HOW TO AVOID A REPEAT OF THE GREAT CRASH / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

How to avoid a repeat of the Great Crash

By Peter Clarke

Published: October 28 2009 23:24

The 80th anniversary of the Great Crash is upon us. This touches a nerve because we seemed to be looking into the same bottomless pit only a year ago. The chain of events, leading from a dramatic collapse in stock prices on Wall Street, beginning in late October 1929, to a Great Depression that engulfed the world economy for years, has suddenly leapt off the pages of the history books with an entirely fresh verisimilitude. Pessimists have asked, what is to stop it all happening again? Optimists have asked, what can we learn to stop it from doing so?

The links between the Great Crash and the Great Depression have always been controversial. After all, the bursting of a speculative bubble in the US, however widespread its effects upon a society that had extended democracy into share ownership, is not the same thing as a global spiral into mass unemployment and impoverishment. One key question is how a process of deflation led to depression, – falling output in the wider economy. Another question is what could be done about it? This is a different question because running the film backwards is not an option in real life.

Academic economists and historians, marooned in what is usually derided as their ivory tower, have long made a frugal living out of debating such issues. In the tower at Princeton, about 10 years ago, one economist decided to republish the collected articles that he had written over the past couple of decades. “I guess I am a Great Depression buff, the same way people are Civil War buffs,” he wrote in the preface, and barely a dog barked as the unworldly man confessed to his harmless hobby.

“I have enjoyed studying the Great Depression because it is a fascinating event at a pivotal time in modern history,” he continued. “How convenient for me, then, professionally speaking, that there is also so much to learn from the Depression about the workings of the economy.” What he had learnt, as an economist who professed an intellectual debt to Milton Friedman, was that misguided monetary contraction by the authorities was largely to blame. What he added himself to this analysis was the insight that banking panics had a special significance in transmitting deflationary shocks into the real economy.

Ben Bernanke – for it was he, of course – has found himself in an even more privileged position to learn such lessons. As chairman of the Fed, his record already deserves more plaudits than those prematurely heaped upon his predecessor. How lucky for us that a Great Depression buff was running the Fed when a second Great Crash came along! For this time the contractionary forces have not been intensified, in the name of sound money. Instead, an active monetary policy has pursued a strategy of easing credit restraints on the real economy, and the threat of inflation has been rightly dismissed as a purely notional danger under present circumstances.

So far, we might say, so Friedmanite. Mr Bernanke has shown himself faithful to his intellectual heritage as an economist in making sure that this time a great crash did not lead via a great contraction to a great depression. He has also been consistent in ensuring that the public was saved from the greater evil of bank panics, even at the politically unpopular price of supporting the lesser evil of “bailouts for Wall Street”. In these ways, Mr Bernanke has been the right man at the right time, reinforced by his understanding of how the crisis came about in not making it worse – but also with a streak of pragmatism that goes beyond anything in Friedman.

For when we address the question of how to lift the economy out of another great depression, monetarism runs out of answers. The fiscal strategy of a direct stimulus to the economy is straight out of the Keynesian copybook. It was the “drastic remedy” for unemployment that John Maynard Keynes urged in a British context from as early as 1924, five years before the Great Crash, and 12 years before his General Theory sought to revolutionise the theoretical concepts of orthodox economics. Keynes produced a pragmatic justification for temporary government intervention that did not depend upon converting anyone to doctrinaire Keynesianism.

When it came to practical issues of economic policy, Keynes preferred to appeal to common sense rather than abstruse economic theory. Indeed that is the basis for his famous maxim, “in the long run we are all dead”. Routinely misinterpreted as a heedless call to ignore long-term consequences, it is an indictment of a doctrinaire refusal to open our eyes to the real world around us. So when we ask why the Great Crash led to the Great Depression, and how our situation today is different, part of the answer is that some of the relevant lessons have been absorbed. For once, history and economics have been heeded in a pragmatic way, and policy has marched in step with common sense.

The writer’s new book on Keynes is published by Bloomsbury in London and New York

Copyright The Financial Times Limited 2009.