TEHREEM HUSAIN: The interwar period can offer rich lessons for our discussion today, as the world had then just come out of a public health crisis brought about by the Spanish Flu, when just a decade later, global economic conditions soured due to the Great Depression. Then, just as the world was reeling from that massive economic shock, the onset of World War Two threw the world into another crisis. How similar or different were the economic conditions of the interwar period to today?
NATACHA POSTEL-VINAY: Similar to today, several European countries such as Austria, Hungary, Germany, experienced very high inflation during the 1920s. It went to the extent that Germany experienced a hyperinflationary period over 1921-23. These countries resorted to printing unbacked money to finance government deficits. This was done on a scale that led to the depreciation of currencies of a sizable magnitude. Moreover, similar to today, the end of the Great War brought significant disruption to supply chains that also fuelled inflationary pressures.
On the other hand, in my opinion, the Spanish Flu had little impact on inflation during the 1920s. Relative to today, there weren’t many lockdowns and they were primarily short-lived. Contrary to the stricter and more restrictive measures in terms of social isolation that we have experienced during the COVID-19 pandemic, the UK government in the 1920s adopted a relatively easy-going approach where people were encouraged to keep calm and carry on and not to worry too much about the disease. Lockdowns mainly affected small production locally and only exacerbated inflationary trends afterwards. So, I believe, that the main cause of inflation was the war rather than the pandemic.
TH: Building on your answer, how did past pandemics affect inflation dynamics? So, the idea being that the more prolonged and severe pandemics are, the more persistent the impact on inflation?
NP-V: If you take a very long-term view, the welfare state developed only very recently. Today, states take much stronger policy actions even with the slightest amount of health risk. Stronger policy actions can result in further mobility restrictions and shortages and consequently in more inflationary episodes. This is in contrast to government policy responses during the 1920s. Government policies to deal with the pandemic were quite limited. Undoubtedly there were pressures on the labour supply due to mortality caused by war and the pandemic, but the economic repercussions of these events on inflation was quite limited.
This time is also very difficult as we have two tail events in the form of the war with Ukraine and the post-pandemic effects existing together. So that makes it very difficult to extricate the impact of each of these events on general inflation levels. A recent study that comes to mind is by Daly and Chankova (2021), which takes a very long-run view, going back to the Middle Ages, and explores the economic ramification in the aftermath of pandemics and wars. They conclude that inflation and bond yields typically rise in wartime but remain relatively stable during pandemics.
TH: Your research highlights interwar Britain as a high-debt environment with a turbulent business cycle. Today, one grave implication of the crisis brought about by war, inflation, and pandemic is indebtedness, which has especially aggravated the economic health of low income and developing countries. What lessons can the interwar period offer us in this regard?
NP-V: That’s correct. Indebtedness is a major similarity between then and now. When Britain came out of the First World War, it had a debt-to-GDP ratio of 140 or 150 percent, well above what we have today. It kept increasing throughout the 1920s and required an appropriate policy response. However, Britain was not alone in this regard. The US also had a raised debt-to-GDP ratio. More importantly, Britain’s indebtedness post-WW2 was much higher than after the Great War.
Restrictive fiscal policies were being put in place in the early 1920s to try to reduce the debt burden across Europe. A key example is that of austerity policies. The policy framework focused on a reduction in government expenditure and a concomitant increase in taxes. But taking a long-run view, austerity policies did not always produce the desired effect in terms of controlling country debt burdens. Debt-to-GDP ratios kept increasing throughout the 1920s in Britain, but I do recognise there might be other factors at play as well.
However, after World War Two we have a completely different picture. Post-World War Two, the debt-to-GDP ratio was even higher relative to the 1920s and there was an understanding in British policy circles of the ineffectiveness of austerity policies. Hence, they tried a different policy mix. This focused on a dramatic increase in spending, even though I would not call it deficit spending per se. While, on the one hand, they were increasing spending, there was also a rise in taxes, so the spending increase was funded. Deficit spending would have looked too risky with high debt-to-GDP ratios. What they did is called a balanced-budget fiscal expansion. With the help of low interest rates, the hope was that this funded spending increase would lead to greater economic growth, which would increase tax receipts and thus help pay back the debt. And debt was reduced dramatically over the next few decades.
Fiscal expansion was an increase in spending but that was balanced by an increase in taxes. Interestingly, there was political acceptance of these high taxes due to the events that had occurred during the 1920s. The post-WW1 experience had shown that austerity policies had been ineffective, so under Clement Attlee’s Labour government from 1945-51, there was a sort of political consensus in favour of a different kind of policy. However, there are some caveats to this. For example, the social security policies weren’t very well targeted and poverty levels remained high. Moreover, I believe nationalization went too far in many respects, and some have criticised an era of “financial repression” (the fact that the government forced banks to hold its debt, to keep funding costs low). But perhaps it’s interesting to draw this contrast between World War One and Two. In the aftermath of both of these events, the focus remained on the reduction of debt but in a completely different way. They only succeeded post-WW2.
TH: This is really interesting in terms of understanding the policy responses in the aftermath of the World Wars. I would also like your opinion on the impact of tail events such as the pandemic and the war on bank lending and global credit supply.
NP-V: If we go back to World War One, it was increasingly complex. I would like to focus on Germany, to answer this, in order to provide a perspective other than that of the UK.
Germany had a very high level of debt coming out of the war, and under the Dawes Plan of 1924 there were also significant obligations in terms of reparation payments. So, there was a sense that the German economy could be completely crippled. Money inflows coming into Germany were next to none and there were considerable outflows, for example in terms of reparations payments. Moreover, post-World War One, credit conditions were extremely tight. Physical capital was destroyed and inflation destroyed savings. It got worse during the hyperinflation episode in 1923.
But, interestingly, after 1925 there was an international agreement that incentivised commercial lending to help Germany recover despite it being incredibly indebted. There was a strong sense among international players to incentivise commercial investment in Germany. This resulted in a huge influx of capital into Germany in the second half of 1920s. Unfortunately, and perhaps paradoxically, given the capital shortage that had followed the war, this resulted in a credit boom, which is also partially linked to the Great Depression. The great influx of capital into Europe was a complete change in circumstances and converted a boom into a bubble. So, coming out of the war and a pandemic, there can be a great shortage of capital that eventually resolves in certain ways, but not necessarily the best possible way.
TH: Thank you Natacha. You very rightly point to evidence that suggests that bank lending was much more adversely affected in countries that were harder hit by the pandemic relative to others. Moreover, Germany’s hyperinflation episode is a key factor coming off the gold standard, so there are crucial monetary implications to this as well.
This brings me to the second part of our discussion today focusing on solutions you can offer the world as historians of finance. Independent economic think tanks increasingly emphasise central bank credibility and the continuity of policy frameworks to deal with the cost of living crisis and heightened inflation levels. Keeping in mind your great recent work on tax reform, what near-term and long-term interventions would you propose as a solution to this crisis?
NP-V: My works focuses on the 1920s, and the risks arising then centred on credit. The economic boom of the 1920s was non-inflationary, so there was no general inflation in the US. It is important to understand that there are different types of inflation and to understand which kind of inflation central bank policies are best at addressing. In the 1920s, the Fed increased the policy rate, but it had no impact in terms of dealing with inflation and preventing the boom. But, inflation existed in certain sectors of the US economy, such as housing and the stock market. It also existed in certain baskets of consumer spending but in ways that didn’t impact the general inflation level.
So, there could have been policies that could contain inflation/bubbles in certain sectors, rather than instead focusing on the main policy rate. If policymakers had focused on what was happening in those sectors of the economy rather than focusing on the overall inflation rate (which was low), it might have been more effective in pricking bubbles earlier and spotting where the trouble was looming. Moreover, quick and targeted policy responses would be more effective. This is especially true in those sectors of the economy where there was inflation and supply chain disruptions, specifically in the consumer and retail sector.
At the same time dealing with inflationary pressures in terms of increasing the interest rates is penalising consumers in ways that perhaps they shouldn’t be, since the source of inflation is shortages in certain sectors. There is no justification to penalise home owners or first-time buyers who are already constrained because of the rising cost of living. Overall, I would argue for more targeted interventions to control credit in certain, specific sectors of the economy.
TH: A key implication of pandemic and war is increased fragmentation in global responses. This is manifested not only as divergences in policy responses to fight the crises, but also, more globally, a lack of coordination to fight the key challenges facing the world today, such as climate change. What is your opinion on this?
NP-V: The question of fiscal space is a huge one and there are lots of misconceptions about that. During the COVID-19 pandemic it seemed like there was no limit to how much debt you could have. So, people questioned the need for austerity policies if you could borrow as much as you wanted. Policy makers have again turned to implementing austerity policies, so it is now unclear what the extent of the fiscal space is.
The debate over fiscal space also featured in the policy actions of Liz Truss’s government where taxes were lowered while maintaining the level of government spending. This action would have had the effect of substantially increasing the deficit. This policy action did not go well with a number of key economic stakeholders including investors. So, the lesson to be drawn here is that in some ways it is not true that you can just increase deficit spending without regard for anything else. A similar logic applies to printing money without limits. The key strand behind both of these ideas of limitless money creation and reduction in taxes is the role of investor expectations, investors’ trust in the government, and the threshold of debt investors can tolerate.
However, there may be an approach that is somewhere in between. This could be done through financing deficit spending with higher progressive taxation. The UK has a tax-to-GDP ratio of about 33%, lower than the OECD average, and much lower than Scandinavian countries which are above 40%. This leaves more room to increase taxation in a fair way while maintaining spending to fight key global challenges such as climate change. An important historical precedent of this is Roosevelt’s New Deal in the 1930s. It was based on a balanced budget fiscal expansion funded by tax increases.
TH: I would like to conclude by asking you what some of the risks to recovery are? Some political and economic forecasts paint a grave picture in terms of the worsening of the impact of war, resurgence of COVID or any other pandemic, or monetary policy that is either too strong to cause deep recessionary conditions or that is too weak that it leads to higher inflation. What is your opinion on this?
NP-V: I agree with all the risks that you mentioned here. There is obviously the risk of too tight a monetary policy but also a too loose one. Moreover, there is increased emphasis on the policy rate. There should be a policy mix that would shed some of the excessive burden that is placed on policy rate alone. To conclude, I can’t make predictions. I know economists love to make predictions, but economic historians hate to make predictions. I think they are too aware that all predictions are wrong and we just simply cannot say what the future has in store for us.