The Great Depression Analogy

PRINCETON – Whenever today’s economic crisis is discussed, analogies to the Great Depression are never far away. In its latest “World Economic Outlook,” the IMF examines the analogy explicitly, in terms not only of the collapse of financial confidence, but also of the rapid decline in global trade and industrial activity. In general, history, rather than economic theory, seems to offer a guide to interpreting wildly surprising and inherently unpredictable events. Almost every contemporary use of the depression analogy takes the year 1929 as a reference point. But two completely different pathologies were manifest in the Great Depression; each called for different diagnoses – and different cures. The first, and most famous, pathology was the stock market crash of October 1929 in the United States. No other country had a stock market panic of similar magnitude, in large part because no other country had experienced the euphoric run-up of stock prices that sucked large numbers of Americans, from very different backgrounds, into financial speculation. The second pathology was decisive in turning a bad recession into the Great Depression. A series of bank panics emanated from central Europe in the summer of 1931 and spread financial contagion to Great Britain, then to the US and France, and finally around the world. The 1929 panic has dominated all analysis of the depression for two rather peculiar reasons. First, no one has ever been able to explain satisfactorily the October 1929 market collapse in terms of a rational cause, with market participants reacting to a specific news event. So the crash presents an intellectual puzzle, and economists can build their reputations on trying to find innovative accounts. Some people conclude that markets are simply irrational. Others strain to produce complicated models, according to which investors might have been able to foresee the Depression, or ponder the likelihood of protectionist reactions in other countries to the American tariff act, though the US legislation had not yet even been finalized. The second reason that 1929 has been popular with academic and political commentators is that it provides a clear motive for taking particular policy measures. Keynesians have been able to demonstrate that fiscal stimulus can stabilize market expectations, and thus provide an overall framework of confidence. Monetarists tell an alternative but parallel story of how stable monetary growth avoids radical perturbations. The 1929 crash had no obvious cause, but two very plausible solutions. The European banking disaster of 1931 was exactly the other way round. No academic laurels are to be won by finding innovative accounts as its cause: the collapses were the result of financial weakness in countries where bad policies produced hyper-inflation, which destroyed banks’ balance sheets. Intrinsic vulnerability made for heightened exposure to political shocks, and disputes about a Central European customs union and about war reparations was enough to topple a house of cards. But repairing the damage was tough. Unlike 1929, there were (and are) no obvious macroeconomic answers to financial distress. Some famous macroeconomists, including Larry Summers, the current chief economic thinker of the Obama administration, have tried to play down the role of financial-sector instability in causing depressions. The answers, if they exist, lie in the slow and painful cleaning up of balance sheets; and in microeconomic restructuring, which cannot simply be imposed from above by an omniscient planner, but requires many businesses and individuals to change their outlook and behavior. The improvement of regulation and supervision, while a good idea, is better suited to avoiding future crises than to dealing with the consequences of a catastrophe that has already occurred. The consequence of the long academic and popular discussion of the 1929 crisis is that people have come to expect that there must be easy answers. But the collapse of Lehman Brothers in September 2008 was a 1931-like event, highly reminiscent of the world of depression economics. Austrian and German bank collapses would not have driven the entire world from recession into depression if those countries had simply been isolated or self-contained economies. But they had built their economies on borrowed money – chiefly from America – in the second half of the 1920’s. That dependence is analogous to the way in which money from emerging economies, mostly in Asia, flowed into the US in the 2000’s, when an apparent economic miracle was based on China’s willingness to lend. The bank collapses in 1931, and in September 2008, have shaken the confidence of the international creditor: then the US, now China. Both lessons – about the slowness and painfulness of bank reconstruction, and about dependence on a large external provider of capital – are unpalatable. For a long time, it was much easier to repeat the soothing mantra that the world community had collectively learned how to avoid a 1929-style collapse, and that the world’s central banks clearly showed this in 1987 or 2001. Governments undoubtedly merit praise for stabilizing expectations, and thus preventing crises from worsening. But it is misleading when officials tout simple, if not simplistic, policy proposals as the basis for hoping that we can avoid a long period of difficult economic adjustment. Harold James is Professor of history and international affairs at the Woodrow Wilson School, Princeton University and Professor of history at the European University Institute, Florence. Copyright: Project Syndicate, 2009. www.project-syndicate.org

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The Great Depression Analogy