What’s the difference between a financial crisis and a Depression? At least initially, the symptoms appear similar. Banks won’t lend to one another, even overnight. Strong and respected businesses cannot borrow short-term money in the commercial paper market even though their default rates are negligible.
The banking systems in many countries have ceased functioning and required major government intervention. It is like a patient experiencing multiple organ failure because the basic circulatory system has gone kaput. Despite urgent measures, the patient appears unresponsive.
Yes, it’s that bad … but is it the beginning of another Great Depression?
That question has been posed repeatedly–and often feverishly–over the past several weeks. The answer–and I don’t mean to be theatrical–is “No … but …” So first, let’s talk about the “no,” and then we’ll come back to the “but.”
The current situation in the U.S. economy is not even slightly good. The financial crisis is global, and real. Nevertheless, the impact on the “real” U.S. economy is not yet dire. To date, more than 700,000 jobs have been lost, and we can expect more, but some perspective is in order.
The losses to date represent less than .5% of the work force. In the relatively mild recession of 2001 to 2002, job losses equaled about 1% of the work force. In the much more severe recession of 1981 to 1982, job losses totaled nearly 3% of the labor force–six times today’s figure. And in the (truly) Great Depression–invoked, now, with an alarmist frequency–job losses between 1929 and the trough in 1933 were 21% of the labor force; and by 1939, total employment remained 13% below 1929 levels.
Output in the Eurozone economies, as well as Britain, Japan and others, is shrinking; but measured output in the U.S. has yet to decline in the current slowdown. I believe it will shrink, but in the Great Depression, real output shrank by 38% between 1929 and 1933 and remained well below trend for a decade.
Evidently, we are a long way from a Great Depression.
Now, given the amount of hand wringing that is going on, some of you will assume that I’m channeling Mr. Micawber, one of literature’s most hapless optimists. The situation is serious, and something has to be done. Unlike Mr. Micawber, I don’t expect that “something will turn up.”
Rather, I want to ask the more important question: What do we know about the road that leads from a financial crisis to a severe and prolonged downturn–and how can we avoid it?
The American Great Depression of the 1930s is the most familiar–and most studied–economic collapse, but it is important to know that it is not the only one. Other countries suffered prolonged downturns in the 1930s, and many, including Japan, Mexico, Chile, Argentina, Brazil, New Zealand, Switzerland and Finland have experienced prolonged episodes of below-trend output in the period since the Great Depression.
The book Great Depressions of the Twentieth Century, edited by Timothy Kehoe and Edward C. Prescott, contains studies of depressions in 14 countries. Harold Cole and Lee Ohanian have done the most in-depth recent research on the American Great Depression, as well as the long decline in the U.K. economy. There is also a terrific book by Amity Shlaes, The Forgotten Man, which reexamines the roots of the Depression.
With all of this scholarship, what do we know about why depressions–whether in upper, or lower, case–occur?
Not surprisingly, there isn’t one story that fits all of them, but there’s a common theme that emerges: It is that unwise policy choices made in the throes of a crisis exacerbate and prolong the real downturn associated with the crisis. In particular, government policies that affect productivity and hours of work are most often responsible for throttling economic growth.
That this was true in our Great Depression is now clear. While earlier historians focused attention on the failures of monetary policy, and on the distortions caused by the Hawley-Smoot tariffs, evidence now points more strongly to policies that tried to keep wages artificially high (under Hoover and then Roosevelt) and to cartelize industry (under Roosevelt).
OK, now here’s the “but” part: Policies matter. Roosevelt was viewed as a great activist leader during the Depression. In fact, he was a great experimenter, willing to try one thing, then another, to turn the country around. The result was an economic downturn that lasted for many years longer than it might have.
For many decades following the Great Depression, conventional historians viewed the crash as a failure caused by laissez-faire policies, rampant speculation and the incompetence of people like Hoover and Andrew Mellon. They attributed the subsequent recovery to the inspired leadership of Roosevelt and to the role of the government in directing economic activity. We are beginning to hear these rumblings again, along with rhetoric that is hostile to trade, globalization and immigration, not to mention a mounting distrust of markets.
These are easy populist positions to adopt, but they are dangerous and false–even dangerously false–because policies matter. They matter deeply, and once adopted, it is extremely hard for the country to change course. Can the current leadership in Washington right the ship enough to forestall a head-long rush into a catastrophic storm? This writer is optimistic–guardedly–that good sense will prevail. But he is not, as yet, a Micawber.
Originally published at Stern on Finance blog and reproduced here with the author’s permission.