Deja Vu: The U.K.'s Brexit Decision May Trigger A Replay Of The 1931-1932 Global Devaluations

by: Kevin Wilson


The Brexit vote is being widely interpreted as potentially catastrophic in its implications and repercussions; it reminds me of a similar decision the UK made in 1931.

Famous economist Barry Eichengreen and his co-authors have shown that the structure of the eurozone is having similar effects now to what the gold standard did in the 1930s.

Brexit by itself may not mean much, but it is likely that others will follow, and these will lead to essentially a replay of the uncoordinated devaluations of 1931-1932.

We may also finally see the resolution of the seemingly everlasting eurozone crisis; healthy GDP growth and lower unemployment should eventually return to Europe, creating a great opportunity for investors.

For now, I would stay defensive, holding intermediate to long Treasuries (TLT, IEF, BIV, BOND, AGG), defensive funds (SPLV, USMV), liquid alternatives (OTCRX, QLENX, QMNIX), and CEF strategies (BXMX).


The Brexit vote is being widely interpreted as both historic and potentially catastrophic in its implications and repercussions. There are many published speculations about how the Brexit could trigger a wave of departures from the EU, starting with potential exit referendums in Italy, Spain, the Netherlands, and France, but possibly including so many countries actually leaving that the EU completely disintegrates over the next two years. Indeed, the media are full of articles about the horrific economic and financial troubles that may be in store for the world in the years ahead, all based on the "disaster" of the Brexit, and there is seemingly little that I could add that would be unique in any way.

However, in thinking about this in the days since the vote, I am reminded of another time that the British government made a bit of a splash. This was in late 1931, when the world was in the grip of the Great Depression, and adherence to the gold standard had held back monetary policy from making effective changes that could have helped the economy recover.

The UK's reserves of sterling were being drained away as a result of a run on the banks in Austria and then Germany in the spring and summer of 1931. The Bank of England had to choose between defending the exchange rate (i.e. the gold standard) or supporting the economy, according to famous author and economist Barry Eichengreen (2015; Hall of Mirrors: The Great Depression, the Great Recession, and the Uses - and Misuses - of History, Oxford University Press, New York, 512p).

The BOE dithered for quite some time because the Governor, Montagu Norman, had been ill. However, the UK's gold reserves were being drawn down as speculators shorted sterling and demanded gold in exchange, and every attempt to punish speculators with currency interventions only accelerated the loss of reserves. In fact, the BOE lost 25% of its reserves in less than three weeks in July, 1931. Something big was bound to happen, and eventually it did.

The Labour government of Ramsay McDonald resigned on August 24, 1931, unable to agree on how to proceed. A new national unity government took over, imposing an austerity program to balance the budget, which did not have the desired effect of boosting confidence. The BOE then realized that going off the gold standard would sever the connection between the (deflationary) price level and the balance of payments, which could end the negative cycle.

On the evening of September 20, 1931, with its gold reserves already at the legal minimum, the BOE announced that it was suspending the convertibility of sterling into gold, which Parliament validated the following Monday. The UK was the first major country in the Great Depression to exit the gold standard. Unfortunately, the UK failed to adopt an expansionary fiscal policy in tandem with abandoning gold, which had the effect of setting up a beggar-thy-neighbor policy. Other countries were then hit with negative capital flows and falling exports, causing them to devalue one by one with no policy coordination, which in turn led to the devastating trade war of the Great Depression.

The significance of this, as I have mentioned elsewhere, is that the gold standard artificially held policy under tight constraints that prevented effective action on the crisis of the Depression. This was true in every country on the gold standard, and Eichengreen (1995; Golden Fetters, Oxford University Press, New York, 448p) has discussed in detail the fact that each country's recovery from the depths of the Great Depression began in the exact order sequence that they went off the gold standard (Chart 1).

In fact, the imbalances in the world economy now and the imbalances seen in the Great Depression are somewhat similar in nature, in my opinion, although not in degree; i.e., the current situation is nowhere near as dire as it was then. What is perhaps most similar now is the analogous way the eurozone has acted as an economic factor in comparison to the gold standard of the 1930s; it appears to be causing structural problems and its imbalances are spreading economic distress (aggregate demand shock) in a range of countries, as was first pointed out by Eichengreen and Temin (2010).

Chart 1: Eichengreen's 1931-1932 Devaluation and Recovery Sequence

Source: Eichengreen, 1992; Seeking Alpha

Admittedly, the UK still has its own currency now and has not suffered like the eurozone periphery has, so the gold standard analogy doesn't really apply to the UK on its own. But what comes next may very well be analogous to the devaluations of the 1930s. Indeed, now there are legitimate fears that other EU countries will follow suit, just as they did in 1931 and 1932. These countries (e.g., France, Italy, Spain, Portugal, etc.) actually are in an analogous situation to that of the countries on the gold standard in 1931, because unlike the UK, they are part of the eurozone.

There are already long-term divergences in interest rates, banking policies, fiscal policies, trade balances, capital flows, immigration policies, and other political policies between the member states in the eurozone. These cannot be sustained, and I fully expect, as do others like famous investor George Soros, and famous economist Nouriel Roubini, that these or other EU countries will at some point leave the EU and individually devalue in emulation of the UK.

Whether this causes more serious consequences, such as another damaging trade war as in the 1930s, or even a depression, probably depends in part on the level of coordination of the devaluations. As of right now, it would appear that there will again be no policy coordination at all. Perhaps this will change, but if it doesn't, this is potentially a very bad thing, because world trade, as I've noted before, is already in trouble and the global economy is quite fragile. Brexit may not be the catalyst of catastrophe, but it may portend one if the EU starts to break up in an uncoordinated manner, or other major countries feel forced to devalue without an effort at international policy coordination.

For example, China has been in devaluation mode since 2014, moving sometimes very rapidly (Chart 2) but in small steps, and sometimes very slowly, even a bit stealthily (Chart 3). So far, the yuan's cumulative devaluation against the US dollar is relatively minor, but there are fears that China may repeat its sudden devaluation of last August again this summer, and perhaps with not so small a move this time. They are undergoing a financial crisis of their own, and are probably not in as much control of events as they would like.

As readers no doubt recall, that devaluation event last August instantly triggered a big stock sell-off. Because of the slow and generally incremental nature of China's devaluation efforts so far, I consider them to have not yet really devalued in the way that the UK now has. Hence, I still consider the UK to have taken the lead on this, even if it is by accident, because China must ultimately devalue much more than it has so far. The same is partially true for Japan; its early success has been greatly diminished by the recent yen rally (Chart 4), and a yen intervention is probably in the works.

Chart 2: Sudden 2% Devaluation of Chinese Currency in August 2015


Chart 3: Gradual Chinese Devaluation Against Its Currency Basket Since December 2015


Chart 4: Recent Yen Rally Is Taking Back Much of the Big Devaluation

Source: Author;

The British pound sterling has already fallen from a high of about $1.58 a year ago (when the Brexit vote first became a possibility), to a closing low on June 24 (the day after the vote) of about $1.37, for a total devaluation of around 13% so far. It is falling again Monday morning, the 27th, and is now at an intraday low of $1.327. This is only a few percent lower than it was in February, however, so we are only a little ways into new territory with the pound (Chart 5).

Still, some observers expect the pound to drop a total of 20% or more before it's through. Thus, the UK appears to again have led the way (as it did in 1931) for the major economies, being the first in the EU (even though not a part of the eurozone), and indeed one of the first in the world, to undergo a step-function devaluation in the present crisis. The ripples from this stone thrown into the economic pond will likely travel far.

Chart 5: Gradual Decline Followed by Sudden Devaluation of the Pound Sterling on June 24, 2016

Source: Author;

It is interesting to note that Japan was the first major country in the world to devalue after 2008, although its long-term plan appears to be failing currently. In 1931, however, the Japanese were actually the second big country to devalue (right after the UK), and that time around it was the British plan that had floundered a bit at first. Ironically, in the 1930s, the Japanese recovery plan actually worked very well. In both crises, after the crashes of 1929 and 2008 respectively, QE was used by some countries (e.g., Japan and the US), and devaluations were ultimately required or at least occurred. Devaluations as countries abandoned the gold standard ultimately became very widespread in 1931-1932. The near symmetry and coincidence of these two countries' devaluations in two global crises arising 85 years apart is striking. If this parallel crisis history continues, then a wave of devaluations and market turmoil is still in front of us.

If we follow the analogy a bit further though, we will see something that most observers are not talking about as yet. This is the fact that if devaluations spread to the rest of the EU as expected, it will surely cause the break-up of that poorly conceived experiment. This is likely to be very upsetting to the markets, and we may well see a global bear market and even a global recession as a result.

These were already potentially in the cards, but Brexit may be the trigger to take us on an unwanted journey to a worse place. That is very bad of course, but if we can avoid a depression, which I believe is entirely in our own hands, then we will have survived one of the greatest of history's economic disturbances relatively intact. Indeed, we will also finally see the resolution of many of the great imbalances in the world economy, and the end to a seemingly everlasting eurozone crisis that has distracted governments and markets for years on end.

Thus, although there will be some pain and suffering to come perhaps, there should also be some very beneficial effects that also come from the end of some of the world economy's imbalances. Healthy GDP growth should eventually return to Europe, perhaps in just a year or two, and of course, the same should apply indirectly to other parts of the world. The horrific unemployment in parts of Europe may get worse before it gets better, but it won't last forever, because once the imbalances are gone and the devaluations completed, recovery should be strong. The wise and patient investor will see much opportunity in this thesis. Perhaps in as little as a year, or at most two years, there will be tremendous opportunities popping up around the world for long-term investors.

For now, I would stay defensive, holding intermediate to long Treasuries: the I-Shares 20+ Yr. Treasury Bond ETF (NYSEARCA:TLT), the I-Shares 7-10 Yr. Treasury Bond ETF (NYSEARCA:IEF), the Vanguard Intermediate-Term Bond Fund (NYSEARCA:BIV), the PIMCO Total Return Active ETF (NYSEARCA:BOND), and the I-Shares Core Aggregate Bond ETF (NYSEARCA:AGG); also defensive sector funds like the PowerShares S&P 500 Low Volatility ETF (NYSEARCA:SPLV), the I-Shares Edge MSCI Minimum Volatility ETF (BATS:USMV); also some liquid alternatives like the Otter Creek Prof. Mngd. Long/Short Portfolio (MUTF:OTCRX), the AQR Long/Short Equity Fund (MUTF:QLENX), or the AQR Equity Market Neutral Fund (MUTF:QMNIX); and even some sophisticated hedge-like Closed-End Fund strategies like the Nuveen S&P 500 Buy-Write Fund (NYSE:BXMX).

Disclosure: I am/we are long TLT, BIV, BOND, AGG, OTCRX, QLENX, QMNIX, BXMX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.