UNLEARNT LESSONS OF THE GREAT DEPRESSION / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Unlearnt lessons of the Great Depression

By Harold James

Published: January 3 2010 19:35

We are puzzled by the length and severity of the financial crisis and its effects on the real economy. We are also mesmerised by the possibility of parallels to the Great Depression. But at the same time we are sure that we have learnt the lessons of the Great Depression. We assume that we can avoid a repetition of the disasters of the deglobalisation that occurred in the 1930s.

The problem is that there are several different lessons from the Great Depression. They are confusing when we conflate them. Especially in the US, the Great Depression is usually identified with the stock market crash of 1929. Economists have two simple macro-economic policy answers to that kind of collapse. The first is the lesson that John Maynard Keynes already taught in the 1930s – in the face of a collapse in private demand, there is a need for new public sector demand or for fiscal activism.

The second is the lesson above all drawn by Milton Friedman and Anna Schwartz in the 1960s. In their view, the Depression was the result of the Fed’s policy failure in the aftermath of 1929. There was a massive monetary contraction, which was responsible for the severity of the downturn. In the future, central banks should commit themselves to providing extra liquidity in such cases.

Both lessons have been applied, consistently and quite successfully, not just to deal with the turmoil of 2007-08. Stock market panics in 1987, or 1998, or 2000-01, were treated with the infusion of liquidity. The fact that these anti-crisis measures were applied in many countries after 2007 also explains why the fallout is milder than it might have been. The years 2007-08, and especially the dramatic aftermath of the Lehman collapse, brought a new challenge, in that it repeated one aspect of the Great Depression story that is different from 1929. That type of crisis demands a different set of policy debates.

In the summer of 1931, a series of bank panics emanated from central Europe and spread financial contagion to Great Britain and then to the US, France and the whole world. This turmoil was decisive in turning a bad recession (from which the US was already recovering in the spring of 1931) into the Great Depression.

But finding a way out of the damage was very tough in the 1930s and is just as hard now. Unlike in the case of a 1929-type challenge, there are no obvious macro-economic answers to financial distress. The answers lie in the slow, painful cleaning up of balance sheets; and in designing an incentive system that compels banks to operate less dangerously.

A 1931-type event requires micro-economic restructuring, not macro-economic stimulus and liquidity provision. It cannot be imposed from above by an all-wise planner but requires many businesses and individuals to change behaviour. The improvement of regulation, while a good idea, is better suited to avoiding future crises than dealing with a catastrophe that has already occurred.

There is another reason that the aftermath of Lehman looks reminiscent of the world of depression economics. The international economy spreads problems fast. Austrian and German bank collapses would not have knocked the world from recession into depression had they occurred in isolated or self-contained economies. But these economies were built on borrowed money in the second half of the 1920s, with the chief sources of the funds lying in America. The analogy of that dependence is the way money from emerging economies, mostly in Asia, flowed to the US in the 2000s, and an apparent economic miracle was based on China’s willingness to lend. The bank collapses in 1931 and in 2008 shook the confidence of the international creditor: then the US, now China.

As in the Great Depression, the attention focuses on the big states and their policy responses. This is true of the by now classic answers to a “1929” problem. Smaller countries find it harder to apply Keynesian fiscal policies, or pursue autonomous monetary policies. Some countries, such as Greece or Ireland, have reached or exceeded the limits for fiscal activism; and there is – as in the 1930s – a threat of countries going bankrupt.

From the perspective of the US, debate has been distorted by fears that something like this could hit America. That is unrealistic. But even the default of an agglomeration of smaller countries would end any hope of an open international economy and inaugurate an age of financial nationalism.

In the recently ended era of financial globalisation, in the 20-year period since the collapse of Soviet communism, the most dynamic and richest states were generally small open economies: Singapore, Taiwan, Chile, New Zealand and in Europe the former communist states of central Europe, Ireland, Austria and Switzerland. In the world after the crisis, the centre of economic gravity has shifted to really large agglomerations of power. There has been an obsession with the Brics (Brazil, Russia, India, China) as new giants. The continuation of the crisis will turn them into Big Really Imperial Countries.

The writer is professor of history and international affairs at Princeton University. This article is based on ‘The Creation and Destruction of Value’, Harvard University Press, 2009

Copyright The Financial Times Limited 2010