The Great Depression left many lessons for economists and policymakers, and the Great Recession shows there are many lessons yet be learned. (More)

Hall of Mirrors, Part VI: Lessons Learned and Yet to Be Learned (Non-Cynical Saturday)

For the past two weeks, Morning Feature has considered Barry Eichengreen’s Hall of Mirrors: The Great Depression, the Great Recession, and the Uses – and Misuses – of History. Last Thursday we began with the roots of the Great Depression. Last Friday we saw similarities, and differences, in the roots of the Great Recession. Last Saturday we explored how governments in the U.S. and Europe initially responded, or didn’t respond, to the Great Depression. This Thursday we saw why policy responses to the Great Recession were not as dramatic as those of the 1930s. Yesterday we explored how mistaken policies extended and deepened the Great Recession. Today we conclude with Dr. Eichengreen’s lessons and warnings for the future.

Barry Eichengreen is the Pardee Professor of Economics and Professor of Political Science at the University of California, Berkeley, where he has taught since 1987, and Pitt Professor of American History and Institutions, University of Cambridge, 2014-15. He is a Research Associate of the National Bureau of Economic Research (Cambridge, Massachusetts) and Research Fellow of the Centre for Economic Policy Research (London, England). He earned Masters degrees in Economics and History and his PhD in Economics at Yale University. Hall of Mirrors is his 21st book.

“A rich repository of analogies”

Dr. Eichengreen’s concluding chapter is, in one sense, an exposition on George Santayana’s famous quote:

Progress, far from consisting in change, depends on retentiveness. When change is absolute there remains no being to improve and no direction is set for possible improvement: and when experience is not retained, as among savages, infancy is perpetual. Those who cannot remember the past are condemned to repeat it.

Dr. Eichengreen opens his conclusion:

The historical past is a rich repository of analogies that shape perceptions and guide public policy decisions. Those analogies are especially influential in crises, when there is no time for reflection. They are particularly potent when so-called experts are unable to agree on a framework for careful analytic reasoning. They carry the most weight when there is a close correspondence between current events and an earlier historical episode. And they resonate most powerfully when an episode is a defining moment for a country and a society.

The U.S. and European housing and finance bubbles peaked in 2007 and by the fall of 2008 their collapse had triggered an economic crisis. Faced with delusional claims that this was merely a small market correction, others forecasting disaster, and still others preaching about moral hazard – “so-called experts … unable to agree on a framework for careful analysis” – policymakers turned to history.

Specifically, they looked to the lessons of the Great Depression, as distilled by economists and historians. The Wall Street Crash of October 1929 was turned into a worldwide depression by bad policy choices. Rather than letting markets seize up, central bankers should determine which banks had cash-flow crises and which were insolvent. The cash-strapped banks needed injections of money to weather the storm. Insolvent banks must be recapitalized or wound down.

And while businesses and families tighten their belts and then pay down debts, governments must spend money to take up the gap in demand, and expand the social safety net to care for the casualties. As Dr. Eichengreen writes:

Helping these less fortunate members of society is fair and just insofar as their suffering results from the malfunctioning of a system that operates disproportionately to the benefit of others. But such help is also required to maintain broad support for prevailing economic and political processes.

“The paradox is that we failed to do better”

During the autumn of 2008 and into 2009, central banks and governments in the U.S. and Europe proved they had learned those lessons. Interest rates were cut to near zero and the Fed and European central banks flooded the market with cash. Congress passed the $800-billion American Reinvestment and Recovery Act in February 2009. By that summer, a combination of tax cuts, aid to states, and infrastructure projects were already beginning to stem the contraction. The National Bureau of Economic Research, the official arbiter of such data, would later conclude that June 2009 was the last month of the GDP decline that began in December 2007, and the beginning of the recovery. As always, unemployment lagged GDP changes, peaking at 10% in October 2009. In contrast, during the Great Depression GDP fell each year from 1929-1932, and unemployment peaked at 25% in 1933.

“This at least was no Great Depression,” Dr. Eichengreen writes. But he continues:

The paradox is that we failed to do better. Unemployment in the advanced economies still rose to double-digit levels, not as high as in the Great Depression but higher than in normal recessions, and higher than anticipated by those taught to believe that economic science had cracked the problem of avoiding a Depression-like slump. Financial distress was more acute than expected by those taught to believe that central banks and regulators had learned how to prevent a 1930s-style crisis. Recovery was marred by slow growth, high unemployment, and a falling rate of labor force participation. It remained sluggish for longer than could be explained by the need for firms and households to work down excessive debts and banks to repair damaged balance sheets, alone.

“It resided mainly on the fringes of economics”

As we saw yesterday, Dr. Eichengreen argues that austerity – returning to ‘normal’ fiscal and monetary policies before the economy had returned to normal function – slowed the recovery. He also argues that the damage from 2007-2009 was worse than economists, policymakers, and pundits realized, and that even ideal policy choices could not have produced the quick rebound that too many expected. Comparing the Great Recession to the shorter downturns of the post-World War II era – and especially not to the mild ripples of the 1982-2007 Great Moderation – is one of the “misuses of history,” in Dr. Eichengreen’s phrase.

Indeed such “misuses of history” helped set the stage for the Great Recession:

In addition, a long period of stability born of good policy or good luck empowers those inclined to argue that regulation is too strict. A regulatory response to the Great Depression, which produced a tightly cosseted financial system and an extended period of stability, thus contained the seeds of its own destruction. Financiers could argue that since they had learned how to better manage risk, capital and liquidity requirements for financial institutions could be relaxed. Restrictions on cross-selling financial products could be removed. The heavy hand laid on financial markets in the 1930s could give way to light-touch regulation. The instability of financial markets and hence the dangers of light-touch regulation should have been another lesson of the Great Depression as distilled by economic and historical scholars. This view existed as well, but it resided mainly on the fringes of economics.

He argues that lesson lay at the fringes, in part, due to a glaring gap in the scholarship about the Great Depression. Economists studied at length how the 1929 Wall Street Crash grew into the Great Depression, but, he writes, “Explanations of the onset of the crisis were the least systematic and satisfactory part of the historical narrative.”

“Weakened the incentive to think deeply about causes”

That gap in understanding the root causes of debt bubbles and economic crises has not yet been closed. For example, conservative economists Michael Bordo and Christopher Meissner insist there is no causal relationship between rising income inequality and the debt bubbles that trigger economic crises. Debt bubbles, they argue, are caused by an overheated economy and low interest rates. But Jonathan Ostry and his colleagues at the International Monetary Fund Research Department present evidence that “lower inequality is robustly correlated with faster and more durable growth,” and German economists Till van Treeck and Simon Sturn conclude that “reducing inequality is crucial for more macroeconomic stability on a global scale.”

As part of that discussion, Dr. Eichengreen argues, U.S. and (especially) European leaders must change the dialogue on debt:

A balanced analysis would have observed that for every reckless borrower there is a reckless lender. It would have acknowledged that it was easier for one country to export its way out of trouble than for every Southern European country to do so. It was easier to conjure up an export miracle with the support of an accommodating monetary policy and a weak euro, as in Germany in the early 2000s, than now that the opposite conditions prevailed.

Nobel laureate Paul Krugman made the same point yesterday:

Like all too many crises, the new Greek crisis stems, ultimately, from political pandering. It’s the kind of thing that happens when politicians tell voters what they want to hear, make promises that can’t be fulfilled, and then can’t bring themselves to face reality and make the hard choices they’ve been pretending can be avoided.

I am, of course, talking about Angela Merkel, the German chancellor, and her colleagues.

It’s true that Greece got itself into trouble through irresponsible borrowing (although this irresponsible borrowing wouldn’t have been possible without equally irresponsible lending). And Greece has paid a terrible price for that irresponsibility. Looking forward, however, how much more can Greece take? Clearly, it can’t pay the debt in full; that’s obvious to anyone who has done the math.

Financiers routinely defend extravagant incomes by proclaiming themselves “risk-takers.” Yet now, as in the 1920s, those same financiers demand that policymakers backstop their risks by squeezing borrowers. The Greek government, like too many families seeking mortgages in the 2000s, was sold dicey loans with by lenders for whom “due diligence” was merely a buzz phrase. In a wild scramble for lending fees, too little attention was paid to whether borrowers could afford to repay loans. And when the borrowers could not, they were scolded for “recklessness” … while the “risk-taker” financiers demanded (and continue to demand) repayment in full.

As Dr. Eichengreen concludes:

Finally, that policymakers did just enough to prevent another Great Depression weakened the incentive to think deeply about causes. Having avoided financial collapse, it was still possible to defend America’s banking and financial system and Europe’s monetary union as the worst alternatives except for all the others (to paraphrase Winston Churchill on democracy). As a result, there was too little discussion of executive compensation practices, in the financial sector and generally, and their implications for financial stability. In the wake of the crisis, there was the short-lived Occupy Movement, which questioned the merits of financialization and warned of growing inequality. But there was no sustained discussion on the roots of these phenomena or their consequences. Inequality reflected the failure of society to provide the majority of its members with the education and training needed for a world of global competition. It reflected technical change that made it easier to substitute robots for workers. There was little willingness to address these problems or to acknowledge that the disappointing recovery from the crisis reflected not just the headwinds from deleveraging but also a long period of underinvestment in infrastructure, basic research, and education.
In many cases, addressing these problems would have required more government, not less. This was the response to the Great Depression, but it was not the response now. The irony was that policymakers, by preventing the kind of depression that brought about the New Deal, discouraged hard thinking on the role of government.

The question now is whether economists like Dr. Eichengreen and others can force that “hard thinking,” both in the academic community and among policymakers … or whether it will take another, even worse calamity to wake us up.


Happy Saturday!