Did monetary forces cause the Hungarian crises of 1931?

Flora Macher is a PhD student at
London School of Economics

Financial crises are a “hardy perennial” and while their recurrence never fails to cause substantial economic loss, on the positive side, researchers of financial history have a long record of episodes that they can use as a comparative reference when they are analyzing the one crisis just occurring. 

A recent EHES working paper by Flora Macher illustrates that there is a clear parallel between the recent sub-prime crisis and a financial crisis of the Great Depression era. The example shows that financial crises are a “hardy perennial” not only in a sense that they never cease to return but also that they always seem to arise from the same human folly.

US politicians, in their drive to increase their popularity, advocated the increase in home ownership in the 1990s and early 2000s and thus chose to promote mortgage lending. For almost a decade, everything seemed perfectly fine, in fact, more than fine. The period was an economic miracle: the fiscal side was solid, monetary conditions were easy, and everybody, even those without income could buy a house. The catch was that unfunded liabilities were accumulating in the financial system and before anyone could identify their existence, the housing bubble blew up and the well-known sub-prime crises started to unfold.

Hungary underwent almost exactly the same events on its march to the Great Depression. In the years leading to the crisis of 1931, Hungarian authorities used the banking system for populist measures catering to the needs of their constituency and helping them to maintain their political power. The only difference from today was that Hungarian policy-makers tried to win over the public not by raising home ownership but by providing subsidies to the agricultural sector.

Hungary was on the losing side after World War I; it suffered significant territorial losses and incurred reparations obligations based on the Peace Treaty of Versailles. Economic, social, and political turmoil followed in the years after the war. Since domestic capital fled or was obliterated and foreign financiers avoided the country, authorities had to resort to the central banks’ printing press to finance the ever increasing expenses of social demands. The subsequent hyperinflation could not be ended by domestic means as the domestic public was unwilling and unable to finance the government deficit through increased taxation. Eventually, Hungary rid its economy from the hyperinflation through a foreign loan arranged by the League of Nations in 1924. (Bácskai 1999) Nonetheless, the stabilization loan was conditional upon the League’s long-term surveillance which demanded a balanced government budget, forbade government borrowing and required full commitment to a legislatively set gold parity through an independent central bank that refrained from financing government debt and constrained its liquidity provision to the economy. Under these circumstances, fiscal and monetary policy had no room whatsoever to yield to domestic social demands.

Nevertheless, domestic political pressures were substantial. The stability of the government was dependent on the support of landed interest. (Romsics 1991) Large landowners’ demands were a top priority for the administration as the aristocracy retained a powerful role in shaping Hungarian politics, and Prime Minister Bethlen himself belonged to this class. The interests of small landowners and farm laborers, who made up over half of the workforce, also had to be satisfied in order to maintain social stability, which rested on very shaky grounds due to widespread poverty. (Ungváry 2013) Under these conditions, economic fragility and rising unemployment had to be avoided.

Since the short leash set by the League and the international creditors behind the reconstruction loan did not allow policy-makers to spend on domestic political interests, authorities had to find a channel through which they could still address the political pressure but, at the same time, not invite the criticism of international institutions and keep foreign capital flowing in. The banking system, enjoying the backing of the monetary and the fiscal authority, hence became a strange guarantor of domestic, and especially agricultural interests. The central bank developed a strong positive bias towards the rediscount of agricultural bills even during a period of restrictive monetary policy to ensure lending to this sector. The government provided substantial guarantees for farm lending. These were indirect means of support from the authorities to the financial system through which banks could inject “stimulus” into the economy and satisfy the political constituency of the ruling regime.

The flipside of this arrangement was that the financial system was assuming all the risk for the economic stimulus, a role that the authorities themselves were unable to pursue. As a result of the policies of indirect stimulus, the banking system became excessively exposed to the agricultural sector.

The share of agricultural lending in total lending (click to enlarge)

However, when in 1930 the country experienced an agricultural crisis, approximately 50-60% of banks’ equity was wiped out by defaults within months. Thus by the end of 1930, the financial system was already highly vulnerable to shocks and eventually experienced a collapse in July-August 1931. Years of recession and long-term slow economic growth was the outcome of meddling with the banking system and then seeing it fall apart. The post-crisis recession lasted until mid-1932 and the four years of crawling recovery afterwards only landed Hungary’s economy at 1926 levels by the end of 1936.

Domestic national income, million pengős (click to enlarge)

Although the US sub-prime episode and the Hungarian debacle of 1931 can be traced back to the same political folly, there is a significant difference in how the two crises were managed once the events were unfolding. Hungarian authorities responded by reinforcing conservative fiscal and monetary measures: monetary policy restrictions, constraints on the flow of capital, and austerity in government spending. The US followed the same route in the fiscal arena and cut back on government spending. In the monetary field, however, US authorities implemented counter-cyclical measures and started on a path of monetary easing that is still the determining policy action today. The US economy fell into a recession in 2009 but within two years it recovered and by today it is 10% above its pre-crisis size.

Comparing the US sub-prime crisis with Hungary’s 1931 events suggests that even though humans will never cease to indulge themselves to short-term gain, we do still improve on how we clean up the mess once a tragedy of excesses has occurred. The new, unorthodox monetary policy actions of today’s central banks are an intriguing experiment with money supply in a modern economy. While its long-term impact is still unclear, in the short-term, it has proved much more effective than the crisis responses to the 1931 calamities.

The blog post was written by Flora Macher, LSE
The working paper is downloadable here: https://www.ehes.org/EHES_86.pdf