Lower interest rates, it is argued, provided much-needed stimulus for recovery. Bank Rate was lowered to 2% in 1932 and remained pegged at this rate for the rest of the decade. Due to this, long-term interest rates were pushed down, allowing the government to convert the 5% War Loan to a 3.5% stock in 1932, helping the country towards economic recovery. In contrast, countries still on the gold standard, such as France, Belgium, Switzerland and the Netherlands, were forced to maintain high interest rates to defend their reserves. The monetary policy pursued in Britain allowed it to expand its money supply much more quickly than the Continent until 1936, when the remaining members of the gold bloc finally abandoned the gold standard. This explains why Britain was able to recover quicker than the Continent between 1931 and 1934. Other countries which abandoned the gold standard in the early 1930s recovered from the depression in much the same way as Britain, supporting the theory that gold standard and monetary policy were key to economic recovery in the interwar period.
One of the most often cited ways in which monetary policy led to economic recovery was via the house-building boom of the 1930s, which accounted for 17% of the increase in GDP between 1932 and 1934. In addition, it stimulated output and employment in other sectors through its backward linkages to firms producing bricks, tiles, pipes and other construction materials. House building and associated trades accounted for 30% of the increase in employment in the first three years of recovery, according to Worswick (1984). In turn, Broadberry (1986) allocates about 50% of the rise in housing investment in 1931-1933 to the advent of ‘cheap money’, and hence monetary policy. Monetary policy, therefore, impacted strongly on residential investment, as well as supporting the recovery of the commercial and industrial sectors, ultimately leading to economic recovery. Therefore, by stimulating the housing sector, monetary policy could be seen as a vital factor in explaining the turning point in the 1930s, when economic recovery finally began.
Although monetary policy can be helpful in explaining how the recovery phase began, it does not suffice in explaining the extent of the recovery for several reasons. First of all, by mid 1933, investment in housing slowed down in comparison to other sectors, such as manufacturing and transport, which were growing at an average of 14% throughout 1937. These new manufacturing and transport industries were providing one third of all new jobs by 1937, and thus powering the recovery. Secondly, although rising government spending on goods and services was only a small feature of the recovery in its early stages, it formed a very significant stimulus to recovery from 1935 onwards, with the rapid growth of expenditure on rearmament ensuring that the 1937-1938 recession was of short duration and that the economy was growing rapidly by the eve of the Second World War. Defence spending had represented 3.01% of GDP in 1935, but grew rapidly to 3.71% in 1936, 4.82% in 1937, 8.72% in 1938, and finally, its pre-War peak was at 15.19% in 1939. Rearmament is therefore very important in explaining the extent of the recovery, and hence so is fiscal policy.
When looking at the path of fiscal policy, it is worth noting that for the contraction phase, the combined public authorities’ deficit fell from 0.7 to 0.5 per cent of GDP between 1929 and 1932; the product of an increase in the expenditure ratio of 3.4 percentage points of GDP and the receipts ratio by 3.6 percentage points. For expenditures on goods and services plus gross capital formation plus current grants to the personal sector, there was a rise of 3.3 percentage points, but against this must be set tax rises of 3.6 percentage points, with taxes on income rising slightly more than taxes on expenditure. Looking at the recovery phase, 1932– 7, the receipts ratio was reduced by 5 times more than the expenditure ratio, showing how difficult was fiscal consolidation on the expenditure side and how, with the recovery, taxes on income, in particular, could be relaxed. The beginnings of rearmament are also evident on the expenditure side. It is noteworthy that at the end of this phase there was a deficit of 1.5 per cent of GDP, this in the circumstances of a cyclical peak, whereas in the depth of the crisis the 1931 deficit had only been 2.3 per cent of GDP. Finally, the rearmament phase sees an unprecedented peacetime surge in expenditure on current goods and services, this financed by borrowing as the combined authorities’ deficit was by 1939 some 8.3 per cent of GDP, making the fiscal stimulus of 1937– 9 the most pronounced ever experienced by the British economy in peacetime. This large fiscal stimulus was of great help to the recovery, and hence fiscal, and not monetary policy, played a key role in sustaining the economic recovery.
In 1931-1932, budget adjustments were made, totaling £76m, comprising additional taxation (£40.5m), retrenchment (£22m), and reduction in the sinking fund (£13.7m). This tightening of the fiscal stance amid a depression known to be deepening was a gamble, which luckily succeeded in powering the recovery. As noted by Mowat (1955), “The deflationary phase of the National government’s policy was short-lived . . . [their] financial policies made the best of both worlds; they seemed sufficiently deflationary to restore confidence; they were in fact sufficiently inflationary to assist recovery by maintaining the purchasing power of the people.” However, had the recovery not commenced, cheap money not been successfully implemented, and fiscal window-dressing not deployed extensively, then the year would almost certainly have closed with a substantial deficit. As it was, a deficit of £32.3m (0.9 per cent of GDP) was posted, but this was not corrosive of confidence in the way that it would have been even 12 months earlier, and by the following year a surplus of almost the same sum was achieved. Thereafter, for the next 3 years, recovery in the public finances tracked recovery in the real economy, providing scope thereby for tax remissions and a resumption of expenditure growth.
We can therefore conclude that although expansionary monetary policy helped to start the recovery in the early 1930s, it is by no means the main explanation for the extent of the recovery. Monetary policy stimulated recovery via the housing market in the early 30s, but it was a combination of growth in the manufacturing sector post 1933 and fiscal policy, especially post 1935, which contributed to keeping the recovery on track and speeding up the growth of GDP.