Escaping liquidity traps: Lessons from the UK’s 1930s escape: The UK escaped a liquidity trap in the 1930s and enjoyed a strong economic recovery. This column argues that what drove this recovery was ‘unconventional’ monetary policy implemented not by the Bank of England but by the Treasury. Thus, Neville Chamberlain was an early proponent of ‘Abenomics’. This raises the question: is inflation targeting by an independent central bank appropriate at a time of very low nominal-interest rates?
In mid-1932, the UK had experienced a recession of a similar magnitude to that of 2008-09, was engaged in fiscal consolidation that reduced the structural budget deficit by about 4% of GDP, had short-term interest rates that were close to zero, and was in a double-dip recession (Crafts and Fearon 2013). The years from 1933 through 1936 saw a very strong recovery with growth of over 4% in every year. The Chancellor of the Exchequer, Neville Chamberlain (in office from November 1931 to May 1937) was the architect of this recovery. Given the similarities with the situation now facing George Osborne, is there anything he could learn from the policies adopted by his predecessor?…
[U]p until 1935 monetary stimulus was the main instrument…. The government-expenditure multiplier was probably below one, even in the depressed economy of the 1930s. This may be a consequence of the massive public debt to GDP ratio (a legacy from World War I) which was central to the context of fiscal policy. The policy framework adopted from mid-1932 has a strong resemblance to the so-called ‘foolproof way’ of escaping from the liquidity trap (Svensson, 2003) and to ‘Abenomics’ in today’s Japan… a price-level target was announced by Chamberlain in July 1932 which aimed to end price deflation and return prices to the 1929 level… the Treasury adopted a policy of exchange-rate targets that entailed a large devaluation first pegging the pound against the dollar at 3.40 and then against the French franc at 77 (Howson 1980), intervening in the market through the Exchange Equalisation Account…. Real interest rates fell quite dramatically and very quickly and gold reserves almost doubled within a year. By the end of 1936, the money supply had grown by 34% compared with early 1932 (Howson 1975)…. [T]he Treasury under Chamberlain, rather than the Bank of England under Montagu Norman, ran monetary policy after the exit from the gold standard. The classic problem with the ‘foolproof way’, especially for central banks, is whether they can credibly commit to maintaining inflation once recovery appears to be under way. Because of its problems with fiscal sustainability, the Treasury was in a good position to persuade markets that it wanted sustained moderate inflation as part of a strategy to reduce the real interest rate below the growth rate of real GDP and to benefit from this differential in reducing the public-debt-to-GDP ratio. This reliance, based on ‘financial repression’, allowed more tolerance for lower primary budget surpluses and eased worries about ‘self-defeating austerity’ without a Keynesian approach to the public finances.