A refresher on the 1930s
Sep 19th 1998
From The Economist print edition
With investors reeling and recession on the march, thoughts turn to the Great Depression. Could it happen again? Maybe, if governments try hard.
FROM a distance of more than 60 years, it should be possible to view the 1930s objectively. What went wrong, how things were handled and how they should have beenall this ought to be understood by now, you might think. If it were, lessons could be drawn to guide policymaking in difficult times such as these. Unfortunately, it isnt.
The centurys greatest economic minds have examined the subject without producing anything like a consensus. Still, enough is known to refute the folk-memory versionnamely, that the Depression started with the Wall Street crash of October 1929; that the slump persisted because policymakers just sat there; and that it took Roosevelts New Deal, heralding the modern era of enlightened activism, to put things right. Briefly, the Depression did not start with the stockmarket crash; American policymakers were not passive, they were incompetently active; and on balance the New Deal, far from ending the slump, most likely prolonged it.
At around the beginning of 1928 the Federal Reserve, worried about financial speculation and inflated stock prices, began raising interest rates. Industrial production turned down in the spring of 1929, and overall growth turned negative in the summer. A recession had started. In the two months before the Wall Street crash, industrial production fell at an annual rate of 20%. When the crash came, however, it was savage: stunning drops on October 24th, 28th and 29th, then a rally, then another fall. By mid-November the market had declined by a half.
Coming on top of a recession that had already begun, the crash set the scene for a severe contractionbut not for the decade-long slump that ensued. The key question about the Depression is why a bad downturn just kept getting worse, year after year, not just in the United States but around the globe.
In 1929 most of the world was on the gold standard. Allowed to work, this system should have helped stabilise the American economy. As demand there slowed, its imports fell, its balance of payments moved further into surplus andunder the ordinary rules of the gamegold should have flowed into the country, expanding the money supply and buoying the economy. But this mechanism was deliberately shut down by the Fed, which was still worried about the effect of easier credit on speculation. The inflow of gold was sterilised by the sale of government debt, and money grew tighter.
Abroad, meanwhile, outflows of gold had their customary effect of reducing the money supply and curbing demand. Governments everywhere then tried to reduce imports through tariffs, with America kicking things off with the Smoot-Hawley act of 1930. The effort was futile: the monetary pressure wasnt eased, and collapsing trade only added to the plight of industry. The Feds policy, together with Smoot-Hawley, had turned the gold standard into a global-recession machine.
There was worse to come. In 1930 American banks began failing. The Fed let them, again not out of neglect but as a deliberate act. Its policy was to insist on collateral before it would help out, but the kind it wanted (commercial bills) the banks didnt have. Before the Fed was created in 1913, the banks had had their own clearing-house arrangements for helping each other resist runs; now, with those arrangements all but defunct, the banks looked to the Fed to do the job, and nothing happened. As the crisis of confidence spread, more banks failed, and then more. By 1933 more than 11,000 of Americas 25,000 banks had failed. As people rushed to turn bank deposits into cash, the money supply collapsed.
So much for monetary policy. Fiscal policy was little better. Hoover notoriously raised taxes in 1932, to help balance the budget and restore confidence. But history has been unfair to Hoover, who tried to get the Fed to do more for the banks, and too generous to Roosevelt. His New Deal delivered no substantial fiscal stimulusRoosevelt, like Hoover, believed in balancing the budget. On the good side, it brought in bank-deposit insurance (a wise move, though not without problems). On the other hand, it piled taxes on business and sought to prevent excessive competition. To stop prices falling, controls were brought in, alongside other new and avowedly anti-business regulations.
In 1935 the economy was recoveringby now America was off the gold standard and the money supply was expanding againbut unemployment stayed up, partly because of the New Deal. In 1937-38 the economy moved into recession again. In 1939 the jobless rate was still 17%. It was the war, not the New Deal, that restored full employment in America.
A study of the 1930s offers rather little comfort in 1998. It shows how much damage bad policy can do, and how fragile economies can be. The policies of those years now seem grossly mistaken, but that was not obvious at the time, and every age has its own flawed orthodoxies. Indeed some rationales for bad policy in the 1930s have echoes in todays debatesthe need for fiscal austerity to restore confidence, the moral hazard argument against extending assistance to countries in financial distress, and so on. But the best cure of all for complacency is to reflect on the fact that banks, the crux of what went wrong in the 1930s, are still causing mayhem 60 years on, and regulators havent yet worked out what to do with them.