Shocks and aftershocks

5: After Armageddon, rebirth.

Socialism turned out to be much worse than liberalism. Then a new way appeared … for a while.

Over three decades, the world suffered the greatest cataclysms of modern times. Two world wars – more accurately, two episodes of the same war – caused the deaths of somewhere between 85 million and 110 million people from combat, disease and starvation. Another 50 million died in the Spanish flu pandemic of 1918 to 1920. The Great Depression devastated the global economy, throwing tens of millions out of work, causing massive bankruptcies and producing a global wave of poverty and deprivation.

Berlin, 1945

By 1945, when it was at last all over, the world had changed almost beyond recognition. Empires had all but vanished. Great and historic cities – Berlin, Dresden, Warsaw, Kyiv, Hamburg, Tokyo, Hiroshima, Nagasaki – were dust and rubble, their populations grubbing in the ruins for food and shelter.

The wars and their aftermath empowered another episode of murderous Utopianism: this time, Marxist socialism. Nation after nation succumbed: Russia in 1917, the whole of eastern Europe after 1945, North Korea in 1948, China in 1949, Vietnam after 1954, Cuba in 1959, Cambodia in 1976.

Maynard Keynes, writing in 1925, couldn’t see the attraction. “Marxian socialism must always remain a portent to the historians of opinion – how a doctrine so illogical and so dull could have exercised so powerful and enduring an influence over the minds of men and, through them, the events of history.”

The practical answer, perhaps, is fairly simple. The desperate mass of the people were enthralled by the promise of paradise and failed to read the fine print. A few did read the fine print and were attracted by the prospect of power. By the time it became clear that paradise was not on offer, it was too late. The emperor was in place, and in place too was his apparatus of brutal control.

The failure of central planning and collectivisation was evident early. Following the 1917 revolution in Russia, an estimated 9.2 million people starved to death over five years, before Lenin allowed a partial return to capitalism. In China, all previous famines were eclipsed by Mao’s Great Leap Forward. Within In five years from 1958, an estimated 35 million people died from hunger. The scale of this disaster is so great that you could almost miss the blip in 1975. That blip represents 230,000 people.

In the west, conditions were better. After the devastation of war and depression, rebuilding western Europe needed – and got – immense new investment. The most damaged nations – Germany, France, Italy and Russia – showed the greatest proportional economic growth.

Market economies are usually better than centrally planned economies at producing wealth, but perhaps less so than is popularly imagined. The provinces of east of Germany has long been poorer than the west, and still are. In 1950, GDP per capita in East Germany was half that of West Germany. But to compare the efficiency of two economic systems, we must look instead at their capacity to produce growth. And comparing the two shows surprisingly little difference.

The difference in growth cannot explain why so many East Germans wanted to migrate to the West that a wall was constructed to bisect East and West Berlin. There are two obvious answers: the West was more attractive because it was more prosperous at baseline and because the East was so repressive and so dull. Communism did not produce pleasant places in which to live.

But the liberal capitalism of western countries had two big problems: the failure to distribute wealth effectively or fairly, and the apparently endless boom-bust cycle that crippled long-term growth and disproportionately burdened the most vulnerable.

Through the late 1920s, a boom in asset prices became a bubble and, in October 1929, the bubble burst. Within a month, share prices on the New York Stock Exchange had fallen by 48%.

Everywhere, business shut down and workers were sacked. By 1933, unemployment in the US was at 25%; in Australia it was worse: 32% in 1932.

To understand what was going on, we must first understand something about the gold standard. In the 18^th and 19^th centuries, pegging currencies to the price of gold was a necessary requirement of international trade. People in one country could be sure that when they came to collect their money from another country that they wouldn’t be getting just a worthless pile of paper.

Each country had to ensure it held enough gold to cover the paper money on issue. At all costs, the government’s budget balance had to be protected.

So when a nation’s economic circumstances deteriorated relative to the rest of the world, the adjustment had to be made domestically because no external adjustment was possible. That meant domestic prices had to rise and wages had to fall: those without money or power were made to bear the cost of protecting the interests of those with money and power.

That worked while the mass of people could be kept in various states of poverty. It worked less well when working people started to gain some power of their own.

When World War One wrecked the economies of Europe, most were forced to abandon the gold standard. When these currencies were floated, their exchange rates were allowed to sink to true value. Imports became more expensive, protecting domestic industries and exports became cheaper for other countries to buy – again, benefiting local businesses and jobs.

But conventional policies returned and the gold was re-embraced: Winston Churchill, as Chancellor of the Exchequer, put Britain back on the gold standard in 1925, pegging the pound at the level of 1913. But the British economy could no longer support such a level without massive internal disruption: lower wages, rising prices and sinking demand, in a vicious spiral. Britain had to import capital to cover its deficit. It was good for the banks but not for almost anyone else. And in 1926 there was a bitter general strike.

When American asset prices tanked in 1929, capital imports from the US stopped. British interest rates rose sharply to attract loans from elsewhere and the British economy went further into the red. Unemployment soared even further and government debt went from 170% of annual GDP in 1930 to 190% in 1933.

Only when war loomed again, and re-armament provided a massive fiscal stimulus, did the British economy start to recover.

Similar scenarios played out in other countries including Germany, where those policies can be held directly responsible for the rise to power of the Nazi Party and Adolf Hitler.

Meanwhile, Maynard Keynes was advocating that governments should put money into the economy when private activity falters. He showed that the standard view – that stimulus would create little new employment but at impossible cost – was simply wrong. Using the multiplier effect developed by his “favourite student”, Richard Kahn, Keynes showed that money paid to previously unemployed people would be spent, supporting further economic activity and creating more employment and another round of consumption.

Some of the extra money being generated would find its way back to the government through taxation; at the same time, the government would spend less on unemployment benefits. Put together, the cost to the budget would be far less than had previously been supposed. But stimulus should be financed by borrowing or by (up to a point) by printing money. Doing so by increasing taxes would defeat the purpose of the entire process.

But conventional policies continued to be pursued in the United States by the Hoover administration, with disastrous results. Hoover, under pressure from massive unemployment, introduced some relief measures but they were too small to make much difference. Only when Franklin Roosevelt came into office in 1933, and introduced the New Deal with its massive and continuing fiscal stimulus, did the US economy begin to recover.

“In the past,” wrote Keynes to Roosevelt in 1933, “orthodox finance has regarded a war as the only legitimate excuse for creating employment by government expenditure. You, Mr President, having cast off such fetters, are free to engage in the interests of peace and prosperity the technique which hitherto has only been allowed to serve the purposes of war and destruction.”

Hitler was not a Keynesian. He followed the old, risky path of spending for war. By 1940, Germany’s economy had recovered further than America’s. Disaster, of course, followed.

After four years into the New Deal, the US had a painful lesson in  the costs of not staying the course for long enough. Roosevelt and his advisers thought the job had been done, and in 1937 stimulus was prematurely cut back. That mistake was reversed, but it put the American economy back. Business activity faltered and unemployment rose sharply. By 1940, output was still substantially less than it otherwise would have been.

Keynes wrote again in 1938: “I am terrified lest progressive causes on all the democratic countries should suffer injury because you have taken too lightly the risk to their prestige which would result from a failure measured in terms of immediate prosperity. The need be no failure. But the maintenance of prosperity in the modern world is extremely difficult; and it is so easy to lose precious time.”

According to Robert Skidelsky, his biographer, Keynes wanted “to find not a middle way between laissez-faire and central planning ... conservatism and socialism but a genuine Third Way that promised to achieve the benefits that each of the traditional poles of politics had claimed but had never been able to deliver”. 

This aim was never realised, but the war ended with a widespread sense that things now had to change. Second only to the immediate priorities of ending the fighting and resettling millions of hungry and devastated people was the need for a redrawn international financial system that would allow the world to recover.

Even in 1939, the US economy was 5% bigger than the economies of Britain, France and Germany combined. By war’s end, it was twice as big. The US controlled two-thirds of the world’s gold. Only America had the capacity to bring the western world back from the financial brink.

In June 1944, 730 delegates from all 44 allied countries met at a hotel in Bretton Woods, New Hampshire, to draw up a structure for the postwar world. The cornerstone was a system of controlled exchange rates which would prevent the wild fluctuations of capital flow, and the competitive devaluations, that had so profoundly complicated the Depression.

Keynes and the British delegation argued for a system that would “peg” each national currency to a new world currency unit. All international trade would be conducted in this currency unit and would be cleared through a central international body.

At Bretton Woods, the Americans rejected the proposal. They had the heft to do so. Instead, they forced through an outcome that was in many ways inferior and less equitable than the British idea, but had major ongoing benefits to the US.

Keynes and his American nemesis, Harry Dexter White

The conference settled for the US dollar to become, effectively, the world’s reserve currency. The US undertook to keep the dollar steady at $35 to an ounce of gold. Other currencies would be pegged to the dollar at various levels, with minimal room for deviation. There was to be a new stabilization fund – the International Monetary Fund – which would provide temporary finance for states with exchange-rate shocks under the new fixed-rate system. In effect, this put the burden of maintaining the balance of trade on deficit (poor) nations, but no limit on the surpluses that rich countries (notably, the US) could accumulate.

A second organisation, the World Bank, was instituted as a lender of last resort, providing temporary loans to low-income countries – mostly in postwar Europe – that could not obtain loans commercially. It was largely sidelined by other programs like the Marshall Plan.

Ever since, the US dollar has been the indispensable currency. It gave America what a French finance minister, Valéry Giscard d'Estaing, called an “exorbitant privilege” that endowed immense financial and fiscal benefits to the United States which have lasted, now, for eighty years.

But as a means of recovering from the war in Europe and Japan, the system worked reasonably well. Together with huge capital transfers from America to Britain and Europe, it underwrote the greatest period of expansion in economic history.

In 1945, the combined GDP of Britain, France and Germany amounted to 95% of America’s. By 1968, it was just over half.

That is despite a massive rebuilding effort, particularly by France, whose economy was over five times as big in 1968 as at the end of the war. America’s had only doubled, but it started from a very much higher base.

The world had, for a time, moved away from the liberal economic orthodoxy that had survived, modified but with its essential features intact, since Adam Smith and Jeremy Bentham. The economic growth of the 19^th and early 20^th centuries was due to the industrial and agrarian revolutions, not to liberal economics. The lesson of the postwar (broadly Keynesian) period is that the liberal formula – non-activist government, free markets and an impoverished working class – had hindered growth rather than boosting it.

The industrial revolution was largely complete by 1945, but the Keynesian period oversaw the most remarkable growth not only in economic output but also in the improvement in conditions for the working and (particularly) the middle classes.

In 1930, the richest 10% of Americans controlled 49% of all income. By 1968 that had fallen to 34%. The bottom 50% improved from 14% to 21% and the middle class became dominant.

There were similar outcomes on other western democracies, such as France and Britain.

In most of the developed world, though not in the US, there was a new era of social improvement. This was the era of the welfare state: free healthcare, education, unemployment benefits, pensions, child support. This “social wage” substantially boosted the effective income of the middle and, particularly, working classes.

But every silver lining has its black cloud. The World War was hardly over when the Cold War began. “From Stettin in the Baltic to Trieste in the Adriatic an iron curtain has descended across the continent”, said Winston Churchill in 1946.

“From what I have seen of our Russian friends and Allies during the war, I am convinced that there is nothing they admire so much as strength, and there is nothing for which they have less respect than for weakness, especially military weakness. For that reason the old doctrine of a balance of power is unsound. We cannot afford, if we can help it, to work on narrow margins, offering temptations to a trial of strength.”

The period saw such a proliferation of nuclear weapons that the prospect of global annihilation became real and frightening. The Korean War broke out in 1950 and petered out in a draw three years later. Three million people died, most of them civilians. During the war the South Korean leader, Syngman Rhee – America’s (and Australia’s) main man in Korea, ordered the massacre of political opponents, many of whom had no connections to North Korea, China or the Communist Party. Somewhere between 60,000 and 200,000 were murdered.

In America and Australia, conservative politicians flourished under the imagined threat from the Communist enemy within. For three years in the US, Republican Senator Joseph McCarthy – a good friend of the Kennedy clan – ran a witch-hunt for fictitious communists allegedly infiltrating the State Department, universities, Hollywood, newspapers and a range of organisations. In Australia the Menzies government tried to ban the Communist Party and, although the referendum was defeated, the communist issue split the Labor Party in 1955 and kept it out of office until 1972.

John F Kennedy’s inaugural speech on 20 January 1961 was even more ominous than Churchill’s: “Let every nation know, whether it wishes us well or ill, that we shall pay any price, bear any burden, meet any hardship, support any friend, oppose any foe, in order to assure the survival and the success of liberty.”

In 1961, Kennedy’s first year in office, he launched the notorious Bay of Pigs invasion of Cuba; a few months later, the world came perilously close to nuclear war when he and Khrushchev faced off during the Cuban missile crisis. Further near-misses and miscalculations over the next 35 years brought the world unknowingly but repeatedly to the brink of annihilation.

In south-east Asia a war raged between North and South Vietnam. After s series of strategic setbacks, Kennedy saw an opportunity, telling James Reston of The New York Times that “Now we have a problem making our power credible and Vietnam looks like the place.” By the time of his assassination in November 1963, Kennedy had put 60,000 US troops into South Vietnam. Under this successor, Lyndon Johnson, the number rose to  536,000 by 1968.

In the end, America lost the war. But it sparked a sea-change in western society and, once again, the world reached a tipping point.

The foundations of change both came from America: visceral opposition to the war and all it represented, particularly by the young; and the black civil rights movement.

On 28 August 1963, Martin Luther King led a quarter of a million people on the March to Washington, where he told them he had a dream:

“In a sense we have come to our nation’s capital to cash a cheque. When the architects of our republic wrote the magnificent words of the Constitution and the Declaration of Independence, they were signing a promissory note to which every American was to fall heir …

“So we have come to cash this cheque – a cheque that will give us upon demand the riches of freedom and the security of justice.”

Five years later Robert Kennedy ran for President, rejecting the war, promising civil rights and a new age of justice. He was the odds-on favourite to win the election in November that year.

On 3 April, Martin Luther King was shot dead in Memphis, Tennessee. On 6 June, Robert Kennedy was shot dead in Los Angeles. On 5 November, Richard Nixon was elected President.

Throughout America and the democratic world, amid the anger and despair, there was a profound sense that the world had to change. And that change – that hope for a better tomorrow – rested with the young.

A new era had begun.

NEXT: 6: Peace, love and company profits. The upheavals of 1968 presaged the ultimate triumph of liberalism. Personal freedoms were finally realised but liberal economics failed as badly as ever.