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A NEW DEPRESSION? THE LESSONS OF THE 1930s
By Jeffrey Frankel
We often hear the question “Isn’t this economic crisis becoming as bad as the Great Depression?” Economists can offer a variety of reassurances, but each of them is quite circumscribed:
1. First reassurance: So far, the downturn is at worst competing with 1981-82 for the title of worst post-war recession. True, it is too late for the large monetary and fiscal stimulus applied from Washington to prevent a major recession. In April the current episode is all but certain to surpass the 1981-82 recession in length. It is still quite possible, however, that with the help of the stimulus package the current recession could fall short of the 1981-82 in depth. Unemployment peaked at 11.4% in January 1983, whereas so far we are “only” up to 8.5% (in January 2008). But the situation is clearly going to get worse before it gets better.
2. Second reassurance: The standard forecasts currently call for the US and other economies to begin to recover by 2010. Even if the situation continues its recent rapid deterioration and the current recession in a year or so attains the prize for most severe of the post-war recessions, it still has a long way to go before it rivals the Great Depression in either length or severity. In the Depression unemployment peaked at 25% in 1933; as late as 1941 it was still as high as 9.9%, far above normal levels (e.g., the levels before the 1929 stock market crash). But how do we really know for sure that this recession won’t reach the league of the economic disaster that was the 1930s? After all, Japan in the 1990s endured a period of essentially zero growth that lasted as long as the Great Depression. Over the last year, forecasters have already marked down their growth forecasts over and over again, both in the U.S. and globally. When the sub-prime mortgage crisis first hit, in the summer of 2007, the Fed and White House said it was “contained.” When instead it spread, freezing up liquidity throughout the financial system, they said that Wall Street was not Main Street. When it became increasingly evident that the entire U.S. economy was in recession, most emphatically including Main Street, many talked of “decoupling:” under which other major economies would remain centers of global growth. Yet this optimistic hope, like the others, soon crumbled away to nothing.
3. Third reassurance: Even if the worst were to happen, and we turned out to be at the beginning of a decade of high unemployment and stagnation analogous to the Great Depression, standards of living in absolute terms would remain far higher than in the 1930s. This fact is worth noting. But it does not offer much solace. There is a reason why the focus is always on the growth rate of income, rather than the level. People tend to form expectations based on their parents’ lifestyle and a trend expectation of continued economic improvement, and to grow accustomed to their recent standard of living. At least after human beings get past subsistence, their happiness is related more strongly to the rate of change of their standard of living than to the absolute level. A five per cent loss of income from current levels probably leaves people more miserable than a five per cent increase from 1930s levels of income. And loss of a job or house is, needless to say, enormously disruptive to a family, often traumatic.
4. So the important question, then, is: how do we know that the recession that began in December 2007 will not turn out to be analogous to the downturn that began in 1929: the beginning of what could turn out to be a very severe loss of income and a decade of high unemployment? There are plenty of analogies between now and then:
(i) a crisis in the US financial sector that had its roots in long excessive booms in real estate and the stock market;
(ii) the spreading of the crisis from the financial sector to the real economy and throughout the world; and even
(iii) popular American disillusionment with a Republican president perceived as too passive and too beholden to the rich, which then helps elect a charismatic and activist new Democrat.
The usual reason that is given not to fear a repeat of the Great Depression is that we have learned from the mistakes of that era, and won’t repeat them this time. What exactly is it that we learned? How can we be sure of doing it right this time? There are four big lessons for economic policy from the 1930s:
(Lesson I) Monetary policy — The Fed should respond to a severe loss of demand by aggressive monetary expansion, not by allowing the money supply to contract as happened in the 1930s (most famously pointed out by Milton Friedman and Anna Schwartz, in the Great Contraction chapter of a Monetary History of the United States). It happens that the Chairman of the Federal Reserve, Ben Bernanke, and the Chair of the President’s Council of Economic Advisers, Christie Romer, are two of the very top experts in the monetary history of the 1930s. The lessons of this period have been well absorbed, and the Fed has already given us an appropriately aggressive response. But that can only take us so far.
(Lesson II) Regulation of the financial sector — In times of financial crisis, many banks and especially their depositors will have to be bailed out; this recognition in turn requires a corresponding degree of regulation in normal times. The 1930s left us with institutions such as deposit insurance and minimum requirements for banks’ reserves and capital. The existence of these safeguards is another reason why it is indeed unlikely that we will experience anything as bad as the Great Depression. The origins of the financial crisis of 2007 was not that de-regulation fervor had led to a dismantling of the important safeguards from the 1930s. (It’s true that Glass Steagall and prohibitions on inter-state banking were dismantled in the 1990s. But that did not cause the crisis.) The problem was rather that regulation did not keep up with new innovations in non-bank financial institutions. Reform in this area is more easily said than done, and more easily done wrong than done right; but will nevertheless have to be attempted as soon as we get past the current crisis.
(Lesson III) Fiscal policy — When a deficiency of aggregate demand leads to a serious and prolonged recession, the government should respond with intelligently designed fiscal easing, in the form of both spending increases and tax cuts. To the extent that Franklin Roosevelt tried Keynesian stimulus in 1933, it worked, though only World War II spending years later finished the job. There are several critical qualifiers to note before we generalize to the post-war era. First, the budget process must not be so encumbered by political machinations or corruption as to delay disbursements until it is too late, on the one hand, or to divert them to projects with miserable cost/benefit ratios, on the other hand. Second, the budget plans must also pay due attention to the constraints of long-run fiscal sustainability. Absent these conditions, a fiscal expansion could well make things worse rather than better. The good news is that the fiscal stimulus package that President Obama signed into law last Tuesday was better designed than those enacted in many past American recessions, let alone those enacted in other countries. The efforts to block it, by those in the Congress who do not understand the lessons of the past, were unsuccessful (though they did succeed in slightly reducing bang for the buck). The bad news is that Obama has taken office with a handicap that Franklin Roosevelt did not have: a trillion-dollar deficit and a $11 trillion national debt, both of which are already guaranteed to reach alarming levels as a share of GDP in the coming year. This negative inheritance constrains the extent of fiscal expansion that is feasible.
(Lesson IV) Trade policy — The lesson that economists have long thought had been most clearly demonstrated by the 1930s is the lesson to which today’s Congress has paid the least heed. Senator Smoot (R) and Congressman Hawley (R) in 1929 proposed legislation to raise US tariffs sharply. Warnings of the damage that such protectionism would cause were ignored, including a petition organized by the leading economists of the day and signed by 1,028 of the profession. President Hoover (R) signed the infamous Smoot-Hawley bill in 1930. The consequences are well-known. Other countries instantly retaliated, and emulated this aggressive act of protectionism. Over the subsequent years world trade collapsed (down 60% by 1932), helping to put the “Great” into Great Depression and facilitating the rise of rabid nationalism in Germany and Japan.
The Buy America provisions in the original House version of the current stimulus bill risked a repetition of the mistake of Smoot-Hawley. These provisions have received far more attention in the media in every foreign country than inside the United States. President Obama insisted that the legislation abide by our international treaty commitments. It would have been better if this statement had come earlier, but it was music to the ears of us free traders. The final stimulus bill that the President signed this week was somewhat better from a trade perspective than the original. In his short time in office, Obama is already doing a better job of respecting international commitments than did his predecessor, who imposed WTO-illegal steel tariffs in 2002.
We are assured that:
(i) the government will apply the remaining Buy America provisions in a judicious manner (we are only talking about government procurement here, not interference with private-sector imports); that
(ii) in particular, the legal commitments to open markets vis-à-vis Canada and Mexico will continue, and that
(iii) the import content to the stimulus package would have been low in any case (just some iron and steel in bridges). I still worry. The part of the Smoot-Hawley lesson that even a mercantilist can appreciate is foreign retaliation: the initial reduction in imports is more than offset by a reduction in exports. If the Buy America provision was heard internationally as the firing of a starting gun in a new race toward protectionism, then the preceding three reassurances are not very reassuring.
To say that the 1930s hold important lessons for policy makers today is not to underestimate the other important lessons from subsequent history, especially the excessive fiscal and monetary expansions of 1964-2005. President Obama will turn to the issue of long-run fiscal sustainability tomorrow.
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