Several lessons from this disastrous interwar experience are directly relevant for today’s Europe. First, nominal wages were sticky downward during the Great Depression (Bernanke and Carey 1996), implying that deflation led to rising real wages, and falling employment and output. Wages were not unusually rigid during this period (Hanes 2000); rather, downward stickiness is a fact of life in modern economies. Figure 1 shows indices of wages and salaries between 2008 and 2012 in Greece, Ireland, Portugal, and Spain, four countries currently trying to achieve nineteenth century style internal devaluations. As can be seen, wages have been steadily rising in Portugal and Spain, despite very high levels of unemployment there. Even in Ireland, a country widely regarded as having unusually flexible labor markets and as having successfully accomplished an “internal devaluation,” there is no sign of wages falling, although they have managed to avoid rising. In all four countries, by contrast, employment levels have been continually falling, although the Irish decline came to an end in the second half of 2012.
The one important eurozone exception to the general conclusion that nominal wages are rigid downwards is Greece, where manufacturing wages declined by more than 10 percent in the three years starting in 2010. The impact of the depression on the fabric of Greek society has been particularly harsh: if this is what it takes to produce nominal wage declines, prudence might suggest alternative adjustment mechanisms, such as rising wages and prices in surplus countries. As in the interwar period, however, eurozone countries running current account surpluses are reluctant to accept temporarily higher inflfl ation rates. Second, deflfl ation during the interwar period was dangerous in other ways. It increased the real value of debts, placing indebted households, businesses, and fifi nancial institutions under pressure (Fisher 1933). It weakened bank balance sheets in the fifi nancial crisis, with knock-on effects for businesses reliant on bank lending. It increased real interest rates and induced households to postpone expensive purchases. Deflfl ation helped deepen the Depression; even if internal devaluation were possible in modern economies, deflfl ation would not be desirable.
Third, large public debts are difficult or impossible to stabilize when deflation is increasing the real value of the debt and slowing economic growth.3 During the interwar period, Britain ran primary budget surpluses of 7 percent of GDP during the 1920s. Despite these efforts, the deflfl ationary low-growth environment meant that the British debt-to-GDP ratio increased substantially over the decade. The IMF’s (2012, p. 112) conclusion is that this episode is “an important reminder of the challenges of pursuing a tight fifi scal and monetary policy mix, especially when the external sector is constrained by a high exchange rate.”
Fourth, as the interwar period wore on, more countries (such as Germany)attempted to adjust based not only on internal devaluation, but also with fiscal austerity. This strategy was costly, since fiscal multipliers were high in the 1930s, given weak economies and interest rates affected by the zero lower bound. Almunia, Bénétrix, Eichengreen, O’Rourke, and Rua (2010) find multipliers well in excess of one in a sample of 27 countries between 1925 and 1939; thus, fiscal austerity policies amplified the Great Depression.
Fifth, countries only started to recover from the Great Depression once they left the gold standard (Eichengreen and Sachs 1985; Campa 1990). Revaluing countries’ gold reserves as they exited made it possible to boost the money supply. In leaving gold, expectations of defl ation were replaced by expectations of inflfl ation (Temin and Wigmore 1990; Romer 1992; della Paolera and Taylor 1999; Eggertsson 2008). There were transitory competitiveness gains for early movers who depreciated first. Countries also tended to do better when they embraced capital controls and used the policy space so liberated, even if their exchange rate remained officially pegged to gold (Obstfeld and Taylor 2004). Regaining monetary independence, one way or another, was the route to recovery.
Sixth, the Depression had calamitous political consequences. Voting for extremism was negatively related to GDP growth during this period, at least in countries that had not been inoculated by a history of democracy stretching back to before World War II (de Bromhead, Eichengreen, and O’Rourke 2013). Ponticelli and Voth (2011) find a strong correlation between fiscal austerity and political chaos (as measured by riots and other disturbances) over the last 100 years or so, and the result is robust when restricted to the interwar sample. It is foolish to ignore the potential political consequences of internationally lopsided and deflationary adjustment strategies. The experience of the 1930s is not only a cautionary tale of the limitations of adjustment strategies based on internal devaluation and fifi scal austerity, but an illustration of the power of monetary policy and of the value of macroeconomic policy flfl exibility. It is a useful reminder that Keynes’ short run is the time frame within which politics occurs, for good or ill.
