Bordo the Great Depression Analogy

7/29/2019 Bordo the Great Depression Analogy

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NBER WORKING PAPER SERIES

THE GREAT DEPRESSION ANALOGY

Michael D. Bordo

Harold James

Working Paper 15584

http://www.nber.org/papers/w15584

NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts Avenue

Cambridge, MA 02138

December 2009

Paper prepared for the conference, Past and Present: From the Great Depression of 1929 to the Great

Recession of 2009 BBVA Foundation, Madrid October 29, 2009 The views expressed herein arethose of the author(s) and do not necessarily reflect the views of the National Bureau of EconomicResearch.

2009 by Michael D. Bordo and Harold James. All rights reserved. Short sections of text, not to exceed

two paragraphs, may be quoted without explicit permission provided that full credit, including notice,

is given to the source.


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The Great Depression Analogy

Michael D. Bordo and Harold James

NBER Working Paper No. 15584

December 2009, Revised January 2011

JEL No. E58,N0,N12

ABSTRACT

This paper examines three areas in which analogies have been made between the interwar depressionand the financial crisis of 2007 which reached a dramatic climax in September 2008 with the collapse

of Lehman Brothers and the rescue of AIG: they can be labeled macro-economic, micro-economic,

and geo-political. First, the paper considers the story of monetary policy failures; second, there follows

an examination of the micro-economic issues concerned with bank regulation and the reorganization

of banking following the failure of one or more major financial institutions and the threat of systemic

collapse; third, the paper turns to the issue of global imbalances and asks whether there are parallels

that might be found in this domain too between the 1930s and the events of today.

Michael D. Bordo

Department of Economics

Rutgers University

New Jersey Hall

75 Hamilton Street

New Brunswick, NJ 08901

and NBER

[email protected]

Harold James

History Department and Woodrow Wilson School

Princeton University

Princeton NJ 08544

[email protected]


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The Gr eat Depress i on Anal ogy

Mi chael Bordo and Harol d J ames

I n t he di scussi on of our cont emporary economi c di sease, t he

Gr eat Depr essi on anal ogy r ef uses t o go away. Al most every

pol i cy- maker r ef er r ed t o condi t i ons t hat had not been seen

si nce t he Gr eat Depr essi on, even bef ore t he f ai l ur e of Lehman.

Some even went f ur t her t he Deput y Gover nor of t he Bank of

Engl and not abl y cal l ed t he cri si s t he wor st f i nanci al cr i si s i n

human hi st or y. I n i t s Apr i l 2009 Wor l d Economi c Out l ook, t he

I MF l ooked expl i ci t l y at t he anal ogy not onl y i n t he col l apse of

f i nanci al conf i dence, but al so i n t he r api d decl i ne of t r ade and

i ndust r i al acti vi t y across t he wor l d. I n gener al , hi st or y

r ather t han economi c t heory seems t o of f er a gui de i n

i nt er pr et i ng wi l dl y sur pr i si ng and i nher ent l y unpr edi ct abl eevent s. Some obser ver s, not abl y Paul Kr ugman, concl uded t hat a

Dark Age of macr oeconomi cs has set i n ( Kr ugman 2009) . There are

however subst ant i al uncer t ai nt i es about what pr eci sel y t he

l essons of hi st or y mi ght be. Char l es Pl osser , pr esi dent of t he

Feder al Reser ve Bank of Phi l adel phi a, r ecent l y sai d t el l i ngl y

t hat : We ar e st i l l r ewr i t i ng t he nar r at i ve, and gai ni ng an

underst andi ng, of what happened i n t he Gr eat Depr essi on and

why. No doubt i t wi l l be at l east 50 years bef ore we under st and

very wel l what happened i n 2008 and 2009 and whet her t he Feder al

Reser ve under t ook t he r i ght pol i ci es or t he wr ong pol i ci es.

( New Yor k Ti mes, 2010)


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Thi s paper exami nes t hr ee ar eas i n whi ch anal ogi es have

been made between t he i nt erwar depr essi on and t he f i nanci al

cr i si s of 2007 whi ch reached a dr amat i c cl i max i n Sept ember 2008

wi t h t he col l apse of Lehman Br other s and t he r escue of AI G: t hey

can be l abel ed macro- economi c, mi cr o- economi c, and gl obal .

Fi r st , t he paper consi der s t he st or y of monet ar y pol i cy

f ai l ur es; second, t her e f ol l ows an exami nat i on of t he mi cr o-

economi c i ssues concerned wi t h bank regul at i on and t he

r eor gani zat i on of banki ng f ol l owi ng t he f ai l ur e of one or mor e

maj or f i nanci al i nst i t ut i ons and t he t hr eat of syst emi c

col l apse; t hi r d, t he paper t ur ns t o t he i ssue of gl obal

i mbal ances and asks whet her t her e are paral l el s t hat mi ght bef ound i n t hi s domai n too bet ween the 1930s and t he event s of

t oday.

Monet ar y Pol i cy

Al most every cont emporary use of t he depr essi on anal ogy

t akes t he year 1929 as a r ef er ence poi nt . But t her e ar e r eal l y

t wo compl et el y di f f er ent pat hol ogi es dur i ng t he Gr eat

Depr essi on, whi ch i nvol ve di f f er ent di agnoses and di f f er ent

cur es.

The f i r st , and t he most f amous, pat hol ogy i s t he U. S. st ock

market cr ash of Oct ober 1929. No ot her count r y had a st ock

market pani c of t he magni t ude of t he Amer i can one, i n l arge part

because no ot her count r y had exper i enced t he euphor i c r un- up of

st ock pr i ces t hat sucked l ar ge number s of Amer i cans, f r om ver y

di f f er ent backgr ounds, i nt o f i nanci al specul at i on. The second


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si ckness, cont agi ous banki ng pani cs, was deci si ve i n t ur ni ng a

bad r ecessi on i nt o t he Gr eat Depr essi on. A ser i es of bank

pani cs begi nni ng i n Oct ober 1930 i n t he Uni t ed St ates conver t ed

a not unusual r ecessi on f r om 1929- 1930 i nt o a ser i ous sl ump.

Through t he f i xed exchange r at e gol d st andar d t he U. S.

depr essi on al so af f ect ed t he r est of t he wor l d. Event s t ook a

t ur n f or t he wor st af t er t he col l apse and r escue of t he

Cr edi t anst al t bank i n Vi enna i n May 1931 and a maj or banki ng

cr i si s i n Ger many i n J une. Thi s spr ead f i nanci al cont agi on t o

Gr eat Br i t ai n, t o France and back t o t he US .

The 1929 pani c has domi nat ed a great deal of t he anal ysi s

of t he depr essi on f or t wo r at her pecul i ar r easons. Fi r st , no

one has ever sat i sf act or i l y been abl e t o expl ai n t he col l apse of

t he mar ket i n Oct ober 1929 i n t er ms of a rat i onal expl anat i on,

i n whi ch mar ket par t i ci pant s r eact ed t o a speci f i c news event .

So t he cr ash pr esent s an i nt r i gui ng i nt el l ect ual puzzl e, and

economi st s can bui l d r eput at i ons on t r yi ng t o f i nd i nnovat i ve

account s. Some peopl e j ust concl ude t hat market s are si mpl y

i r r at i onal . I ndeed, t her e i s consi der abl e evi dence t hat t hemost di st ur bi ng shocks t o mar ket expect at i ons do not ar i se f r om

i dent i f i abl e news ( Bouchaud 2010) . Ot her s ( not abl y Whi t e)

have ar gued that i nvest ors mi ght have been abl e t o f oresee t he

Depr essi on, or t hat t hey wer e ponder i ng t he l i kel i hood of

pr ot ect i oni st r eact i ons i n ot her count r i es t o t he Amer i can

( Smoot Hawl ey) t ar i f f act whi ch had not yet even been cast i n

i t s f i nal f orm.

The second r eason t hat 1929 has been popul ar wi t h academi c

and pol i t i cal comment at or s i s t hat t he af t er mat h of t he col l apse

pr ovi des a cl ear mot i ve f or t aki ng par t i cul ar pol i cy measur es.

St ock exchange col l apses or t he end of asset bubbl es do not


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necessari l y l ead t o pr ol onged r ecessi ons of deep depr essi on. I n

Oct ober 1987 and agai n i n Mar ch 2000 shar p st ock mar ket

col l apses t r i gger ed bot h an ext ensi on of l i qui di t y by t he

cent r al bank and f i scal easi ng. Keynesi ans t hought t hat

gover nment f i scal demand can st abi l i ze t he expect at i ons of t he

mar ket , and t hus provi de an over al l f r amewor k of st abi l i t y.

Monet ar i st s saw monet ar y st abi l i t y as t he key t o avoi di ng

dr amat i c out put cont r act i ons. Much of t hi s debat e has f ocused

on t he Uni t ed St at es: i n ot her count r i es, especi al l y debt or

count r i es, t he gol d st andar d const r ai ned monet ar y pol i cy so that

i t i s har d t o speak of pol i cy opt i ons. The onl y count r y wher e

t her e was an equi val ent r oom f or maneuver t o t he Uni t ed St atesi s Fr ance.

The Gr eat Cont r act i on of 1929- 1933 i n t he Uni t ed St at es

dur i ng whi ch pr i ces, r eal out put and money suppl y decl i ned by

about a t hi r d, and whi ch spr ead t o the r est of t he wor l d, was

pr eci pi t at ed by pol i cy f ai l ur es at t he Feder al Reser ve. A t i ght

monet ar y pol i cy t o ki l l st ock mar ket specul at i on i n 1928 l ed t o

a recessi on begi nni ng i n August 1929. Thi s pol i cy was based ont he r eal bi l l s vi ew t hat st ock mar ket specul at i on woul d l ead t o

i nf l at i on, a bust and t hen def l at i on. The st ock mar ket crash i n

Oct ober exacer bat ed t he downt ur n but di d not cause t he

depr essi on. The f ai l ur e of t he Fed t o f ol l ow i t s mandat e f r om

t he Feder al Reserve Act of 1913 t o act as l ender of l ast r esor t

and t o al l ay a ser i es of f our banki ng pani cs begi nni ng i n

Oct ober 1930 l ed t o the ser i ous downt ur n t hat f ol l owed. The Fed

adher ed t o the f l awed Bur gess Ri ef l er doct r i ne ( Mel t zer 2003)

whi ch vi ewed l ow l evel s of i t s bor r owed r eser ves( i . e di scount

wi ndow bor r owi ng) and shor t - t er m i nt er est r at e i ndi cat or s as

si gns of monet ary ease and hence di d not act . I n addi t i on some


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Fed of f i ci al s bel i eved i n t he l i qui dat i oni st doctr i ne and saw

bank f ai l ur es as benef i ci al . A maj or hi ke i n t he di scount r at e

i n t he f al l of 1931 t o pr ot ect t he dol l ar af t er st er l i ng exi t ed

f r om t he gol d st andar d added f uel t o t he f i r e.

Recovery began i n March 1933 wi t h Roosevel t s banki ng

hol i day, endi ng t he f our t h banki ng pani c. The nat i on s banks

were cl osed f or a week dur i ng whi ch an ar my of bank exami ner s

separ at ed t he i nsol vent f r om t he r est . I nsol vent banks wer e

cl osed endi ng t he uncer t ai nt y dr i vi ng t he pani c. Thi s act i on was

qui ckl y f ol l owed by FDR t aki ng t he U. S. of f t he gol d st andar d i n

Apr i l , Tr easur y gol d ( and si l ver ) pur chases desi gned t o r ai se

gol d pr i ces and pr i ces i n gener al , and f or mal deval uat i on of t he

dol l ar by cl ose to 60% i n J anuar y 1934. These pol i ci es pr oduced

a bi g r ef l at i onar y i mpul se f r om gol d i nf l ows whi ch wer e

unst er i l i zed passi ng di r ect l y i nt o t he money suppl y. They al so

hel ped conver t def l at i onar y expect at i ons i nt o i nf l at i onar y ones

( Egger t sson 2008) . Al so of key i mpor t ance i n pr event i ng f ut ur e

banki ng pani cs was t he i nst i t ut i on of f eder al deposi t

i nsurance(FDI C) i n t he Banki ng Act of 1933 whi ch went i nt oef f ect J anuary 1 1934.

The r ecover y of 1933 t o 1941 i n t he Uni t ed St at es was

l ar gel y dr i ven by gol d i nf l ows ( i ni t i al l y r ef l ecti ng Tr easur y

pol i cy and t he deval uat i on, l at er r ef l ecti ng capi t al f l i ght f r om

Eur ope as war l oomed) . Expansi onar y f i scal pol i cy, despi t e the

convent i onal wi sdom, pl ayed onl y a mi nor r ol e i n t he r ecover y of

t he 1930s ( Romer 1992) . Recover y was i mpeded somewhat by NewDeal car t el i zat i on pol i ci es l i ke t he NI RA whi ch i n an at t empt t o

r ai se wages and pr i ces ar t i f i ci al l y reduced l abor suppl y and

aggregat e suppl y ( Col e and Ohani an 2004) . Over t he per i od 1933-

1937 out put i ncr eased by 33%.


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The Federal Reser ve was l ar gel y passi ve i n t he 1930s.

Al ong wi t h the banker s, i t had been bl amed by t he Roosevel t

admi ni st r at i on f or t he f ai l ur es of t he 1920s and ear l y 1930s.

Maj or r ef orms i n t he Banki ng Act s of 1933 and 1935 gr eat l y

i ncr eased t he powers of t he Federal Reser ve Boar d i n Washi ngt on

at t he expense of t he Reser ve banks and especi al l y t he New Yor k

Fed. Despi t e i t s i ncr ease i n power , t he r econst i t ut ed Boar d of

Governors under Chai r man Mar i ner Eccl es was passi ve and l argel y

subservi ent t o the di ct at es of Tr easur y Secr et ar y Mor gent hau.

The Fed i n t he 1930s cont i nued t o f ol l ow t he same precept s as i t

di d i n t he 1920s and ear l y 1930s. I t s pol i cy i ndi cat or cont i nued

t o be t he l evel of f r ee r eser ves( excess r eser ves l essborr owi ngs f r om t he Fed) . I n t he 1930s bor r owed r eserves wer e

negl i gi bl e so excess r eserves became t he i ndi cat or . As t he

decade wor e on member banks l argel y absor bed t he gol d i nf l ows

i nt o excess r eserves, hel d as a pr ecaut i on agai nst a r epeat of

t he t ype of t ur bul ence exper i enced i n t he ear l y t hi r t i es. By

1935 excess r eserves amount ed t o 50% of t otal r eser ves. Fed

of f i ci al s i ncreasi ngl y vi ewed t he bui l d up of excess r eser ves as

a t hr eat t o f ut ur e specul at i on and i nf l at i on. They al so saw t he

pr esence of si zabl e excess r eser ves as pr event i ng t hem f r om

f ut ur e t i ght eni ng. Si mi l ar concer ns have been voi ced about t he

bui l d up i n bank excess r eser ves i n 2008- 2009. Accordi ng t o t he

Bur gess Ri ef l er doct r i ne whi ch pr evai l ed at t he Fed, t he way t he

Fed coul d cont r ol i nt er est r at es was by f or ci ng banks t o bor r ow

f r om t he Fed. Once bor r owed r eser ves were l ess t han t he open

mar ket port f ol i o, t hen open mar ket sal es coul d f orce t he bankst o bor r ow. Banks woul d t hen want t o reduce thei r i ndebt edness by

cont r act i ng t hei r l endi ng ( Mel t zer 2003 pp 520- 521) .


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The Recessi on of 1937- 1938: The r ecovery was i nt er r upt ed by

a ser i ous r ecessi on ( t he t hi r d wor st of t he t went i et h cent ur y)

f r om May 1937 to J une 1938. Fr i edman and Schwar t z ( 1963) and

Mel t zer ( 2003) and ot her s at t r i but e t he r ecessi on t o a ser i ous

pol i cy mi st ake by t he Feder al Reserve. Mount i ng concer n by t he

Fed over t he bui l d up i n excess r eser ves i n member banks l ed t he

Boar d t o doubl e reserve r equi r ement s i n t hr ee st eps bet ween

August 1936 and May 1937. The rat i onal e f or t hi s act i on was t o

r est ore t he Fed s cont r ol over monet ary pol i cy and r emove t he

i nf l at i onar y thr eat posed by t he excess r eserves. The Fed used

t he bl unt i nst r ument of r ai si ng r eser ve r equi r ement s r at her t han

conduct i ng an open market sal e of secur i t i es because excessr eser ves exceeded t he Fed s por t f ol i o of secur i t i es and sal es

woul d r educe t he i ncome earned f r om i t . Accordi ng t o Fr i edman

and Schwar t z t he banks were hol di ng excess r eser ves as a

pr ecaut i on agai nst a repeat of t he banki ng pani cs of t he 1930s.

When t he Fed l ocked up t hese r eserves t he banks cut back on

l endi ng and sol d ear ni ng assets t o rest or e the pr ecaut i onar y

cushi on t hey had hel d. The Fed s cont r act i onar y pol i cy act i on

was compl ement ed by t he Treasur y s deci si on i n l at e 1936 t o

st er i l i ze gol d i nf l ows i n or der t o r educe excess r eser ves. These

pol i cy act i ons l ed t o a spi ke i n shor t - t er m i nt er est r at es and a

sever e decl i ne i n money suppl y pr eci pi t at i ng a 5 % decl i ne i n

r eal GDP.

Ot her expl anat i ons gi ven f or t he r ecessi on of 1937- 38

i ncl ude: a t i ght eni ng of f i scal pol i cy when t he Admi ni st r at i on

ended a generous vet eran s bonus, i ncr eased i ncome tax r at es and

i mposed a tax on undi st r i but ed pr of i t s; gol d hoar di ng br ought

about by f ear s of anot her dol l ar deval uat i on coupl ed wi t h a

boost t o money wages by t he Wagner Act ( Sumner 2009) and a


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swi t ch back f r om i nf l at i onar y to def l at i onar y expect at i ons

( Eggert sson and Pugsl ey 2006) .

The r ecessi on ended af t er FDR i n Apr i l 1938 pressured t he

Fed t o rol l back reserve r equi r ement s, t he Tr easury st oppedst er i l i zi ng gol d i nf l ows and dest er i l i zed al l t he r emai ni ng gol d

st er i l i zed si nce December 1936, and t he Admi ni st r at i on began

pur sui ng expansi onar y f i scal pol i cy. The r ecover y f r om 1938 t o

1942 was spect acul ar , out put gr ew by 49% f uel ed by gol d i nf l ows

f r om Eur ope and a maj or def ense bui l d up.

The Li qui di t y Tr ap: The 1930s were char act er i zed by ver y

l ow i nt er est r at es. Shor t - t er m r at es wer e cl ose t o zer o t hr oughmuch of t he decade. Long- t erm r at es were cl ose t o 2%. The

t r adi t i onal Keynesi an vi ew has been t hat monet ary pol i cy was

i mpot ent because t he U. S. economy was i n a l i qui di t y t r ap. Li ke

t he 1930s a Feder al Funds r at e i n 2008 cl ose t o zer o( t he zero

l ower bound) has agai n rai sed t he i ssue of pol i cy i mpot ence.

Subsequent r esear ch by Br unner and Mel t zer ( 1968) f ound no

evi dence f or t he l i qui di t y t r ap. Ther e was a spect r um of r at eswel l above zer o thr oughout t he 1930s and t he Fed coul d j ust as

easi l y have bought secur i t i es ot her t han shor t - t er m Tr easur y

bi l l s ( Basi l e and Rockof f 2009) . The r eal pr obl em was not t hat

Fed pol i cy di dn t wor k but r at her t hat t he Fed was unwi l l i ng t o

use t he t ool s t hat i t had t o conduct expansi onary monet ary

pol i cy because i t f eared a r esur gence of asset market

specul at i on and i nf l at i on ( Or phani des 2004) .

Lessons f or Today: The hi st ory of t he 1930s exper i ence has

sever al l essons f or t he pr esent di scussi on over t he pol i ci es


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t hat t he Fed coul d f ol l ow t o ensur e a rapi d r ecover y wi t hout

engender i ng i nf l at i on.

The f i r st l esson i s t hat t he Fed l i ke i t s pr edecessor

sevent y years ago has t he tool s t o ref l ate the economy and t opr event a r esur gence of i nf l at i on. I n t he 1930 s t he Fed was

onl y a mi nor pl ayer i n t he r ecover y because i t was rel uct ant t o

use expansi onar y open mar ket pur chases f or f ear of r eki ndl i ng

specul at i on and i nf l at i on. I t was not i n r eal i t y st uck i n a

l i qui di t y t r ap or hamper ed by t he zer o l ower bound. I nst ead t he

Tr easur y t hrough i t s pol i ci es t owar ds gol d and t he consequence

of deval ui ng t he dol l ar di d mor e of t he heavy l i f t i ng t o pr omot e

r ecover y.

I n t he r ecent cr i s i s t he Fed s pol i cy of st er i l i z i ng t he

ef f ect s on t he monet ar y base of i t s di ver se l i qui di t y oper at i ons

t hrough much of 2008 ( unt i l September ) made monet ary pol i cy

t i ght er t han i t had t o be and l i kel y exacer bat ed t he r ecessi on

whi ch began i n December 2007( Het zel 2009) . However si nce

Oct ober 2008 t he base gr eat l y expanded and the pol i cy adopt ed i n

J anuar y 2009 of quant i t at i ve easi ng ( and cont i nued i n November

2010) by pur chasi ng l ong- t erm Treasur i es and mor t gage backed

secur i t i es can be vi ewed as a r epl ay of t he expansi onar y

Tr easur y gol d pol i cy of t he 1930s.

Second, t he Fed wi l l event ual l y have to t i ght en as t he

economy r ecovers and excess capaci t y i s r educed. Some have

r ai sed t he f ear t hat t hi s coul d pr oduce a r epeat of t he

r ecessi on of 1937- 1938 were t he Fed to at t empt t o r educe t he

excess r eser ves and t he banks ( st i l l gun- shy f r om t he r ecent

cr i si s) t o scr ambl e t o r epl ace t hem. Thi s shoul d not be a

pr obl em f or a number of r easons. Fi r st t he excess r eserves wer e


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bui l t up i n t he t wo er as under ver y di f f er ent Fed oper at i ng

pr ocedur es. I n t he 1930s t he Fed coul d not t ar get t he i nt er est

r at e as i t had done i n t he 1920s because t he banks were

r el uct ant t o bor r ow r ef l ect i ng a st i gma f r om doi ng so. Mor eover

t he bui l d up of excess r eser ves was a consequence of t he gol d

i nf l ows and, gi ven t he Fed s pr ef er r ed oper at i ng pr ocedur es,

creat ed a pr obl em f or i t .

Today t he Fed f ol l ows an i nt er est r at e t ar get and i t can

pay i nt er est on r eser ves ( I OR) . The bui l d up of r eser ves

r ef l ect ed ster i l i zat i on of t he Fed s l i qui di t y oper at i ons usi ng

i nt er est on r eser ves, ( when t he f eder al f unds r at e was cl ose to

zer o) , as t he mechani sm t o get banks t o hol d t hem. Were t he Fed

t o wi sh t o t i ght en i t can separ at e i t s monet ar y pol i cy

oper at i ons f r om i t s l i qui di t y pol i cy by changi ng t he spr ead

bet ween t he f unds r ate and t he I OR. ( Goodf r i end 2009) . Unl i ke

t he Fed of t he 1930s, t oday s Fed can use r everse r epos or open

mar ket sal es of i t s l ong- t er m secur i t i es t o do t he t i ght eni ng.

Were i t t o wi sh t o r educe excess r eser ves t o encour age banks t o

l end i t coul d pay negat i ve i nt er est on r eserves as was doner ecent l y by t he Ri ksbank i n Sweden.

The mai n concer n f or t oday i s not t hat t he Fed can not

exi t f r om i t s pr esent st r at egy because i t can, but t hat when i t

exi t s and begi ns t i ght eni ng t hat i f unempl oyment wer e st i l l t o

be hi gh and wer e t o begi n t o r i se agai n i n t he f ace of t he

t i ght eni ng, t hat t he Fed woul d come under pol i t i cal pr essur e t o

abandon i t s ef f or t s and cave i n under t he pr essur e. I n t hat casei nf l at i onary pr essur es woul d bui l d up as t he bond market s and

t he publ i c began t o doubt t he Fed s r esol ve. Thi s i s what

happened i n 1966 and 1969 under Wi l l i am McChesney Mar t i n and i n

1973 under Ar t hur Bur ns, l eadi ng t o the Gr eat I nf l at i on.


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The Fi nanci al Sect or

Banki ng col l apses pl ayed a cr uci al r ol e i n t he deepeni ng of

t he gl obal cr i si s i n 1931. Unl i ke t he Uni t ed St at es, wher e

banki ng was hi ghl y l ocal i zed, cont i nent al Eur opean economi es

were domi nat ed by f i nanci al syst ems i n whi ch a smal l number of

ver y l arge banks domi nat ed t he economy. I n Aust r i a, where t he

cr i si s began i n May 1931, t he Cr edi t anst al t cont r ol l ed some 60

per cent of Aust r i an f i r ms t hr ough owner shi p st akes ( Nt el 1984) .

The f ai l ur e or pot ent i al f ai l ure of ver y l ar ge f i nanci al

i nst i t ut i ons t hus posed a maj or pol i cy pr obl em.

The col l apses wer e t he r esul t of t he shocks of t he

i nt er nat i onal depr essi on i mposed upon bank weakness i n count r i es

t hat had been wr ecked by t he af t er math of bad pol i ci es t hat

pr oduced i nf l at i on, hyper - i nf l at i on, and a dest r uct i on of banks

bal ance sheet s. An i nt r i nsi c vul ner abi l i t y made f or a

hei ght ened exposur e t o pol i t i cal shocks, and di sput es about a

cent r al Eur opean cust oms uni on and about t he post war r eparat i ons

i ssue was enough t o t oppl e a house of cards.

Banks i n 1931 were vul ner abl e as a r esul t of poor monetary

pol i cy, and t hey wer e vi ct i ms of monet ar y def l at i on ( Temi n

2007) . But t her e wer e pl ent y of speci f i c i ssues whi ch l ong-

ant edated t he col l apses of t he ear l y 1930s ( J ames 1986) . They

ar e t he r esul t of speci f i c desi gn f eat ur es of t he f i nanci al

syst em t hat coul d not si mpl y be cor r ect ed by macro- economi c

pol i cy, whet her monet ar y or f i scal . U. S. banki ng was hi ghl y

l ocal i zed, and t hus vul ner abl e to geogr aphi cal l y l i mi t ed shocks


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13

( such as t he agr i cul t ur al depr essi on) ; whi l e l ar ger nat i onwi de

banki ng i n Canada was much mor e r esi l i ent . Banks i n many debtor

count r i es i n Sout h Amer i ca and Cent r al Eur ope accumul at ed

mi smat ches bet ween asset s ( i n l ocal cur r ency) and l i abi l i t i es

( i n dol l ar s or ot her key cur r enci es) , t hat made f or a

vul ner abi l i t y t o cur r ency t ur moi l . Uni ver sal banks suf f er ed

l ar ge l osses on t hei r shar ehol di ngs, and as t hei r capi t al i zat i on

f el l , cut back on t hei r l endi ng. Some Br i t i sh banks ( t he so-

cal l ed merchant banks) had heavy over seas exposur es t hat made

t hem vul ner abl e t o f or ei gn cr i ses ( J ames 2001, Accomi not t i

2009) .

One of t he st r i ki ng f eat ur es of t he Depr essi on anal ogy i s

how many of t he answers r egar di ng t he banki ng sect or are popul ar

agai n t oday: i n par t i cul ar , t he pr ovi si on of st at e guar ant ees t o

at t empt t o r evi ve t he i nt er bank market and bank l endi ng;

r ecapi t al i zat i on of banks wi t h publ i c money; and t he

est abl i shment of bad banks t o t ake pr obl emat i c asset s of f

banks bal ance sheet s. Al l of t hese pol i cy r esponses wer e t r i ed

i n t he 1930s, most not abl y i n t he epi cent er of t he cent r alEur opean col l apse, i n Germany.

Some of t he i ni t i at i ves t hat t he German government t ook had

a qui t e modern r i ng t o them. I ndeed t hi s was an area i n whi ch

t he German government appear ed t o act swi f t l y i n order t o

i mpl ement a cr i si s management st r at egy. Fi r st , t he government

r eor gani zed t he banks, mergi ng t he t wo weakest ones, Danat and

Dr esdener Bank, t hat had been at t he or i gi n of t he banki ngcol l apse, and i nj ect i ng gover nment money i nt o al l of t hem.

I ni t i al l y, t he gover nment had t r i ed har d t o get pr i vat e money as

wel l , and t her e wer e i nt ense negot i at i ons wi t h t he l eadi ng

f i gur es of t he power f ul Rhi ne- Ruhr s t eel l obby. I n t he end t he


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busi ness l eaders onl y agr eed i f t he government woul d put i n more

money, and i f t he gover nment advanced them t he sums t hat t hey

wer e supposed t o i nvest i n t he r ecapi t al i zat i on of Danat Bank.

By 1932, 91 per cent of t he Dr esdner Bank s capi t al , 70 per cent

of Commerzbank s and 35 per cent of Deut sche Bank s was i n publ i c

owner shi p.

Second, t he German cent r al bank ( t he Rei chsbank) pushed f or

a new i nst i t ut i on whi ch woul d al l ow i t t o di scount bi l l s f r om

banks whi ch coul d not be t r aded because t he i nterbank market had

st opped oper at i ng. Thi s i nst i t ut i on, named t he Akzept - und

Gar ant i ebank, was est abl i shed wi t h br eat h- t aki ng speed. I t was

gi ven a publ i c guar ant ee i n order t o pr ovi de t he addi t i onal

si gnat ur e t hat made bi l l s el i gi bl e f or Rei chsbank l endi ng

( r edi scount i ng) .

Thi r d, t he Rei chsbank event ual l y ( i n December 1932) cr eat ed

what woul d now be cal l ed a bad bank t o t ake over t r oubl ed

assets whose pr i ces no l onger corr esponded t o t he val ue at whi ch

t hey wer e set i n t he banks bal ance sheet . Two new i nst i t ut i ons

woul d t ake asset s of f f i r ms and banks bal ance sheet s: t he

f i r st , t he Deut sche Fi nanzi er ungsi nst i t ut AG t ook over up t o

t hr ee quart er s of t he bad asset s of a bank, but r equi r ed an

annual amor t i zat i on at 3 per cent . The second, t he Ti l gungskasse

f r gewer bl i che Kr edi t e, r equi r ed a much l ower r ate of

ser vi ci ng, onl y 1 per cent , f or an i ni t i al t hr ee year per i od,

f ol l owed by hi gher r at es as economi c r ecover y set i n.

Lessons f or t oday

The consequence of t he l ong academi c and popul ar di scussi on

of t he 1929 cr i si s and t he appr opr i at e pol i cy r esponse i s t hat

peopl e have come to t he expect at i on t hat t her e must be easy


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answers. But t he col l apse of Lehman Br ot hers i n Sept ember 2008

was a 1931- l i ke event , t he f ai l ur e of a l ar ge f i nanci al

i nst i t ut i on. The answer s requi r ed ar e l ess obvi ous t han i n t he

domai n of monet ar y or f i scal pol i cy, wher e l essons of t he Gr eat

Depr essi on are much cl ear er .

Fi ndi ng a way out of t he damage creat ed by t he col l apse of

a syst emi cal l y i mpor t ant f i nanci al i nst i t ut i on was and i s ver y

t ough. Unl i ke i n t he case of a 1929- t ype event , t her e ar e no

obvi ous macr o- economi c answer s t o f i nanci al di st r ess,

par t i cul ar l y when i t i nvol ves i nst i t ut i ons t hat ar e deemed t o be

t oo bi g t o f ai l . Some f amous macr o- economi st s, i ncl udi ng

Lar r y Summers, t he chi ef economi c t hi nker of t he Obama

admi ni st r at i on unt i l l at e 2010, i n consequence t r i ed t o pl ay

down t he r ol e of f i nanci al sect or i nst abi l i t y i n causi ng

depr essi ons. Rober t Lucas s cl ai m i n 2003 t hat t he cent r al

pr obl em of depr essi on- pr event i on has been sol ved i s one of t he

cent r al pi eces of evi dence f or Kr ugman s onsl aught on

convent i onal macro- economi cs.

1. A key pr obl em at t he hear t of bot h t he 1931 cr i si s i n

Cent r al Eur ope ( but not i n t he Uni t ed St at es) and of 2008 i n t he

U. S. and Eur ope was the doct r i ne of t oo bi g t o f ai l . For t he

U. S. , t hi s doct r i ne was bor n onl y i n t he af t er mat h of t he Lat i n

Amer i can debt cr i si s of 1982, whi ch t hr eatened t he sol vency of

al most al l f i nanci al i nst i t ut i ons i n t he i ndustr i al count r i es.

I n 1984 t he doct r i ne was appl i ed t o j ust i f y t he deci si on t o bai l

out Cont i nent al I l l i noi s, t he f our t h bi ggest U. S. bank whi ch wasi nsol vent . As banks grew i n t he 1990s and 2000s, and t hei r

i nt er connect edness i ncr eased, t he doct r i ne evol ved and was

augment ed by an ar gument about banks bei ng t oo i nt erconnect ed

t o f ai l . I n 2008 t he doct r i ne cont r i but ed t o t he wor seni ng of


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f i nanci al cri si s, as t he bel i ef t hat l ar ge commer ci al banks

woul d not be al l owed t o f ai l was ext ended t o i nvest ment banks

wi t h t he r escue of Bear Stear ns i n March 2008. Then i n September

when Lehman Br ot her s was al l owed t o f ai l and AI G was r escued t he

r esul t i ng conf usi on l ed t o pani c. Too bi g t o f ai l has al so

hamper ed t he r ecovery by pr event i ng t he use of t he good bank/ bad

bank sol ut i on ( t hat had been used so successf ul l y i n t he past by

Sweden and ot her count r i es) t owards Ci t i gr oup, Bank of Amer i ca

i n the US and some bi g banks i n Europe: RBOS, Ll oyds- HBOS, UBS.

I n consequence, gover nment s t ook on t oo l arge shares i n

f i nanci al i nst i t ut i ons i n or der t o r ecapi t al i ze t hem, a move

anal ogous t o what happened i n 1931 i n Germany. And as i nGermany i n 1931 sever al government s have al r eady been r epai d by

some of t he banks whi ch were rescued at a pr of i t . A maj or

col l apse of a l ar ge par t of t he f i nanci al syst em r equi r es a sl ow

and pai nf ul cl eani ng up of bal ance sheet s; and i n mi cr o- economi c

r est r uct ur i ng, whi ch cannot be sol el y i mposed f r om above by an

al l - wi se pl anner but al so requi r es many busi nesses and

i ndi vi dual s to change t hei r out l ook and behavi or . The

i mpr ovement of r egul at i on and super vi si on, whi l e a good i dea, i s

bet t er sui t ed t o avoi di ng f ut ur e cr i ses t han deal i ng wi t h t he

consequences of a cat ast r ophe t hat has al r eady occur r ed.

3. The i nvol vement of gover nment i n f i nanci al r escues

t r ansf er s pr i vat e debt i nt o t he publ i c sect or , and creat es

di f f i cul t i es f or publ i c f i nance unl ess t her e i s a dr amat i c and

qui ck r ecover y of t he pr i ces of f i nanci al asset s. The Aust r i an

gover nment s answer t o t he 1931 Cr edi t anst al t cr i si s i nvol ved

t aki ng over t he bank, and event ual l y mer gi ng i t wi t h ot her

weakened Aust r i an banks, t he Wi ener Bankver ei n and t he

Ni eder st er r ei chi sche Escompt e Gesel l schaf t . The gover nment


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subsi dy was expensi ve, amount i ng t o 9 t o 10 per cent of GNP,

subst ant i al l y l ess t han t he cost of bai l out s f or Mexi co or J apan

i n t he 1990s, but much l ess t han t he cost of t he I r i sh

gover nment s i l l - concei ved guar ant ee of I r i sh bank deposi t s i n

2008, whi ch was r esponsi bl e f or sendi ng t he gover nment def i ci t

t o over 30 per cent of GDP i n 2010. I n t he 1930s, t he af t er math

of t he bai l out par al yzed Aust r i an pol i cy t hr oughout t he 1930s

and made t he count r y vul ner abl e t o i nt er nal ext r emi sm and

ext ernal at t ack. I t i s l i kel y t hat I r i sh pol i t i cs wi l l be

pr of oundl y t r ansf ormed i n t he wake of 2011 el ect i ons.

4. Bai l out s cr eat e pol i t i cal economy pr obl ems. Bai l out s

ar e i nher ent l y cont r over si al , because t hey di st r i but e publ i c

money i n an ar bi t r ar y way, t o one reci pi ent r at her t han anot her .

I n t he Uni t ed St at es, Her ber t Hoover s i nnovat i ve Reconst r uct i on

Fi nance Corporat i on of 1932 qui ckl y ran i nt o pr obl ems because of

t hi s i ssue: i t t ur ned out t hat t he credi t s wer e goi ng t o banks,

f arms and busi nesses t hat were wel l connect ed wi t h Republ i can

pol i t i cs. Ger many of f er s an even more dr amat i c exampl e of t hi s

ki nd of pr obl em. As par t of t he bank bai l out i n t he af t er mat hof t he 1931 cr i si s, 2. 5 m. Rei chsmarks was put i nt o a smal l

Ber l i n i nst i t ut i on, Har dy & Co. , t hat was a subsi di ar y of t he

Dr esdner Bank. Thi s money was pr i mar i l y i nt ended t o f l ow i nt o

t he el ect or al campai gn cof f er s of Paul von Hi ndenbur g, t he

vet eran Fi r st Wor l d War commander who had been el ect ed Pr esi dent

of Germany and was st andi ng f or r eel ect i on i n 1932 ( Bhr and

Zi egl er ) .

I n the f r agi l e si t uat i on of Wei mar Ger many, t he bai l out

t hat was at t he cent er of t he gover nment s r esponse t o t he

banki ng cri si s r an i nt o ever y ki nd of obj ect i on. The cl ai m t hat

t he gover nment had been engaged i n t he soci al i zat i on of l osses


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became an i mport ant part of t he tur bul ent el ect oral campai gns of

1932. I n or der t o get suppor t f r om t he Akzept bank, banks had t o

demonst r at e that i mport ant economi c i nt er est s wer e at st ake,

and i n pr act i ce t he maj or i t y of Akzept bank credi t went t o t he

savi ngs banks ( Sparkassen) . I t was al so used t o suppor t

ent er pr i ses i n st r at egi cal l y vi t al ar eas, not abl y Si l esi a. The

speci al i ssues i nvol ved i n t he suppor t of Si l esi an i ndust r y, and

t he f ear of an oppor t uni st i c t akeover by f or ei gn i ssues, l ed t o

t he Chancel l or Hei nr i ch Br ni ng s most pr obl emat i cal and i ndeed

scandal ous r escue oper at i on, t he so- cal l ed Gel senber g pur chase

concl uded on the l ast day t hat Br ni ng and hi s Fi nance Mi ni st er

Her mann Di et r i ch, t he dr i vi ng f or ce of t hi s bai l out , wer e i nof f i ce. I n t hi s t r ansact i on, t he gover nment , whi ch as a r esul t

of t he banki ng cr i si s had become Fl i ck s l ar gest credi t or ,

bought out Fl i ck s i nt er est i n t he st eel gi ant Ver ei ni gt e

St ahl wer ke. Di et r i ch s f or mer St at e Secr et ar y Hans Schf f er

r ef er r ed t o t he oper at i on as ext r eme st upi di t y.

The r escue of t he Cr edi t anst al t was al so accompani ed by

massi ve cor r upt i on, t he r evel at i on of whi ch became t he st ock- i n-t r ade of t he opposi t i on Nazi movement i n Aust r i a. Then, as now,

t her e was massi ve publ i c host i l i t y t o t he i dea of a bai l out , i n

t hat i t appear ed t o be a f or m of suppor t f or t he i nst i t ut i ons

and peopl e who r eal l y bor e t he r esponsi bi l i t y f or t he cr i si s.

The cost of bai l out s, even when t hey seemed t o have been

admi ni st ered pr ompt l y and wi t h hi gh ef f i ci ency as i n t he Ger man

case, t hus exceeded t he si mpl e f i scal ar i t hmet i c. They br oughtt he st at e i nt o a ser i es of cont ent i ous mi cro- l evel deci si ons on

t he heal t h of par t i cul ar ent er pr i ses and on t he f at e of

i ndi vi dual bank di r ect or s. Gi ven t he poi sonous i deol ogi cal

backdr op of ant i - Semi t i sm i n t he cont ext of Cent r al Eur ope i n


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t he 1930s, i t i s unsur pr i si ng t hat t hi s r adi cal doct r i ne was

f anned by t he char act er of t he government s r esponse t o banki ng

cr i ses, and t hat bot h i n Ger many and mor e expl i ci t l y i n Aust r i a

a pr ocess of expr opr i at i ng J ewi sh pr oper t y ( ar yani zat i on) t hat

was at f i r st cal l ed Ger mani zat i on or Aust r i ani zat i on set i n even

bef or e t he Nazi s t ook power i n those count r i es. The epi sodes of

managi ng bank f ai l ur es i n r et r ospect l ook l i ke t he begi nni ng of

a pr ocess of st at e- domi nat i on, cor r upt i on, and even r aci al

per secut i on t hat woul d r ol l on l i ke an ever more menaci ng

snowbal l .

The pol i t i cs of bank and i ndust r i al bai l out s af t er 2008

r ai sed f ear s of a new f i nanci al and economi c nat i onal i sm, as

government s become more di r ect l y i nvol ved i n t he mi cr o-

management of t he economy. Banks i n st at e owner shi p of wi t h a

subst ant i al degr ee of publ i c i nvest ment Ci t i gr oup, Ll oyds-

HBOS, RBS, Commerzbank cut back on f orei gn act i vi t i es and sol d

f or ei gn asset s, at l east i n par t because of gover nment pr essure

t hat t axpayer money shoul d not be used f or t he benef i t of

f orei gn borr ower s. Economi c nat i onal i sm was even more evi denti n the debat e about government r escues of t he aut omobi l e

i ndust r y i n 2009, wher e domest i c j obs are pr otect ed at t he cost

of f or ei gn j obs i n an i ndust r y deal i ng wi t h gl obal over capaci t y.

Gl obal I mbal ances

Gl obal i mbal ances pl ayed a maj or r ol e i n t he or i gi ns of t he

Gr eat Depr essi on and many ar gue that t hey ar e al so a si gni f i cant

cause of t he Gr eat Recessi on. I n t he Gr eat Depr essi on, t he


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i mbal ances were unwound and r eversed: capi t al af t er 1931- 33

f l owed back t o t he cr edi t or count r i es, above al l t o t he U. S.

The unwi ndi ng of i mbal ances i nvol ved an asymmet r i c adj ust ment .

Cr edi t or count r i es di d l i t t l e, whi l e t he def i ci t count r i es

r educed t hei r l evel of economi c act i vi t y i n or der t o make

t r ansf er s.

Of cour se not al l i mbal ances ar e bad or unsust ai nabl e. I n

t he ni net eent h cent ur y, some count r i es r an per si st ent def i ci t s

because t hey wer e gr owi ng more qui ckl y (Aust r al i a or t he U. S. )

and ot her s had subst ant i al surpl uses because of hi gh savi ngs

accumul at i on i n a mat ure economy ( UK and Fr ance) . Some

count r i es ( such as t he Ot t oman empi r e or Russi a, or Gr eece) had

publ i c debt i nduced def i ci t s t hat wer e unsust ai nabl e, and whi ch

l ed t o i sol at ed debt cr i ses but no gener al r ever sal of capi t al

f l ows. I n t he 1920s, t he i mbal ances that bui l t up i n cent r al

Eur ope wer e heavi l y dr i ven by unsust ai nabl e expansi ons of publ i c

spendi ng and pr i vat e consumpt i on; and the si mul t aneous col l apse

l ed t o a gener al r ever sal of capi t al f l ows.

There was i n t he Gr eat Depress i on a great deal of

di scussi on about t he need f or mor e and bet t er i nt er nat i onal

cooper at i on. I n 1930, t he Bank f or I nt er nat i onal Set t l ement s

began wor k i n Basel . I t s creat or s, above al l t he i nf l uent i al

Governor of t he Bank of Engl and, Mont agu Norman, envi saged i t s

r ol e as not onl y ar r angi ng f or t he saf e and pai nl ess t r ansf er of

Ger man r epar at i ons ( i t s pr i mar y r ol e) but al so i n devi si ng

cr i si s suppor t mechani sms f or t r oubl ed debt or s.

The hi ghpoi nt of i nt er nat i onal cooperat i on was supposed t o

be t he 1933 London Wor l d Economi c Conf er ence. But i t s f ai l ur e

was al most pr edest i ned. The pl enary meet i ng was par al yzed by t he


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way i n whi ch t he preparat ory commi ss i ons had worked. Monet ary

exper t s argued t hat an agr eement on cur r ency st abi l i zat i on woul d

be hi ghl y desi r abl e, but t hat i t r equi r ed a pr i or agr eement on

t he di smant l i ng of t r ade bar r i er s al l t he hi gh t ar i f f s and

quotas t hat had been i nt r oduced i n t he cour se of t he depr essi on.

Tr ade exper t s met i n paral l el and made t he mi r r or i mage of

t hi s argument . They agr eed t hat pr ot ect i oni sm was obvi ousl y a

vi ce, but t hought t hat i t was a necessar y one t hat coul d not be

addr essed wi t hout monet ar y st abi l i t y. Onl y l eader shi p by a

det er mi ned gr eat power , pr epar ed t o sacr i f i ce i t s par t i cul ar

nat i onal i nt er est s i n or der t o br eak t he r esul t i ng i mpasse,

mi ght concei vabl y have saved t he meet i ng. But such l eadershi p

was as unl i kel y t hen as i t i s now.

A f ur t her l esson of t he London Conf er ence of 1933 consi st s

i n gover nment s unwi l l i ngness i n t i mes of gr eat economi c

di f f i cul t y t o make sacri f i ces t hat mi ght ent ai l a shor t - t er m

cost . Even i f t he r esul t woul d have been l onger - t er m st abi l i t y,

t he i mmedi at e pol i t i cal consequences wer e t oo unpl easant . I nadver se economi c ci r cumst ances, government s f el t vul nerabl e and

unsur e, and t hey coul d not af f or d t o al i enat e publ i c suppor t .

Fi nal l y, f aced by a r eal i zat i on of i nevi t abl e f ai l ur e,

par t i ci pant s l ook f or a scapegoat . The 1933 Conf er ence l ooked

l i ke a cl assi c det ect i ve novel i n whi ch ever y par t y had a reason

t o be a suspect . Br i t ai n and Fr ance had t ur ned away f r om

i nt er nat i onal i sm, adopt i ng t r ade syst ems known as I mper i alPr ef er ence, whi ch f avor ed t hei r vast over seas empi r es.

Ger many s pr esi dent had j ust appoi nt ed Adol f Hi t l er s r adi cal

and aggressi ve government . The German del egat i on was l ed by

Al f r ed Hugenber g, who was not a Nazi but want ed t o show t hat he


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was an even mor e i mpl acabl e nat i onal i st t han Hi t l er hi msel f . The

J apanese gover nment had j ust sent t r oops i nt o Manchur i a. Of al l

t he maj or powers i n London, t he Uni t ed St at es l ooked the most

r easonabl e and i nt er nat i onal i st by f ar . I t had a new,

char i smat i c presi dent , who was known as an Angl ophi l e and a

cosmopol i t an spi r i t . Frankl i n Roosevel t was al r eady t aki ng

vi gor ous act i on agai nst t he depr essi on, and was t r yi ng t o

r eorder t he f ai l ed US banki ng syst em. Roosevel t di d not know

what l i ne t o t ake at t he conf er ence, and hi s st r eam of advi ser s

of f er ed i nconsi st ent counsel . At l ast , he l ost pat i ence and

announced that f or t he moment t he US had no i ntent i on of

st abi l i zi ng t he dol l ar . Thi s message, del i ver ed on J ul y 3, 1933,was known as t he bombshel l . Roosevel t t al ked about t he need to

r est or e t he sound i nt er nal economi c syst em of a nat i on and

condemned t he ol d f et i shes of so- cal l ed i nt er nat i onal banker s.

Ever yone pr et ended t o be shocked at t he f ai l ur e of

i nt er nat i onal i sm. But , at t he same t i me, t hey wer e del i ght ed t o

have f ound someone who coul d be bl amed f or t he f ai l ur e of t he

conf erence.

Lessons f r om t he Fai l ur e of I nt er nat i onal Cooper at i on:

The most obvi ous l esson f r om t he hi st or y of t he Gr eat

Depr essi on concer ned t he desi r abi l i t y of an i nst i t ut i onal

mechani sm t o pr event a col l apse of t r ade as a r esul t of

pr ot ect i ve and r et al i at or y measur es t ar i f f s and quot as. The

i nt er nat i onal t r ade r egi me has been i nst i t ut i onal i zed, f i r stt hrough t he GATT and t hen t hrough t he WTO. Al t hough a l arge

number of count r i es i nt r oduced some pr ot ect i ve measur es i n t he

wake of t he f i nanci al cr i si s, onl y about 1 per cent of wor l d

i mport s wer e af f ect ed by t he new t r ade measur es i nst i t ut ed


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bet ween Oct ober 2008 and Oct ober 2009, i n ot her words i n t he

most sever e phase of t he cr i si s ( OECD 2010) . G- 20 meet i ngs i n

November 2008 and Apr i l and Sept ember 2009 pr oduced agreement s

on ant i - pr ot ect i oni st measur es, and some count r i es ( not abl y

Aust r al i a, Mexi co and Canada) i nst i t ut ed a syst emat i c r educt i on

of t ar i f f s ( t hough Mexi co, l i ke Russi a, t ook measur es t o

r est r i ct t he i mpor t of f or ei gn aut omobi l es) .

There was a r api d col l apse of t r ade i n t he si x mont hs af t er

t he col l apse of Lehman i n Sept ember 2008, whose maj or cause was

t he unavai l abi l i t y of t r ade f i nance r at her t han t r ade pr ot ect i on

measur es. OECD expor t s f el l by 12. 9 per cent i n t he l ast quar t er

of 2008 and by 30. 0 per cent i n t he f i r st quar t er of 2009. Af t er

Apr i l 2009, t r ade r ecover ed r api dl y. Never t hel ess, wor l d t r ade

i n 2009 was around 12. 5 percent l ower t han i n 2008 al t hough i t

has al most r ecover ed i n 2010. ( OECD 2010)

I n the debat es bef ore t he Wor l d Economi c Conf erence, a

cr i t i cal i ssue was how t r ade and f or ei gn exchange pol i cy

i nt er act ed. Mul t i l at er al i nst i t ut i ons i n t he Gr eat Recessi on bycont r ast have deal t l ar gel y wi t h a di f f er ent coor di nat i on

exer ci se: t hey have been concerned both wi t h t he coordi nat i on of

f i scal st i mul us and wi t h exchange r at e coor di nat i on. I n

addi t i on, cent r al banks extended swaps, l ess as an act of

monet ar y pol i cy coor di nat i on but r at her l ar gel y i n or der t o deal

wi t h t he cur r ency r equi r ement s r esul t i ng f r om l ar ge cur r ency

mi smatches i n t he bal ance sheet s of maj or cr oss- nat i onal banki ng

groups.

Bot h t he f i scal and t he exchange r at e si des of t he

coor di nat i on exer ci se ar e pot ent i al l y pr obl emat i c. The emphasi s

on f i scal st i mul us i n t he ear l y phase of t he cr i si s made some


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count r i es vul ner abl e t o doubt s about f i scal sust ai nabi l i t y i n

t he second par t of t he cr i si s. I n t he Eur opean Uni on, Gr eece

and Spai n at f i r st pr esent ed thei r st i mul us packages as

cont r i but i ons t o Eur opean r ecover y rat her t han as sour ces of

f r agi l i t y.

More i mport ant l y, t he moder n di scussi on of f orei gn exchange

pol i cy i s much mor e cont r over si al and di f f i cul t t o r esol ve t han

t r ade i ssues, and t he i nt er nat i onal i nst i t ut i onal set t i ng t he

I nt er nat i onal Monet ar y Fund - whi ch or i gi nal l y managed t hi s

i ssue i n t he Br et t on Woods era has l argel y l ost compet ence i n

t hi s f i el d. Ther e has been a gr eat deal of di scussi on of

st r engt heni ng mul t i l at er al sur vei l l ance i n t he wake of t he

cr i si s, but such sur vei l l ance has not had a maj or pol i cy i mpact .

I nst ead, t her e ar e r epeat ed accusat i ons t hat exchange r at es are

bei ng mani pul ated i n or der t o achi eve t r ade advant ages,

accusat i ons whi ch r ecal l t he bi t t er pol emi cs of t he 1930s. The

Uni t ed St at es bel i eves t hat Chi na i s under val ui ng t he r enmi nbi

i n or der t o dr i ve expor t s; Eur opeans compl ai n t hat quant i t at i ve

easi ng i s a t r ade pol i cy desi gned t o dr i ve down t he dol l ar ;

Amer i cans asser t t hat t he Eur o t r oubl es are a mechani sm f or

l ower i ng t he Eur opean exchange r at e; and even more t r oubl i ngl y,

i n t he Eur opean cont ext , sout her n Eur opeans ar e begi nni ng t o

i nt er pr et t he st or y of t he l ocked exchange r at e of t he si ngl e

cur r ency as a devi ce t o obtai n expor t advant ages by Germany ( and

ot her nor t her n Eur opean st at es) .

The r esul t of t hese cont r oversi es has been an er osi on of

i nt er nat i onal economi c cooper at i on. I n t he hal f year f ol l owi ng

t he 2008 col l apse of Lehman, dur i ng the most i nt ense phase of

t he cur r ent f i nanci al cr i s i s, t he wor l d s pol i t i cal l eader s

r eassur ed t hemsel ves t hat t hi s t i me i nt er nat i onal cooper at i on


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was wor ki ng spl endi dl y by cont r ast wi t h t he gr i m pr ecedent of

t he nat i onal i st i c and aut ar ki c 1930s. The gl obal el i t e

const ant l y r ehearsed and r epl ayed a soot hi ng mant r a. Her oi c

f i gur es, l ed by Gordon Br own, wer e r escui ng t he wor l d t hr ough

f ar - si ght ed and benef i cent publ i c act i on. But si nce t hen, i n an

uncanny echo of t he ear l i er col l apse of i nt er nat i onal ef f or t s at

under st andi ng, t he pr ospect s f or sust ai ned cooper at i on and f or

agr eement on who shoul d adj ust have f aded. Gr owt h i s r etur ni ng

f or bot h t he maj or sur pl us and t he def i ci t count r i es, and i t

mi ght i n consequence be ar gued t hat t he coor di nat i on f ai l ur e

does not mat t er . But t he gl obal i mbal ances ar e st i l l t her e, and

t o t he ext ent t o whi ch t hey ar e dr i ven by t he expansi on ofpubl i c debt l i abi l i t i es may be bad i mbal ances capabl e of

l eadi ng t o a 1930s st yl e r ever sal . The 2010 equi val ent of Roosevel t s bombshel l has come f r om

t he Republ i can shel l acki ng of Pr esi dent Obama i n t he mi d- t er m

el ect i ons. The out come i s a r est or at i on f or t he l ogi cal and

beaut i f ul l y desi gned syst em of checks and bal ances t hat t he

ei ght eent h cent ur y const i t ut i onal f at her s dr ew up. That syst em

can work as i nt ended and pr oduce an accur ate r ef l ect i on of t he

concer ns of or di nar y Amer i cans. I t i s l i kel y t o pr event f ur t her

bi g bai l out s, f ur t her economi c st i mul us measur es, but al so to

bl ock ef f or t s at gover nment budget bal anci ng. The f i nal

conf i r mat i on of t he new U. S. st ance came one day l ater , wi t h t he

Fed s announcement of t he new $600 bn. quant i t at i ve easi ng

pr ogr am ( QE2) . The Fed was qui t e r i ght t o cl ai m t hat t he

pr ogr am was not unusual , and t hat i t r epr esent ed mer el y monet ary

pol i cy as usual . I t may be t hat i t i s exact l y what t he U. S.

economy needs at t he moment i n pr eci sel y t he same way as i n

1933 t he U. S. needed a f l exi bl e exchange r ate and benef i t ed f r om


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escapi ng f r om gol den f et t ers. Some comment at ors however argue

t hat t he pace of r ecover y as a resul t of t he pr i vat e sect or s

own ener gy and cont i nuous monet ary st i mul us si nce l at e 2008 may

have made QE2 r edundant . The deci si on however was j ust i f i ed by

Fed of f i ci al s by ref er ence t o t he dual mandat e of t he Fed, t o

mai nt ai n pr i ce st abi l i t y ( wher e f or t he moment t her e i s no

t hr eat of ei t her si gni f i cant i nf l at i on or of any def l at i on) and

al so a l evel of economi c act i vi t y t hat mi ght gener at e an

i mprovement i n t he l abor market .

I t i s onl y when i t comes t o t he i nt er nat i onal ar ena t hat

t he Fed s act i ons ar e i nconsi st ent wi t h pr i ce st abi l i t y i n ot her

count r i es or cl uel ess as Ger man Fi nance Mi ni st er Wol f gangSchubl e undi pl omat i cal l y put i t . A howl of out r age about U. S.

monet ar y pol i cy f ol l owed f r om t he f i nance mi ni st r i es of ever y

emer gi ng market economy. The Br azi l i an Fi nance Mi ni st er , Gui do

Mant ega spoke of a new cur r ency war i nvol vi ng compet i t i ve

deval uat i on ( Fi nanci al Ti mes, 2010) . The Amer i can compl ai nt

t hat Chi na was del i ber at el y under - val ui ng i t s exchange rat e

l ooked out of pl ace as expansi onary Fed pol i cy may have f uel l ed

curr ency wars by weakeni ng t he dol l ar and pr ovi di ng cheap f unds

t hat woul d sur ge i n a wave of l endi ng t o f uel pot ent i al emer gi ng

market bond bubbl es. U. S. monetary pol i cy i s havi ng an i mpact

on emer gi ng market s. Low U. S. r ates are f uel i ng a new ver si on

of t he car r y t r ade, and set t i ng of f i nf l at i onar y booms i n east

Asi a whi ch ar e di f f i cul t t o cont r ol by convent i onal means. The

new U. S. pol i cy mi x i s l i kel y t o be i nt er pr et ed by some as a

r et ur n t o t he 1930s exper i ence, when t he U. S. t ur ned on i n

i t sel f , abandoni ng at t empt s t o st eer a gl obal economy.

The f ai l ure of cur r ency coor di nat i on whi ch woul d go agai nst

per cei ved sover ei gn i nt er est i s not sur pr i si ng f r om a pol i t i cal


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economy vi ewpoi nt , and t he l ogi c f or i t i n a r egi me of f l oat i ng

exchange r at es compar ed t o t he i nterwar gol d exchange st andar d

i s not compel l i ng i n t er ms of economi c t heory. Ther e wer e

si mi l ar f ai l ur es i n t he ear l y 1970s, af t er t he Smi t hsoni an

meet i ng t o determi ne a set of new exchange rat es, or i n t he mi d-

1980s, when at t empt s at coor di nat i on i n the Pl aza and Louvre

Fi nance Mi ni st er s meet i ngs i ncr eased r at her t han decr eased

f i nanci al i nst abi l i t y. The onl y maj or r eason t o wor r y about

such f ai l ur es t oday i s t hat f r ust r at i on about t he cur r ency

r egi me can t r ansl at e pot ent i al l y i nt o power f ul demands i n

par l i ament s and ot her r epr esent at i ve assembl i es f or t r ade

r et al i at i on as a r esponse t o a cur r ency war . So f ar , t hi s t r adecount er bl ast r emai ns a t opi c f or di scussi on r at her t han a

real i t y.

Mor eover , t he consequence of f ai l ur e of i nt er nat i onal

cooper at i on has not been near l y as negat i ve as i n t he 1930s,

because t here has as yet been no sudden r eversal of capi t al

f l ows. So f ar , i n t he af t er mat h of 2008, some smal l er debt or

count r i es have been obl i ged t o undert ake a sharp adj ust ment( Lat vi a moved f r om a cur r ent account def i ci t of 13. 1 per cent i n

2008 t o a 8. 6 per cent surpl us i n 2009, and Hungary f r om 7. 1

per cent t o + 0. 2 per cent ) ) . But t her e has been no r ever sal of

t he posi t i on of t he l ar gest debt or s, t he Uni t ed St at es or t he

Uni t ed Ki ngdom. Even t he Eur ozone pr obl em cases, Gr eece,

I r el and and Spai n cont i nues t o r un a subst ant i al cur r ent account

def i ci t , wi t h ( i ncreasi ngl y ner vous) f or ei gn i nvest or s st i l l

buyi ng government debt ( at a subst ant i al pr emi um) .

I n t he Gr eat Depr essi on, t he maj or i nt er nat i onal pol i cy

pr obl em l ay i n t he expor t of def l at i on by t he sur pl us count r i es,

France and t he U. S. Today s equi val ent t o France s


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st er i l i zat i on of gol d i nf l ows i n t he 1920s woul d be t he ar gument

t hat Chi na i s expor t i ng def l at i on t hr ough t he st er i l i zat i on of

f orei gn exchange pur chases. But t he other si de of t he moder n

st or y, t he cont i nued l ar ge def i ci t s of t he maj or def i ci t

economi es ( US, UK et c. ) do not paral l el t he dr amat i c adj ust ment

of t he 1930s. I n t he Gr eat Recessi on, i nst ead t he expor t of

i nf l at i on r ecal l s t he exper i ence of t he l at e 1960s and t he ear l y

1970s r ef l ect i ng t he exor bi t ant pri vi l ege ( i n t he event s t hat

produced t he breakdown t he par val ue or Br et t on Woods syst em) .

Agai n, t hi s 1970s anal ogy woul d poi nt t o the danger t hat

cur r ency uncer t ai nt y may l ead t o new t r ade pol i ci es.

Why Lessons are Pai nf ul

There ar e many l essons f r om t he Gr eat Depressi on t hat can

and shoul d be l ear nt i n r espect t o t he management of our curr ent

cr i si s; but t hey ar e of t en not as si mpl e or as easy as many

comment at or s bel i eve. The most i mpor t ant and most unprobl emat i c

l esson i s concer ned wi t h t he avoi dance of t he monet ary pol i cyer r or of not i nt er veni ng i n t he f ace of banki ng cr i ses. The

pol i ci es of t he maj or cent r al banks t he Feder al Reser ve, t he

Eur opean Cent r al Bank, t he Bank of Engl and suggest t hat t hi s

i s a l esson t hat has been i n t he mai n l earnt . However t he Fed

af t er expandi ng l i qui di t y i n t he f al l of 2007 t hen f ol l owed t oo

cont r act i onar y a pol i cy i n t he f i r st t hr ee quar t er s of 2008

whi ch may have exacerbat ed t he recessi on that began i n December

2007. Some maj or economi es, not abl y t he Uni t ed St at es and

Chi na, have al so embarked on l arge f i scal st i mul us progr ams

al t hough t he j ur y i s st i l l out on how ef f ect i ve t hey wer e . I n

t he Chi nese case, t her e i s an acut e danger of i nf l at i onar y


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over heat i ng; i n t he U. S. case, t her e i s t he f ear t hat t he f i scal

st i mul us wi l l si gni f i cant l y wor sen al r eady f undament al l y

unsust ai nabl e debt dynami cs.

Learni ng f r om t he Gr eat Depr essi on i n ot her ar eas i s muchhar der . A maj or f i nanci al col l apse has l ong- l ast i ng

consequences, whi ch cannot easi l y be r emoved. Bot h t he l esson

f r om t he Gr eat Depr essi on about t he sl owness and t he pai nf ul ness

of bank r econst r uct i on, and t he l esson about dependence on a

l ar ge ext er nal pr ovi der of capi t al , ar e unpal at abl e. Li mi t i ng

t he si ze of banks t hat ar e t oo bi g or t oo i nt er connect ed t o f ai l

i s a maj or pol i t i cal pr obl em, especi al l y as such i nst i t ut i ons

const i t ut e a power f ul l obbyi ng f or ce. The cur r ent s t r at egy of

guarant eei ng banks, but al so deposi t s and a br oad range of other

l i abi l i t i es, i s l i kel y t o encour age a f ur t her ext ensi on r at her

t han a r ol l - back of t he t oo- bi g- t o- f ai l doct r i ne. Bank r escues

have al so had a si gni f i cant i mpact on t he det er i or at i on of t he

f i scal posi t i on of many count r i es.

Tr ade i s another ar ea where maj or vul nerabi l i t i es wi l l

cont i nue. Cur r ency br eakdowns ar e of t en f ol l owed by t r ade

f i ght s. Monet ar y pol i cy i s not per cei ved any l onger as sol el y

pr omot i ng a st abl e measur e of val ue, but al so ( as i n t he

1930 s) as a t ool wi t h whi ch count r i es can f i ght each ot her f or

t r ade advant ages.

For a l ong t i me, i t was much easi er t o repeat t he soot hi ng

mant r a t hat col l ect i vel y t he wor l d communi t y has l earned how t o

avoi d a 1929- t ype of col l apse, and t hat t he wor l d s cent r al

banks i n 1987 or 2001 cl ear l y showed t hat t hey had l ear ned t he

r i ght l esson. I t i s undoubt edl y mer i t or i ous of gover nment s t o

st abi l i ze expect at i ons, and t o pr event a wor se spi r al i ng of


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cri si s. But pol i cy- maker s and t hei r advi ser s wi l l creat e

i nappr opr i ate expect at i ons when some si mpl e pol i cy pr oposal s are

bui l t up as t he basi s f or t he hope t hat t hey al one can guar ant ee

r ecover y. As bot h Eur ope and t he Uni t ed St at es ar e l i kel y t o

cont i nue t o have r at her anemi c r ecover i es, i t i s as i mpor t ant t o

t ake a sober and r eal i st i c appr oach t o t he unpal at abl e l essons

of t he Gr eat Depr essi on as i t i s t o cel ebr at e t he f undament al

poi nt t hat we do know more about monet ary pol i cy.


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Pet er F. Basi l e and Hugh Rockof f ( 2009) Money and I nt erest

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Bouchaud, J ean- Phi l i ppe ( 2010) , The Endogenous Dynbami cs of

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Eur opean Cent r al Bank, Cent r al Banki ng Conf erence, November 2010

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Kar l Br unner and Al l an H. Mel t zer ( 1968) Li qui di t y Tr aps f or

Money, Bank Cr edi t , and I nt er est Rat es. J our nal of Pol i t i cal

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Hal Col e and Lee Ohani an ( 2004) New Deal Pol i ci es and t he

Per si st ence of t he Gr eat Depr essi on: A Gener al Equi l i br i um

Anal ysi s. J our nal of Pol i t i cal Economy . August .

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Gaut i Egger t sson ( 2008) Gr eat Expect at i ons and the End of t he

Depr essi on Amer i can Economi c Revi ew Vol 94 ( 4) pp 1476- 1516.

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al er t

I MF ( 2009) Wor l d Economi c Out l ook ( Apr i l ) .

Mi l t on Fr i edman and Anna J Schwar t z ( 1963) A Monetary Hi st ory

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Turmoi l : an Assessment of Federal Reser ve Pr act i ce Bank ofJ apan Conf er ence. May.

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Recess i on. Federal Reserve Bank of Ri chmond Economi c Revi ew.

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Yasheng Huan ( 2008) Capi t al i sm wi t h Chi nese char act er i st i cs:

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Harol d J ames ( 1986) The German Sl ump: Pol i t i cs and Economi cs

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Har ol d J ames ( 2001) The End of Gl obal i zat i on: Lessons f r om t he

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At hanasi os Or phani des ( 2004) Monet ar y Pol i cy i n Def l at i on: The

Li qui di t y Tr ap i n Hi st or y and Pr act i ce Nor t h Amer i can J our nal

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Documents

Bordo the Great Depression Analogy