THE GREAT DEPRESSION‘S “LESSONS” ARE NO ROADMAP

Dr. DANIEL KALT
HEAD MACRO & FIXED INCOME – EUROPE UBS WEALTH MANAGEMENT RESEARCH

The Great Depression is probably the most discussed and written about episode of modern economic history. Despite a few dissenting voices, economists can offer some rather compelling explanations about why it happened and why it lasted so long. What is much less well understood, though, is exactly what finally brought the US economy back to life. Was it the result of policy, or politics, or providence? In other words, economists have a good idea about what governments should do to avoid an economic depression. But they can offer far less certainty about how to get out of a depression once it occurs.
In his distinguished academic career, Federal Reserve Chairman, Ben Bernanke, intensively studied the origins of the Great Depression. According to most economists, and to Bernanke, there were two main causes.
First, as argued by Milton Friedman and Anna J. Schwartz in their pivotal study, A Monetary History of the United States, the Great Depression was induced by a severe monetary contraction that was the consequence of poor policy decisions by the Federal Reserve. In a speech honoring Friedman on his 90th birthday in 2002, then-Fed Governor Bernanke apologized: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
The Depression’s second main cause – and here Bernanke has made some lasting scholarly contributions – were the bank runs that started in 1930 and lasted until 1933. These runs, unchecked by the Fed and the US Government, severely disrupted the credit supply and turned a nasty recession into a full-blown depression.
The first factor, too little money in circulation, explains why the Fed and other central banks have slashed their interest rates, in some cases to zero, and why they are willing to take other unorthodox measures to ensure that enough money is created. The second factor, broken lenders and credit lines, explains why governments around the world are bailing out financial institutions. The failure of Lehman Brothers last year was a scary reminder that bank runs are not a thing of the past.
Popular history offers one explanation of how the Great Depression came to an end: with his New Deal fiscal activism, President Franklin Roosevelt’s big spending programs managed to kick-start the US economy back to life by 1933–34. In The General Theory of Employment, Interest and Money, the British economist John Maynard Keynes provided the the-oretical underpinnings for the fiscal “magic bullet”, albeit somewhat belatedly, in 1936. But this explanation may be a bit too simple. Christina Romer, a well-known economic historian and the new Chairwoman of the Council of Economic Advisers in the Obama administration, argued in a widely cited article published in 1992 that fiscal policy played only a minor role in escaping from the Depression. In her view, first and foremost, if not exclusively, the swelling money supply that followed the end of the gold standard and the dollar devaluation was in fact the engine of recovery between 1933 and 1942.
Acknowledging this well-argued view suggests that the current debate raging globally about the size, forms and durations of fiscal stimulus misses the point. For sure, expansionary fiscal policy – be it in the form of built-in automatic stabilizers or discretionary spending programs – has its role to play, in bringing the current downward spiraling in economic activity to a halt. But central banks decisively turning to unorthodox methods of quantitative easing may well prove to be the more effective reflation measure for the world economy. Some central banks, such as the Federal Reserve, the Bank of England or the Bank of Japan have clearly shown their commitment to follow this path.
Yet, the risks involved to longer-term price stability using massive monetary expansion are not to be neglected. It will be a tightrope walk for central bankers to mop up liquidity early and fast enough in order to prevent an inflationary surge, once the economy starts to rebound. On the other hand, by pulling the plug too early central banks may run the risk of chocking an early recovery in an environment which is likely to be very fragile anyway. And last but not least it will be a fight against political pressures to tolerate substantially higher inflation rates as governments may be tempted to opt for structurally higher inflation to reduce the burden of their ballooning government debt.