, are far from certain.

Some historians argue that the loaded term 'currency war' misrepresents what happened in the 1930s. Their optimistic view is that currencies were realigned: coming off gold allowed the pursuit of policies on the lines of today's quantitative easing. Devaluation helped countries recover: those which came off gold first, like Britain, had the fastest rate of recovery, whereas those like France which stayed on gold suffered from slow growth.

On this view, the lesson of the 1930s is not to worry about currency wars - and to celebrate flexible exchange rates. But some countries are now trapped into inappropriate policies because they cannot adjust their exchange rate. Britain left the gold standard in 1931 and could readjust and recover. Ireland and Greece cannot exit the Euro-zone, and the euro's value is boosted by Germany's economy.

Both Keynes and White, though, wanted exchange rates to be pegged to prevent any repeat of the crisis of the 1930s. At Bretton Woods, the dollar was fixed to gold at $35 an ounce, and all other currencies were then fixed to the dollar. Unlike the classical gold standard, currencies were not directly fixed to gold: they could be readjusted against the dollar, avoiding the danger of serious deflation and a political backlash. This system persisted until the early 1970s.

But was the right lesson learned? In 1950, Milton Friedman wrote a paper for the Economic Cooperation Administration, the US government agency set up to run the Marshall Plan in Europe. He argued that floating exchanges - allowing rates to be set by the market - were 'absolutely essential for ... the achievement and maintenance of a free and prosperous world community engaging in unrestricted multilateral trade'. Fixed exchange rates required controls on the economy to sustain those rates. If rates could float, controls on the economy and barriers to trade could be removed.

Friedman also argued that the Depression in the US arose from inappropriate monetary policy by the Federal Reserve, reducing the monetary supply too much in 1929-33 and triggering a serious disruption of the economy. He believed that the Fed should have acted to ensure stable monetary growth - but policymakers opted instead for Keynesian spending on public works.

Ben Bernanke, now chairman of the Federal Reserve, studied the Great Depression and has followed Friedman's prescriptions - injecting money directly into the economy through Quantitative Easing 2. However, this approach can be seen as a form of currency war. Bernanke argues that its only aims are to prevent inflation and to stimulate employment. But his actions weaken the dollar nonetheless, and China and Germany see this as the rationale for QE2. The result could be a very serious standoff.

Trade and protectionism

Another lesson of the Great Depression was the danger of trade wars, with high duties restricting imports from undervalued countries and thus sustaining domestic employment. Again, Britain and America disagreed about what instigated the trade wars. London believed the answer was obvious: the American Smoot-Hawley tariff of 1930, imposing massive tariffs against imported goods. For Washington, the answer was equally obvious: British imperial preference in 1932 - lower duties on empire goods and high duties on foreign goods. For Hull, tariffs were nothing like as wicked as preferences. Tariffs applied to everyone; preferences meant that empire producers were favoured over others, so distorting the market. By contrast, America was even-handed in its treatment of British and German imports.

Both the British and Americans, though, agreed that trade wars were a curse in the 1930s. In the current great recession, avoiding trade wars has been a key theme - and on the whole, governments have delivered. In the 1930s, world trade continued to fall for at least 4 years from the peak in 1929; in the current great recession, the recovery started after about a year, and has been surprisingly strong. We are now almost back to the peak. Much the same applies to industrial production.

We have so far avoided trade wars and increased protectionism. The WTO estimates that new trade restrictions since October 2008 amounted to 1.8% of G20 imports and 1.4% of total world imports - trade remains more open than ever before. Although the report commends the restraint shown by countries, it warns of the dangers of exchange rate protectionism, trade imbalances and high unemployment. As the Financial Times pointed out, politicians are aware that trade barriers led to the Great Depression - but they have been less concerned at the impact of their domestic policies on international trade. Bernanke can say that QE2 is designed to deal with inflation and unemployment, but the dollar falls as a result. Uncoordinated and possibly unsuccessful national policies might lead to political pressure for protectionism.

We need a means of joining the IMF's concern for currencies with the WTO's concern with trade. At present, there are signs of controls over the purchase of assets by firms located overseas, such as the Canadian opposition to BHP Billiton of Australia taking over the major Canadian producer of potash. Open trading has survived, but some fear we might see an outbreak of 'natural resources nationalism'. The WTO is concerned that the most recent round of trade talks - the so-called Doha Development Agenda - has been deadlocked since the end of 2009.

Nevertheless, there is some ground for optimism in comparison with the 1930s. The lesson of the 1930s has been in everyone's mind and is constantly reiterated. I am not convinced that natural resources nationalism is a real threat. But above all, institutional rules make a lurch to protectionism much more difficult than in the 1930s: and since 1947, we have had such rules. The post-war commitment mechanisms and institutions have proved remarkably resilient.

But the shape of the trading system was deeply contentious during and at the end of the war. For the US, the major problem from the 1930s was imperial preference, which they wanted abolished in return for Lend Lease in 1942 - the provision of munitions and other resources without immediate payment - and the large loan to Britain at the end of 1945. London responded that dismantling imperial preference would be dangerous, given Britain's parlous position at the end of the war. The country was facing bankruptcy. Its economy was highly dependent on international trade and therefore had an interest in open markets. But greater involvement in the international economy risked making it liable to recession and unemployment. Above all, the British economy would be more dependent on America - an inherently unstable capitalistic economy which could drag Britain into recession. 'Otto' Clarke, a leading official at the Treasury, feared that US proposals

are on the whole creative of unemployment and ... certainly hinder individual countries from pursuing an internal full employment policy.... .... We are, in fact, embarking upon a high import-high export policy with no safeguards at all about the stability in USA and with very limited powers to take protective action in co-operation with likeminded countries to ease the impact of US depression on our economy.

Britain therefore argued that free trade should depend on countries' commitment to domestic policies of full employment. Free trade would follow after full employment had been secured. Washington differed: free trade should come first, and that would create full employment. Many Americans feared that a commitment to full employment would lead to inflexibility in the economy, stifling change and growth.

These differences led to serious problems in negotiating the Charter for the International Trade Organization which was intended to be the counterpart of the IMF. Three successive conferences were held in London, Geneva and Havana between 1946 and 1948. Although Will Clayton signed the Charter at Havana on behalf of the US, it was never ratified by Congress and the ITO never came into existence. Why?

Britain stressed the need for full employment: others went still further. Australia argued that the exporters of primary products needed policies to fully employ the resources of the world and hence higher raw material and food prices. India felt that justice meant that developed countries should be willing to lose employment to aid development in poor countries. The Latin Americans took a leading role at the Havana conference, arguing for activist policies of economic development and protection of their markets. They had considerable voice because of a shift in the voting system of the ITO. In order to secure the presence of more countries, and to obtain support for the programme of free trade, the Americans decided to allow more countries to attend at Havana and to give each one vote - unlike the IMF. The Latin Americans then seized the chance to insert all sorts of clauses which were unacceptable on Capitol Hill.

What did survive was the interim agreement of GATT signed at Geneva. It was not an institution like the IMF, but a set of agreements between national governments. It offered a means of negotiating down trade barriers in a series of 'rounds'. It thus avoided the issue of voting rights that had stymied the ITO and excluded the wider development agenda that had caused such controversy.

GATT has since been replaced by the World Trade Organization. So far, it has not successfully completed a round of its own. The Doha Development Agenda was launched in 2001 and is deadlocked. There are lessons to be drawn here. The problem with the WTO is that it has many members and a democratic franchise, with an extremely wide agenda from trade in goods to services, intellectual property and development. Is the Doha Development Agenda - much as the Charter of the ITO that was debated at Havana in 1947/8 - too all-encompassing, preventing the emergence of consensus? Perhaps it is better to deal with a defined and limited agenda on trade and not to try to solve all problems at once.

Although there has been more success in containing protectionism than was feared at the start of the great recession, the institutions of the WTO are still in need of reform.

Debt and deficit finance

In the late 1960s, the standard interpretation of the Great Depression assumed that the Treasury had misguidedly rejected Keynes's policies of increased public spending to boost demand and stimulate investment. In 1929, Keynes and the Liberals (who advocated Keynesian policies) were defeated by the advocates of prudence, in the form of the minority Labour government. The same approach was then followed by the National Government after 1931 - balanced budgets and safety first.

The result, we were led to believe, was persistent unemployment and depression. However, Thatcherism made us look differently at the 1930s. After all, Britain recovered faster than other countries and the Treasury was not so misguided in pursuing a policy of cheap money to stimulate private house building, rather than wasteful public works which would lead to a bloated and inefficient state.

These debates are now back on the agenda. An initial result of the recession was the return of Keynesian policies of public spending; now, in Britain, we have the return of the Treasury view and cuts. A major difference between the Great Depression of the 1930s and great recession of the present is the size of the state. In Britain in the 1930s, public spending was about 25% of GDP; now it is 40%. It could be said that the state is too big and should be scaled back. On the other hand, it could be argued that cutting now will have disastrous effects on consumption and might provoke a deeper recession, with similar effects to the collapse of the export industries of the 1930s.

This is not to deny the need for action to solve the structural deficit. But we should not become obsessed with the national debt. Debt is low in historic terms: and Britain has not defaulted on loans since the sixteenth century, unlike Greece and Spain. A question that is worth asking is: why are some countries prone to default, whereas others avoid it, even with much higher levels of debt?

Conclusions: what can be done?

In order to understand what is or is not possible to do in facing up to the problems I have outlined in 2010, we need to undertake a careful political and historical analysis. One of the shortcomings of modern economics is that it excludes historical insight from its purview.

We are at a particularly difficult moment in the development of the world economy. It is rare for one key currency to be replaced by another: the last time it happened, sterling was replaced by the dollar. The process was long-drawn out, from the First World War to the 1960s or 1970s, and caused serious political debate within Britain about national identity as imperial or European, let alone in economic policy. Nevertheless, the process was managed in large part because the American government decided to assist in the gradual displacement of sterling; and the dollar was the obvious alternative.

Things are now very different. The dollar remains the world's major reserve currency, but the American economy is in deficit. The Americans can continue to print more dollars but are coming under pressure from China and Germany. Is there an obvious alternative currency? Before the onset of the great recession, one leading financial historian felt that an alternative existed for the first time: the Euro. We can no longer even be certain that the Euro will survive its current strains. The Renminbi might provide another answer: but the Chinese do not wish to make it freely convertible or a reserve currency.

As today's international institutions were formed in the peculiar circumstances of the war and post-war transition, they have serious difficulties in responding to new problems. Bretton Woods was the result of agreement between two countries with unequal bargaining power: Britain and America. It was therefore relatively easy to come to an agreement in 1944, when the war was still in progress. Furthermore, technical experts had produced reports which created a shared diagnosis of many of the problems.

That shared diagnosis is now absent. Will a cooperative solution prove possible? It is far from clear that the IMF has the mandate to carry through reform or a clear set of policies. It still has weighted voting, though there has been some progress in lessening the role of America and Europe in a settlement this month. Does authority lie with the countries of G20, or with the narrower G8? The G8 is dominated by developed countries and lacks legitimacy to carry through major reform: but G20's size makes it difficult to coordinate. It also lacks clear leadership.

We could, pessimistically, point to President Nixon and the collapse of the initial Bretton Woods system in 1971. The failure to agree reform through the IMF or G10 led to a policy of 'benign neglect' -waiting for a crisis to emerge which would destroy the system and force reform through. When crisis struck, there was no real reform plan: the result was a decade of uncertainty. Is this what we face now? Possibly so: America may be facing a period of serious polarisation of opinion which makes it very difficult for it to deal with its own deficit or to provide international leadership.

The alternative leader is China, but there is little clarity about its policies. In April 2009, Zhou Xiaochuan of the People's Bank of China proposed what he called a 'super-sovereign reserve currency', and referred to Keynes's proposal of 1941. A basket of currencies would replace the dollar and, it is hoped, promote international cooperation. Whether he will have more success than Keynes remains to be seen.

The balance between debtor and creditor countries was different after the Second World War from now. The US has more power as the deficit country, as the dollar is still the major reserve currency: the rest of the world cannot easily force it to adjust. China could allow a gradual appreciation of the Renminbi - but it is very cautious about doing anything swift. Partly, Chinese caution rests on historical experience. In the 1930s, China was still on a silver-backed currency, and in 1934 the US increased its price to help domestic producers. The result was an outflow of silver from China which led to deflation and the abandonment of the silver standard in 1935 - and in turn to hyperinflation. China warns that appreciation and a loss of export markets will create domestic unrest. Again, global policy prescriptions are formed by national circumstance.

What does history teach us? We need to understand the circumstances in which institutions were created, so that we are aware of their problems adapting to new circumstances. We need to understand the assumptions of different countries that are rooted in national histories.

We also need to recognise how politicians and commentators are using and abusing history for their own purposes. And we need to understand that policymaking, both in 1944 and in 2011, cannot be reduced to neat theories and mathematical formulae.

This paper is based on Martin Daunton's Trinity Hall Lecture on 'History and the Financial Crisis'.

Further Reading

Barry Eichengreen, Exorbitant Privilege: The Rise and Fall of the Dollar (Oxford: Oxford University Press, 2011)

Barry Eichengreen, Global Imbalances and the Lessons of Bretton Woods (Cambridge (MA): MIT Press, 2006)

Robert Skidelsky, John Maynard Keynes: Volume 3: Fighting for Britain, 1937-1946 (Basingstoke: Macmillan, 2000)

Carmen M Reinhart and Kenneth S Rogoff, This Time is Different: Eight Centuries of Financial Folly (Princeton: Princeton University Press, 2009)


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