A history lesson for the U.S., from Europe during the interwar years
Why do bad things happen to good economies? In other words, why do countries that do what they "should" sometimes fall behind countries that don't? The question answers itself. There's a time and a place for orthodoxy, and forgetting that fact usually ends poorly.
Great Britain and France took turns learning this lesson in the 20th century, during the interwar period. It doesn't get much more unorthodox than the aftermath of wars and depressions. Setting aside the unprecedented human catastrophe, World War I left both countries with a legacy of high inflation and high debt. Britain was determined to return to the status quo ante and to return almost immediately, which meant bringing back the gold standard and bringing it back at its prewar exchange rate. France took a more laissez-faire attitude about turning the economic clock back to 1913.
This was a disaster for Britain, and, well, not a disaster for France. Returning to the gold standard at its prewar parity, which Britain did in 1925, meant pushing prices down to where they had been before years of high inflation -- in other words tight money and tight budgets. And that meant high unemployment and high debt due to miserable growth. In contrast, France kept the franc free floating, and, boy, did it ever float ... down, that is. This massive devaluation pushed prices up, which in turn pushed war debts down, in real terms. As Paul Krugman points out in the chart below, France finished the decade with better growth and less debt than Britain, relative to where they were before war.
And then it switched. To end its currency cliff-diving, France pegged the franc to sterling in 1926 before returning to the gold standard in 1928, albeit at a new undervalued exchange rate. France in 1927 was a bit like China in 2007 -- running enormous trade surpluses and accumulating foreign reserves (and gold) in the process, due, in part, to a cheap currency. But hoarding gold was far more pernicious for France than hoarding dollars was pernicious for China, because you can't print gold if you need more of it. More gold for France meant less gold for everybody else, and that meant more deflation and more unemployment for everybody else. This stockpiling -- France went from controlling 7 to 27 percent of the world's gold between 1928 and 1932 -- was a big part of what made the Great Depression so great. It sucked countries like Britain even further into a deflationary vortex, eventually forcing Britain to abandon the gold standard in 1931.
That weakness turned out to be a blessing. Getting pushed off gold allowed Britain to reflate and recover, while France's strength let it stay on gold, with all of the deflation and declining output that entailed, until 1936. The chart below shows us the cost of this orthodoxy. I took Krugman's graph and modified it a bit -- indexing GDP per capita, rather than GDP, to 1913 levels to control for both the human and economic devastation of the war. Gold ended up costing France just as much growth after 1931 as it cost Britain before that.
The irony is France made itself be more orthodox than it needed to be. It "sterilized" gold inflows, as did the U.S., to prevent new gold from turning into new money and head off nonexistent inflation. As then-professor Ben Bernanke showed in tables 2.2 and 2.4 here, prices and industrial output both fell at double digit rates in France until it finally left gold in 1936, the last to do so.
Ideas have consequences, especially when it comes to economics. Britain crucified its economy in the 1920s on a cross of gold; France did so in the 1930s. Today, the Fed has ignored destructive calls to raise rates in the face of high unemployment and low inflation because zero rates just seem perverse, but fiscal policy is where bad ideas are a threat. Consider that, adjusted for inflation, we can borrow for 20 years for -0.14 percent. Yes, that's a negative sign there. Investors are giving us $100 now and only asking for $99.86 in two decades time. Not too shabby.
The risk is we're not borrowing enough now, not that we're borrowing too much. Even if President Obama and House Republicans reach a deal that kicks the can on the fiscal cliff, aside from raising taxes on the rich, that's a hundred billion or so that we shouldn't be sucking out of the economy right now. We should take that money and spend it on something else for the next few years -- like infrastructure, smarter electricity grids, or underground power lines. Of course, it's a fairly heroic assumption that Washington will agree on avoiding even this much austerity. The payroll tax cut and extended unemployment insurance, which would add 800,000 jobs in 2013 alone, have become political orphans in the fiscal cliff negotiations, because, well, it's not clear why.
In the long run, we need to come close to balancing our books. But the long run isn't here yet, not when we're getting paid to borrow. This isn't an academic question. Bad ideas are expensive, whether it's the 1930s or the 2010s.
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