"Nothing Terrible Happened"

Yesterday Business Insider interviewed Paul Krugman, who repeated his view, which he has expounded since the Democrats took over the White House, that the  federal deficit does not concern him at present.  He argues that, if the deficit ever becomes a problem, it can be monetized, and sees no ill consequences from that.  He offers what BI calls "an obscure moment in the history of France" as a guide for the 21st century US:

"France, after WWI, came out of the war with a high level of debt, and didn't really ... couldn't bring itself to make the sacrifices needed to service that debt. So what happened was: the franc depreciated, they had a bout of inflation, which reduced the value of the debt, and then the economy stabilized and actually nothing terrible happened,"

I have to explain how dangerously inaccurate the statement about France's post-WWI economy is.

When France entered WWI, its central bank obligingly monetized the cost of the war and, with trade disrupted and so much productivity diverted to the war, massive inflation resulted.  As the franc depreciated by about 75%, not only did Paris become an attractive place for hard-currency Americans to visit and move to, but commodity prices rose several-fold for persons earning francs.  Imagine oil costing $20 per gallon, or milk $20 a gallon, to understand whether "nothing terrible happened" to them from the monetization of the government's debt.

 

But Dr. Krugman is referring to the post-WWI era so let's look at that.  When the war ended, in contrast to his account, a short period of fiscal and monetary discipline set in, and was successful.  As explained in chapter 13 of  the magnificent Pulitzer-winning history, Lords of Finance, the government reduced its deficit rapidly and was nearly in balance by 1924.  Its debt was no longer monetized by the central bank; rather, the bank was required by law to maintain a strict cap of 41 billion francs on the money supply.  (Although the nation had substantial gold reserves, the franc was not backed or directly pegged to them at that time.)  The government financed itself by borrowing both from its citizens, who maintained a high savings rate at the time, and from the UK and US; the external borrowings were in part expected to be repaid from reparations payments France anticipated receiving from Germany.

But, beginning in the spring of 1924, another "nothing terrible" began to happen.   Much like any number of financial frauds in the modern era have begun, the French government began having trouble rolling over its internal debts, which were mainly short-term in nature.  The central bank obligingly assisted the government by issuing it additional money to cover its debts; that unfortunately violated the law capping the money supply, a problem which the bank solved by some creative accounting.  The government looked the other way at the fraud and, within a year, the fake balances, les faux bilans, swelled to 5% of the currency in circulation.  In 1925, the news broke and the government collapsed, along with confidence in the central bank. Again, debt monetization at work.

A run began.  The franc fell about 20% in just a couple of months.  Investors, domestic and foreign, would not buy government paper and the government faced default.  It was forced to beg the UK and US for a write-down of its debt to 40% on the dollar.  Just as the "troika" is imposing on Greece, the government had to commit to maintain a balanced budget to regain investors' confidence.  Even so, the franc's value was cut in half again by the summer of 1926.  The government fell yet again and the leadership of the central bank was completely overturned.   Finally, the new government was able to convince investors that they had the fisc and the central bank under control and the franc began strengthening, ultimately recovering all of its 1926 loss.   

Briefly in 1927 and 1928, the French economy operated well.  Investor confidence brought capital back to both the private and public sector.  The currency, fixed at its 1925 level, was significantly undervalued versus the other major economies; that led to an export surplus, which led to strong employment growth, and things looked rosy.  Perhaps this is what Krugman means when he implies things worked out.

 

Of course, we all know what came after 1928 in Western economies: the Great Depression, the rise of Hitler in Germany and WWII -  "nothing terrible"?  The French economy did not operate in a vacuum.  Its cheap currency was a beggar-thy-neighbor policy and France's neighbor was Weimar Germany, which desperately needed an export surplus of its own to generate money to make the reparations payments with which it was saddled.  As Liaquat Ahamed closes chapter 13:

"Moreau [the head of France's central bank]'s mistake was to assume that the value of the currency of a major economic power such as France, the fourth largest industrial economy, was a matter for that country alone.  Exchange rates, by their very nature, involve more than one side and are therefore a reflection of a multilateral system.  Though it may have been very difficult in 1926 to know the exact ramifications of the franc's exchange rate on surrounding countries, Moreau seems to have deliberately closed his eyes to the impact of his decision on the wider system.  ... Whatever the reason, his decision to fix the franc at an undervalued rate would eventually help to undermine the stability of the very standard to which he had now hitched his currency." 

Indeed, Ahamed blames Moreau as the central banker who had the last clear chance, but failed, to keep the Great Depression from taking place. From his Epilogue:

"having stumbled inadvertently into a position of financial dominance, he seemed more intent on using France's newfound strength for political rather than economic ends. And so what began as modest and corrective recessions in the United States and Germany were transformed by sheer folly and short-sightedness into a world wide catastrophe."

Nothing terrible happened?