CHAPTER 5: GLOBALIZATION BACKLASH: WWI AND THE

INTERWAR PERIOD

INDEX

 Globalization backlash: WWI and its economics

 The 1920s: hyperinflation
 The 1920s: reconstruction of the Gold Standard

GLOBALIZATION BACKLASH: WWI AND ITS ECONOMICS

The early 20th century (historical backround)

 This period was characterized by the international integration in various

markets, and also the second industrial revolution with the introduction of new
technologies such as electricity and chemistry, and a large expansion of
industrialization.

 Apart from these, this era was characterized by the rise of the Gold standard
which influenced the economic order, which was liberal. Freedom was not only
found in the economic sphere but also on the artistic one; “Belle Époque”.

 However, the assassination of the future Austrian leader (Francis Ferdinand) and
his wife by a Bosnian Serb nationalist sparked a chain of events that led to the
outbreak of WW1. (Nowadays this connection is doubted.). This ended with:

- Austria-Hungary declaring war to Serbia (28 july, 1914)

- Germany to Russia and France
- Britain declaring war on Germany (4 august, 1914)

Deeper causes of WWI

 Increasing competition among European powers: Imperialism resulted in

countries searching for markets by colonizing different parts of the world. (As
Lenin called it, Imperial capitalism).

 Aditionally, there were domestic tensions: rise of socialism and nationalisms.

The world at war

 Initially, there was unawareness of the modern nature of war: people thought
that because of the small state budgets, long wars would be unsustainable.
However, the new weapons and war technology favored defense over ofense, so

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 the war ended up in a military stalemate in which both sides were defending its
trenches.

 In order to maintain this stalemate, the role of the state in the economy
expanded. (1) Resources were reallocated into war production; (2) prices and
wages were controlled and (3) the whole economy was cartelized, which means
that firms formed legal monopolies (cartels).

As can be seen in the graph, public expenditure grew massively during WWI.

THEORY: Wars improve state capacity and taxation in order to finance weapons, etc.
That’s why European countries have developed much quicker than other countries, like
Asian countries for instance.

 This period was characterized by the inexistence of the international money flow
that resulted from the suspension of the Gold Standard, and the liquidation of
foreign assets. Then, how did countries finance the war?

Financing the war

1. Taxation: In the UK the income tax doubled; in the US new taxes were
introduced; and in France and Germany indirect taxes were raised. However,
taxes financed less than 1/3 of the war expenses.

2. Public debt issuance: The UK issued long-term bonds and short-term “treasury
bills”; the US issued liberty Loans; and France issued “bonds de la defense
nationale”.

3. Money creation: central banks purchased government debt paying it by issuing

banknotes, which led to an increase of money printing. This increase in money
supply led to hyperinflation. (The most affected country was Germany)

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THE 1920S: HYPERINFLATION

Understanding hyperinflation

 Hyperinflation is a term to describe rapid, excessive, and out-of-control general

price increases in an economy. (to the point that money loses its value and
becomes just a piece of paper).

 This was seen between during 1922-1924, when a high increase of prices was
experienced in the countries that had lost the war (Germany, Austria and
Hungary). For example, in Germany inflation levels reached 1000% a month in
1923.

Why is hyperinflation an issue?

 Relative prices guide consumer and producer decisions. According to classical

economists, moderate and countinuous levels of inflation don’t have a negative
impact on the economy. But what about hyperinflation?

 Hyperinflation has 2 fundamental problems:

- Relative price distortions: companies do not change their prices at the

same time, which creates microeconomic inefficiency in the
allocation of resources. (if Apple increased prices on day 1 and
Samsung on day 2, for one day Samsungs would be relatively
cheaper than iphones. With levels of 1000% inflation, this creates a
very big problems for many companies.)

- Uncertainty: prices increase a lot and not in a continuous way, so its

impossible for companies or the government to plan their expenditure
and investment.

Why can inflation be beneficial?

 During inflationary periods, nominal wages are rarely reduced. This may make
recessions worse, as in crisis periods companies should make nominal wage cuts
in order to reduce their expenses.

 However, during inflationary periods real wages can fall without nominal wage
cuts. Therefore, moderate inflation (ex: 2%) may improve the functioning of
labour markets and absorb recessionary shocks smoother without the need of
cutting nominal wages. (or firing workers).

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Distributional consequences of inflation

 Inflation erodes the real value of debt: wages usually increase with inflation, but
debts usually are constant over time. This means that debtors benefit from this
situation, while creditors lose.

 Inflation also erodes the real value of taxes, as taxpayers gain, and tax collectors
lose. (as taxpayers can postpone their fixed tax payments to the end of the year,
when their wages are higher).

The doom loop of hyperinflation

 Hyperinflation is really difficult to stop, as it is a doom loop. Budget deficits are

solved printing money, which creates more inflation. This increase in inflation
erodes the real value of debt and taxes, generating more budget deficit. (in the
exam explain how do central banks “print” money, etc).

 In the Treaty of Versailles (1919) and the London agreement (1921) Germany
was considered guilty for the war. Their industrial heartland was occupied and
intervened, and they were forced to war reparations and payments of 6% of their
GDP.

 This situation increased even more the German’s budget deficit, making it
impossible for Germany to get out of the loop. The problem was that the UK and
France were issuing debt to the Americans, and to pay it they needed the money
from Germany.

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Why did hyperinflation end abruptly?

 The Nobel prize for economics Sargent gave a rational explanation for this
phenomenon based on expectations.

 He begins with a starting point that if workers expect higher inflation, they will
demand higher wages in order to face rises in prices of goods and services.
According to this, firm´s will incur in higher costs, so they will charge higher
prices.  So high inflationary expectations cause high inflation.

 People form these expectations observing the government’s monetary and fiscal
policies. If people see that the government is “printing” money, they will
demand higher wages, and thereby companies will increase prices to compensate
this, thereby creating inflation.

 Therefore, according to the rational expectation view, the only way to end this
inflationary spiral is to make a big fiscal and monetary reform that can change
the consumers’ and companies’ expectations. Ex: creation of an independent
Central Bank forbidden from lending money to the government. (In Germany
they created the “Rentenmark”, a new currency which was linked to gold).

The end of hyperinflation: effects

 The monetary economy was almost destroyed: as savings and debts wiped out
(which was damaging to middle classes).

 Germany learned from the hyperinflation period, and since then they have
promoted balanced budgets and fiscal discipline. (Ex: during the 2008 crisis,
Germany was an example in this matter)

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THE 1920S: RECONSTRUCTION OF THE GOLD STANDARD

Consequences of the war: a new economic and political landscape

 The countries involved in the war experienced (1) a displacement of agriculture;

(2) excess capacity in heavy industry; (3) unemployment and social unrest and
(4) trade disintegration. However, one positive outcome was the rise of women
in the workplace, which created an everlasting change in the labor market.

 Economic consequences were also experienced in neutral countries which

augmented productive capacity and increased import tariffs to protect new
industries. Ex: Latin American countries benefited from the war.

 Another consequence was that France and Germany became debtor countries
and UK ceases to be a financial superpower, with the US emerging as the main
creditor country.

 Additionally, the political situation was different with the emergence of new
countries (Poland, Yugoslavia, etc) in the ruins of old empires. Also, democracy
became more important, and feminism and socialist parties rose.

The return to the Gold Standard

 Countries returned to the Gold Standard after WWI and this period of
hyperinflation; however, the situation was very different to the 19th century.

 In order to return to the Gold Standard new currencies and new gold parities
were introduced. For example, the UK returned to the gold standard at pre-war
gold parities, what made currency overvalued; while in France they introduced
the new gold parities, where currency devalued in terms of gold.

 This currency misalignment generated an uncompetitive economy in the UK (as

their currency was overvalued) and a competitive economy in France (as their
currency was undervalued). (which led to a balance of payments surplus.)

 As the countries were approaching the Great Depression there were severe
tensions with this “New” Gold Standard, as it favoured some countries (like
France) and damaged others (like the UK).

 Additionally, the new political landscape (rise of socialism and democracy)

made less likely a deflating economy based on the Gold Standard, as now
workers had a vote and won’t accept cuts in wages.

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