The Great Depression

This post draws significantly on M. Pettis

Countries that left the gold standard quickest, and thus were able loosen credit sufficiently to counteract the banking collapse, had the mildest economic contraction. Countries with the largest balance of payment surpluses (the U.S.) were in the strongest position to hang onto gold, and thus the last to leave the gold standard, and suffered the most painful economic contraction (it took 18 year for SP500 earnings to reach their pre-great depression peak, by comparison, it took the SP500 to 19 months to reach its pre-credit crisis peak). Countries with the strongest balance of payments were also those with the largest trade surpluses, and thus most exposed to collapse of net demand.

Besides the standard impact of the stock market crash of 1929 on consumer confidence, consumption, and cost of capital, economist agree that:

1. Significant industrial overcapacity in the United States was exported abroad, financed through massive foreign borrowing in the U.S. The 1929 crash not only crushed domestic demand, but eliminated the ability of foreign borrowers to finance imports from the U.S.
As international trade collapsed (and US tried to force the adjustment abroad through import tariffs), domestic demand was not nearly enough to absorb what U.S. factories produced. Government did not respond by spending, so so overcapacity was resolved through unemployment and factory closings. Government action (Smoot Hawley, mercantilism) invited retaliation and made the process more difficult.

2. Excess monetary creation caused by massive expansion of gold reserves in the 1920s lead to over investment and risky lending. The stock market crash set off the de-leveraging cycle, bank assets collapsed, and a sudden collapse in the money supply. The Fed failed to intervene with liquidity and the sharp contraction in economic activity became a depression. This is widely believed (Friedman, others) to be the biggest policy blunder that ensured the contraction turned into a depression.

Some comparison's to China:
China's trade surplus is about the same size in terms of Global GDP as the U.S. in 1929 - about .5% Though China's economy today is one fifth the relative size of the U.S. So, overcapacity, and domestic demand are likely to be much smaller than the U.S. in 1929.

Unlike in the 1920s, authorities recognize the importance of forceful monetary and fiscal response to sustain demand and provide liquidity. On the other hand, China most certainly has had excessively low interest rates, excessive monetary expansion (excess of savings), risky lending, and over investment.

A sharp reversal in China's trade surplus will result in a decline in foreign currency, and with it a decline in the money supply (effectively those savings leaving the country). This is because so long as the PBoC main job is to fix the value of its currency, it has limited ability to manage the money domestic money supply. In 2009, China did a fantastic job managing a contracting money supply with an explosion of loan growth.