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Before getting into part two of chapter 5, where most of the action is, I’d like to make a few comments on a recent paper by Greg Mankiw. Although the comments will be mostly critical, it is a very good paper, and I probably would end up agreeing with most of his policy conclusions, albeit for utilitarian reasons.

A left-leaning liberal might say Mankiw is a rich guy trying to defend the privileges of his class. Perhaps so, but let’s look at the arguments on their merits. Mankiw’s central argument is that utilitarianism is an unreliable value system, and that we would be better off relying on our moral intuitions. However, he starts off by criticizing the anti-utilitarian thought experiment that goes like this:

Would you push a fat guy off a bridge onto a train track to deflect a train and save the lives of three innocent children further down along the track?

Apparently some philosophers regard this as a good argument against utilitarianism, as they would feel squeamish about pushing the fat guy off the bridge. My response is that that pushing the fat guy off the bridge is the right thing to do, and if we don’t do it, it would be because we have let emotions overrule reason. But public policy decisions should be based on reason, not emotion.

Mankiw’s central argument is that people have a “moral intuition” that inequalities due to productivity differences are justified. I.e., it’s acceptable for a highly talented and hard-working guy to make lots of money, but not for a banker who has only gotten rich by gaming the system. OK, but this distinction between earned and unearned wealth is also consistent with the utilitarian approach to income redistribution.

At the same time he doesn’t end up with laissez-faire policy views, as he favors taxes to address externalities and public goods. And he considers the removal (or at least mitigation) of poverty to be a public good, as it is a sort of blight on our society. Furthermore, the rich benefit more from governments that protect property rights than do the poor, so they should have to pay more taxes.

I suspect that Mankiw and I have pretty similar views on optimal tax regimes, but I get there from a different direction. I don’t think we can rely on moral intuitions. At various points in history our moral intuitions about the dignity of aristocrats was quite different. Our moral intuitions about war and slavery have changed. Ditto for women’s rights, civil rights, and gay rights. Indeed our views on gay rights are still changing, as the younger generation has more liberal views than the older generation. And what do you notice about all these changes? In every single case our moral intuitions have moved in the direction of utilitarianism.

So I still think utilitarianism is the right way to go. Mankiw mentions two hypothetical policies that utilitarians should support, but that he regards as absurd. One is a higher tax rate on tall people. And the other is sending 1/3 or our GDP to poor countries. I agree that utilitarianism would call for both of those policies if there were no efficiency costs in implementing each policy, but in fact the costs are likely to be massive. A tax on tall people is likely to trigger several problems:

1. Tall people would lie about their height. So you’d probably need a government program to measure everyone’s height. But then people who were athletic would slump down as much as they could while being measured. Stiff people who couldn’t slump would complain about the unfairness of NBA players getting away with being under 6 feet. They would demand that the players be put on “the rack,” so that we could find out their true height.

2. OK, that was silly, but there is a more serious argument. This tax would trigger the demand for other similar taxes. Indeed the moral argument for a higher tax on white people (compared to black people) might seem much more appealing. Now imagine the US government getting into blood tests to determine race.

Yes, I’m making the disreputable slippery slope argument. By my final comment might surprise you, as I am nearly 6’4”. I think if there were no practical problems, if height was the only important way that people differed in terms of measurable innate differences, if eating a low protein diet didn’t make you shorter, if the scheme didn’t lead to a slippery slope, then yes, tax me and other tall guys more. If it were the only important measurable innate difference then people would regard it as an unfair advantage. And yes, push that fat guy onto the railroad track while you’re at it.

Here’s why I don’t buy the “just deserts” argument for inequality. Wealth creation in a modern society is a collaborative effort. No rich guy gets there on his own; he is working with 100s of other low paid individuals. Yes, the “marginal product” is a useful economic concept, it explains why people born with great athletic skills make more than teachers, but I don’t think it provides any moral justification for those income differences. Indeed I often hear people say that it shows our society’s values are out of whack that a baseball player can make 100 times more money than a school teacher.

From the outside someone like Greg Mankiw seems to lead a charmed life. He has a beautiful house in Wellesley and a nice family. One of his posts showed him teaching an honors seminar full of bright, interesting students. He has made tons of money on a textbook. Yes, he’s worked hard, but his greatest good fortune was to be born into Greg Mankiw’s body and mind. (BTW, if we refer to Mankiw’s body and mind in the possessive sense, then who is the “Mankiw” that possesses these entities?) Mankiw even seems to have a fairly upbeat mood, at least compared to another famous blogger. So my moral intuition tells me the universe would be a better place if Greg Mankiw gave me $1,000,000 of the money he has earned on his book. It’s not that I haven’t also been pretty lucky compared to the average third world peasant, but not quite so lucky as Mankiw.

But in the end I can’t quite favor a lot of redistribution, despite my utilitarian leanings. To raise 1/3 of national income in taxes would mean government spending would double from 1/3 to 2/3 of GDP, which is more than even Denmark spends. Even worse, our labor force is much more diverse than Denmark’s, so even equal tax rates would impose much greater supply-side costs here than there. On the other hand I can’t support the dogmatic libertarian opposition to any income redistribution, as I think there is some amount of redistribution for which the benefits exceed the costs. Indeed my only disagreement with those on the left is about incentive effects, not ethics. I think the supply-side effects of high taxes and subsidies (in the long run) are much more important than many others believe, indeed they are much more important than common sense suggests. Thus I favor a low-tax welfare state similar to Singapore, which spends enough to eliminate severe poverty, and also provide universal health care, education, etc. BTW, Singapore spends much less than we do, so calling for the US to move to that “welfare state” system is equivalent to calling for dramatically lower taxes on the rich.

The most difficult problem (implicitly) raised by Mankiw is how can one favor spending lots of money helping the poor in America, when the opportunity cost of that spending is not aiding the much more poor residents of some place like Bangladesh. I don’t have an answer to that question. I suppose it would require some sort of communitarian argument. (And for similar reasons Will Wilkinson’s argument for open immigration raises tough issues for progressives.)

Because I am a utilitarian, I am open to new evidence on incentives. If I am wrong, I have no moral objection to the Danish system. Indeed I hope the Danes are right. However, based on the success achieved by lower tax countries of similar size (Singapore, Switzerland, etc), and the fact that even the southern European countries have found it hard to replicate the Danish model (read Algan and Cahuc), I think it would be pretty hard to make the case for applying the Danish model to the US on utilitarian grounds. (Yes, the Danes are the happiest people on Earth, but in another post I argued the causation went from values to happiness, not from economic system to happiness.)

Off topic, but Niklas Blanchard sent me this interesting link. OK, on to the 1931 chapter:

5.d The German Economic Crisis of 1931

In retrospect, the March 21 announcement that Germany and Austria had agreed to form a customs union appears as the first of a long series of events that disrupted European affairs. The Austro-German Customs Union was viewed by many as a violation of the Versailles Treaty provision that guaranteed the sovereignty of Austria, and the French in particular were concerned that the union was merely the first step toward an “Anschluss,” or political union. The dispute became a complicating factor several months later when Austria and Germany required financial assistance from their international creditors.

The Dow reached its March peak on the day before the announcement of the customs union, and then began a long steady decline that extended into early June. Equation 3 in Table 5.1 shows the result of regressing movements in the Dow on YPBs during the period from March 20 to May 1. Although in contrast to the January 1 – March 20 period (equation 2), the coefficient on the YPB price is significant at the five percent level, the relatively low adjusted R2 provides little evidence that German problems were a major factor in the ongoing decline in the Dow.

The period from May 1 to June 19, 1931 is especially problematic from the perspective of the link between Germany and Wall Street. Historians consider the failure of the Kreditanstalt in Austria in mid-May to be the event which triggered the subsequent international monetary crises. The Dow did decline continuously for eight straight trading days from May 11 and May 20, and the YPBs also declined almost continuously during this period. Yet as equation 4 clearly indicates, there was no significant relationship between changes in the Dow and the price of YPBs during the period from May 1 to June 19.

There was certainly no shortage of news relating to problems in Central Europe during mid-May, 1931. On May 11th, the NYT reported that uncertainty over the customs union was slowing investment in Germany and Austria and on May 13th they reported that the Kreditanstalt crisis was depressing German stock prices. French Premier Briand favored closer policy coordination, and according to the May 15th NYT his unexpected defeat in the French presidential election of May 14 was likely to increase political tensions in Europe. Briand’s conciliatory position toward Germany had been undermined by the German government’s decision to form a customs union with Austria.

On June 1 the Dow declined by 4.4 percent, and the next day the NYT noted that the German situation had deteriorated rapidly in the previous few days. They also reported that a bailout of the Kreditanstalt was expected soon, but that the customs union had injected politics into the negotiations. By this time the banking crisis had spread from Austria to Germany, and there was growing speculation that the Young Plan would have to be revised. In early June the British and German leaders conferred on the debt issue at Chequers, England, where German Prime Minister Breuning argued that the German economy was in dire shape and that some form of debt relief was essential. Unfortunately, the entire war debts/reparations crisis was complicated by the fact that Germany’s biggest reparations creditors (Britain and France) had also incurred large war debts with the U.S. Thus any debt relief for Germany would require leadership from the leading creditor nation, the United States.

June 3 saw the largest increase in the Dow (7.1 percent) since the rebound in November, 1929. The following day’s NYT (p. 39) found no explanation in the news, and suggested that “That [startling news] may conceivably come later, and speculative Wall Street’s reversal of position may have had in mind its possibility”. Startling news did arrive on June 19 in the form of a debt moratorium, but it is difficult to say whether the June 3 rally anticipated this development. We do know that it was announced on June 3 that Secretary of State Stimson would depart soon for Europe, and that in a secret meeting on the evening of June 2, President Hoover had communicated his intentions to the U.S. ambassadors in Britain and Germany.

On June 7 it was announced that Secretary of State Mellon would also be departing soon for Europe and rumors of a moratorium began affecting the financial markets. The June 8 NYT headline suggested a “Change Seen In Our Attitude On Debts” and also (p. 26) enigmatically referred to the “sudden appearance of a few unpredicted reassuring developments in the news, which the stock market [on June 3] may or may not have foreseen”.

There is one glaring weakness with the preceding hypothesis, the correlation between the price of YPBs and the Dow turned negative during the weeks immediately preceding the moratorium (see figure 5.1) The interests of Young Plan bondholders and U.S. stockholders did not exactly coincide, and thus conceivably the bondholders could have (erroneously) believed that the deteriorating economic situation in Germany would lead to a moratorium which included the YPBs, while U.S. stockholders focused on the widely held expectation that a moratorium would improve the prospects for international monetary cooperation. Even before the moratorium was announced, some contemporaneous observers were making exactly that argument, i.e. that holders of YPBs had misunderstood the likely impact of a moratorium:

“In any case, the postponement of transfers contemplated in the Young Plan has, of course, nothing whatever in common with a moratorium in the ordinary sense, and would involve no suspension of payments in connection with Germany’s private or public loan obligations. Nobody in Germany has thought of such a thing for a moment, but misunderstanding on this question seems to have had an unfortunate effect, especially in America.” (Economist (6/20/31, p. 1326.)

Of course this hypothesis is a bit ad hoc, and also seemingly at odds with the efficient markets hypothesis that I utilize throughout this narrative. But rational expectations do not imply perfect foresight, and subsequent events strongly support the Economist’s view that Americans initially misjudged the effect of the moratorium on YPBs. U.S. stock and German (Young Plan) bond prices became closely synchronized immediately following President Hoover’s announcement of June 19 (at 6 P.M.) of his intention to put forward a plan for international debt relief.[1] The following day the Dow jumped 6.6 percent, and the YPBs soared by 7.9 percent. After the stock market closed on Saturday, June 20, the details of the plan were revealed to show an even more far-reaching moratorium than had been anticipated. The following Monday the Dow rose another 4.9 percent and the price of YPBs advanced another 4.2 percent. And the extraordinary (worldwide) stock market rally[2] was also accompanied by large increases in the prices of major commodities such as corn, wheat, and cotton.

[1] Apparently the rapid deterioration in the German economy led Hoover to move forward the announcement of the moratorium. Eichengreen (p. 161) notes that Hoover had proposed a war debts moratorium as far back as 1922.

[2] The NYT (6/28/31, p. 10N) noted that except for the recoil from the 1929 crash, the rally in the week following Hoover’s announcement was the “swiftest advance during any corresponding period in a generation”.

The correlation between changes in the Dow and the price of YPBs jumped from 0.0 percent in the period from May 1 to June 19, to an astounding 42.6

percent in the period from June 19 to July 30 (Table 5.1, equation 5.) The increased correlation between the Dow and the price of YPBs is certainly consistent with the hypothesis that Wall Street became concerned about Germany when the German crisis threatened to disrupt the entire international monetary system. Nevertheless, no level of correlation between changes in the Dow and the price of YPBs is able to establish causality. Thus it is essential to examine contemporaneous news coverage.

One of the most striking aspects of this period is the intensive coverage of the German crisis provided by the NYT. For 36 consecutive days, at least one NYT headline discussed the German debt and/or exchange rate crisis, and almost all were the dominant headline. This certainly indicates a level of interest in European financial affairs that would be unimaginable in post-WWII America. Even more striking is that fact that, throughout this period, movements in Dow were frequently linked to these news stories.

The heterogeneous nature of news makes it difficult to quantify. Therefore in appendix 5b the NYT headlines from June 20, to July 24, 1931 are provided, along with some clarifying excerpts. The column width of each headline is also provided, which serves as a proxy for the importance that the editors of the NYT gave to each story. (A typical lead headline would be two or three columns across.) DLDOW and DLYPB represent the first differences of the logs of the change in the Dow and the price of YPBs from the last closing before the news event, to the subsequent closing. European news reported in the NYT on a given day was usually received by U.S. financial markets before the markets closed on the previous day.

Enthusiasm for Hoover’s proposal was not confined to the NYT. The June 27 issue of the CFC (p. 4635) enthused “President Hoover has electrified the whole world and possibly turned the tide of business depression”. A “Hooverstrasse” was proposed for Berlin. The British compared the proposal to a new armistice and suggested that the move ranked in importance with the U.S. entry into World War I. Of course, Hoover’s debt moratorium was subsequently shown to be ineffective in arresting the ongoing depression. Nevertheless, the financial community had great hope for the plan, which provides some indication of the forces that they believed were inhibiting recovery.

Between June 2 and June 27the Dow soared by almost 29 percent, and the next day’s NYT (p. 7N) suggested that “War Debt Plan Aids Commodity Prices. . . Sharpest Advance Since Last Summer Shown in Most Groups in Fortnight”. Although the reaction of financial markets to the moratorium was unquestionably enthusiastic, the reasons are unclear. Perhaps it was felt that the moratorium would reduce gold flows to countries with a high propensity to hoard (i.e. the U.S. and France.) The June 27th CFC (p. 4653) suggested that Hoover’s goals were limited and that it was hoped that the agreement could lead to a climate of “international good will”. On June 30th the NYT (p. 1) quoted a bank official as indicating that “it would be a mistake to over-emphasize the proposed debt adjustment as an economic factor in itself”. Unfortunately, Hoover strongly opposed two initiatives that might have provided meaningful help for Germany; a coordinated international policy of tariff reduction, and a coordinated attempt to lower the world gold ratio through expansionary monetary policies.[1]

After June 27th, U.S. stock prices see-sawed for several days as the French raised objections to various aspects of the agreement. Because the size of Germany’s debts to France greatly exceeded the French war debts to America, the French were naturally less enthusiastic about the moratorium than the British, who had a less favorable net creditor position at the governmental level covered by the moratorium, but were also important commercial lenders to Germany. Although a preliminary agreement was finally hammered out in early July, the contentious negotiations made it clear that future cooperation on international monetary and financial issues would be exceedingly difficult. Meanwhile, the German financial system continued to deteriorate rapidly and the CFC noted that “it was also realized that the delay of two weeks [in the agreement] had somewhat vitiated the good effects”.[2]

The July 18 issue of the CFC (p. 335) ominously reported that “The world the present week has been confronted with one of the greatest and gravest financial crises of which history furnishes any record”. Both the Dow and the price of YPBs declined steadily in the week leading up to Germany’s establishment of strict exchange controls on July 15. Although historians sometimes view July 15, 1931 as the date on which Germany “departed from the gold standard,” the contemporaneous view was slightly different. Maintenance of the exchange rate at its par value was viewed as the sine qua non of being on the gold standard. Germany did not devalue the reichsmark, and was viewed as having partially surmounted the crisis (albeit with a much weakened link to gold.)

The 6.2 percent drop in the Dow between July 10 and July 15 was made up over the next five trading days as Hoover organized an international loan to assist the Reichsbank.

[1] Hoover criticized the theory that deflation was resulting from a “maldistribution” of monetary gold stocks.

[2] CFC, 711/31, p. 174.

Unfortunately, political discord continued to complicate efforts to aid Germany. French opposition prevented anything more that a temporary aid package; and the markets fell back in late July as it became apparent that a permanent solution to the German financial crisis had not been achieved. The largest movement in the Dow during August 1931 occurred on the 11th, when the Dow jumped 4.4 percent. The next day’s NYT (p. 27) commented; “suddenly reversing its trend, the stock market advanced spiritedly yesterday, simultaneously with the announcement that agreement had finally been reached on all points involved in the debt suspension proposal”.

Temin argued that the short-term victory associated with the maintenance of the reichsmark at par merely insured that Germany’s financial crisis would continue to intensify. In contrast, by devaluing the pound in September 1931, Britain was able to swiftly end its financial crisis, although it did not take full advantage of its new position. German leaders were prevented from devaluing the reichsmark by treaty obligations associated with the reparations agreement, and by the public’s still fresh memories of the 1920-23 hyperinflation.

The temporary nature of the moratorium also insured that the war debts/reparations issue would reappear later. Only three months into the one-year moratorium, the international crisis associated with the British devaluation intensified the world-wide deflation, and it became abundantly clear that Germany would be in no better position to pay its debts in mid-1932, than it had been in mid-1931. Financial markets faced additional months of bitter recriminations and debate over these issues.

5.e The Devaluation of the British Pound

Despite the extended crisis of July 1931, the price of YPBs, which began the year at 69 1/4, had only declined to 56 1/4 by the end of July. They would finish 1931 trading under 24. Similarly, the Dow, which began 1931 at 164.58, ended July at 135.39, and then plunged to 77.90 at yearend. During September the Dow declined almost continuously, ending the month down over 30 percent. Although it would be natural to attribute this decline to the developing crisis in Britain, there is actually very little evidence (in the forward exchange rate market) that fears of a British devaluation affected Wall Street until September 18. The devaluation of the pound was unquestionably the dominant economic event of the autumn of 1931, yet it appears to have had only a modest direct effect on U.S. financial markets. Its indirect effects, however, were profound.

The British crisis actually began in July 1931 as the run on the reichsmark reduced confidence in the entire international gold standard. On July 26, (the first time in 36 days that the German debt problems failed to earn a NYT headline), a Times headline reported “British Gold Loss Totals $145,500,000 In The Last 13 Days”. The 3-month forward discount on the pound (against the dollar) rose from less than 1/2 cent during the first half of 1931, to just over 2 cents in early August, and then remained at that level until the eve of the devaluation. By the fall of 1931 the actual spot exchange rate had declined by well over 100 cents. Thus although some concern about the pound was evident in the forward markets, there is no indication that a significant devaluation was considered imminent during the two months leading up to Britain’s departure from the gold standard.

There are good reasons why the markets would not have anticipated the devaluation. First, the British had undergone a prolonged period of austerity in restoring the gold standard only six years earlier. Second, the British financial position was clearly stronger than that of Germany, and Germany had been able to avoid devaluing during the July crisis. Third, a new National (coalition) government was formed in August, and this government agreed to balance the budget by cutting government salaries and unemployment benefits.

Nevertheless, the increased forward discount shows that currency traders were a bit more apprehensive about the pound during August and the first half of September, probably due to uncertainty regarding the government’s willingness to reduce the deficit through painful budget cuts. An imminent election created further uncertainty. On September 16, a NYT headline reported “Disorders in British Navy Follow Economy Pay Cut”. Withdrawals of gold from Britain accelerated sharply with $25 million leaving on September 16, $50 million on the 17th, and $90 million on the 18th.

This “mutiny,” or “strike,” (depending on one’s perspective), touched off a series of events which led to the devaluation. What appears to have been decisive was not the disturbance itself, but rather the government’s willingness to listen to the sailors’ demands, and their promise of no reprisals. The press coverage of the event provides a fascinating study in contrasts. While the British Government was trying to downplay the importance of the sailors’ action, the foreign press expressed astonishment at the willingness of the once-proud British Navy to cave-in to the demands of mutinous sailors.[1] In the House of Commons, Labor members taunted “You’ve surrendered once, and you’ll keep on surrendering,”[2] a reference to escalating demands that proposed cuts in the pay of teachers, police, and other members of the military be rescinded.

[1] The September 17 NYT (p. 1) reported “As startling as was the incipient mutiny in the British fleet, without precedent in modern times, the actions of the government in making terms with those who have broken discipline is regarded as even more startling.”

[2] The NYT, ibid.

Although the suspension of convertibility occurred on September 20th, word that the government was considering devaluation appeared to have leaked out several days earlier. The price of British government bonds (5 1/2 percent coupon), which had traded in the 104 3/4 – 105 5/8 range throughout the first 17 days of September, fell to 101 1/4 on September 18th, then plunged to 93 on September 19. Thus, data from the British bond market compliments the forward market evidence that devaluation was not considered likely until the last moment. What then caused the sharp decline in U.S. stock prices during the first part of September 1931?

Whereas the value of British government bonds remained stable during early September, the price of YPBs fell from 58 3/8 at the beginning of the month, to 46 3/4 on September 17th, before dropping to 40 on the 18th, and 38 on the 19th. Similarly, the Dow declined from 139.41 at the beginning of the month, to 121.76 on September 17, and then plunged 5.5 percent on the 18th, and an additional 2.9 percent on the 19th. And, although during September 1931 German events were not dominating U.S. news coverage to the extent that they had in June and July, the NYT continued to link movements in U.S. stock prices to problems in Germany.[1] Equation 6 in Table 5 shows that movements in the price of YPBs remained highly correlated with the Dow throughout the interval between the German and British exchange crises.

[1] For instance, the September 4 NYT blamed the previous day’s 3.1 percent decline on the unexpectedly severe collapse in German stock prices following the re-opening of the German Bourse.

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