Wednesday, March 18, 2009

Lessons from the Great Depression

These lessons from the Great Depression are very relevant for the current economic situation.

1. Credit Bubbles can be Very Damaging.

In the 1920s, the US economy expanded rapidly on the basis of cheap credit, rising money supply and an exuberance bordering on overconfidence. It led to consumers buying large quantities on credit and a booming stock market. By 1928, the US economy was heavily unbalanced with over inflated asset and share prices. (At least one lesson we didn't learn from)

2. Deflation can Devastate Economic Growth.

From 1929, to 1933, in the US the money supply fell by 35%. Prices fell by 33%. This deflation was caused by bank collapses, restriction in lending and adherence to the gold standard. The effects of deflation have widely been shown to be very damaging to the economy.
  • Debt Inflation. Falling prices and wages increase the real value of debt. This makes it harder for people to pay off their debt repayments reducing consumer spending. This rising debt burden was exacerbated by the number of American consumers who had bought expensive items on credit with short repayment periods.
  • Real Interest Rates Very High. With falling prices, real interest rates were very high, reducing investment.
  • Real Wages become too high. Hoover actually tried to bolster the power of labour to set higher wages. But, with falling prices, firms couldn't afford the labour.
(Through zero interest rates and quantitative easing, UK and US central banks have shown they are taking this threat of deflation very seriously)

3. Depressions should not be Seen as a form of Penitence.

In the Great Depression there was a widespread feeling that somehow the depression was a necessary penance for the excesses of the 1920s. In the early stages of the great depression, Treasury Secretary Andrew Mellon, who advised President Hoover told him to:
“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.... It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people” (Hoover, 1952).
To some extent an unsustainable boom is going to cause a painful period of correction. But, this doesn't mean that the depth of the depression was inevitable. This attitude encouraged a hands off approach to the depression. H.Hoover in his memoires claimed that if only Roosevelt had continued his policies the depression would have been resolved. But, Hoover had 3 years of failed policies which had seen industrial output fall by 33%. It is hard to see how he could have done a worse job.

4. Don't Let Banks Fail.

The Wall Street Crash precipitated many problems, but in 1930, there was no certainty the economic downturn had to develop into a full blow depression. One of the most damaging events was the widespread failure of medium sized American banks - with the Federal Reserve unable or unwilling to act as lender of last resort. The widespread bank failure caused a decline in the money supply and loss of confidence in banking sector - investment fell drastically.

5. Avoid Protectionism and 'Beggar My Neighbour'

The infamous Smoot-Hawley Tariff tariffs of 1930 were designed to protect American jobs by raising tariffs on imports. The consequence is that it led to a global rise in tariffs, reducing trade and exacerbating the global recession. Trade slumped apart from areas of trade preference like within the British Empire. (there are powerful protectionist impulses which will take political courage to avoid) See: Beggar my my neighbour

6. Don't Balance the Budget in a Depression.

The neo-classical response to the depression was to attempt to balance the budget. In the 1931 UK budget, the Labour party was split as Ramsey McDonald followed treasury advice to increase taxes and cut unemployment benefits. This contributed to a further fall in aggregate demand, lower growth and ironically required higher borrowing. In 1932, Hoover increased the top rate of income tax from 24% to 63% in an effort to pay for his modest spending commitments. (thankfully the Republicans lost the US elections. Republican leaders have been calling for a balanced budget). More worryingly the 50 US states have been forced to cut spending to meet legal requirements for state budgets.

7. Fiscal Policy does Help.

Between 1929 and 1931, Japanese GDP fell by 8%. The Japanese Finance Minister Takahashi Korekiyo oversaw a genuine period of expansionary fiscal policy financed by government borrowing. This led to a remarkable turnaround in the Japanese economy; it became one of the first economies to experience lasting recovery.

People often point to the Roosevelt's New Deal as evidence of failed Fiscal Policy. But, the problem with Roosevelt is that he was actually reluctant to finance the New Deal by government borrowing. He wanted to raise taxes to finance it. In 1937, the US made an attempt to balance the budget, this harmed the recovery and was one factor in creating a recession within the depression (37-38).

8. Government Borrowing is not the End of the World.

People assume government borrowing is very damaging. But, in a depression, government borrowing helps to offset the rise in private sector spending. The US was reluctant to borrow until the start of the second world war, when national debt rose to 125% of GDP. It was only then unemployment fell to pre 1929 levels.

9. The Gold Standard was Very Damaging

The Gold standards forced countries to peg their exchange rate at a certain level. In the UK this cause deflationary pressure as the UK lost gold reserves and rejoined at a rate too high. Often countries who left the gold standard were able to recover. E.g. UK recovered after leaving in 1931, the US recovery was delayed until 1933 after leaving. The Netherlands experienced one of the longest economic depressions until it finally left the gold standard in 1936. It was a similar situation for France and Poland

10. Government Intervention doesn't mean micro management of industries.

The New deal was heavy on regulations for industry. The power of labour was increased (e.g. National labour Relations Act1935 - also known as Wagner Act) This led to an rise in strikes and poor industrial relations. Governments set prices for many industries. People were even jailed for selling suits at the wrong price. Keynes didn't advocate this kind of government intervention. He argued the government's main job was to boost demand by government borrowing. This doesn't require a command economy with many fiddly regulations.

11. The Human Cost of Great Depression

After finding the photos for the great depression. I was struck at one obvious lesson from the Great Depression - the human cost. Just read Road to Wigan Pier by George Orwell or J.Steinbeck's classics of this period

Tomorrow - Myths of Great Depression

Further Reading

Photographs from the Franklin D. Roosevelt Library, courtesy of the National Archives and Records Administration.

No comments: