It Can Be Worse than the Great Depression

This is the worst global asset bubble and financial panic since the Great Depression of 1929–33. Still, almost all argue that it cannot become equally bad, because we have learned those lessons.

Analytically, that statement does not hold. True, our policymakers are not likely to repeat the same mistakes of the Great Depression, but they may commit other mistakes. Bank deposit insurance has come to stay for good, but not all advances represent progress, and many create new vulnerabilities.

One 1930s mistake was to defend exchange rates by all means. Today, most exchange rates float freely. Right now, we are seeing an unprecedented US dollar surge, which is not warranted by fundamentals but reflects a desperate search for a safe haven. The new hazard might be excessive and destabilizing exchange rate fluctuations caused by financial panic. If so, the major financial powers need to intervene to stabilize exchange rates.

Milton Friedman attacked the Fed for allowing the nominal monetary supply to contract sharply during the Depression, and John Maynard Keynes argued for more public expenditures through budget deficits, while the prevailing policy was budget surplus. The monetary expansion and budget deficits may become excessive this time.

Deficit spending and monetary expansion are supposed to boost demand, but people spend less in a financial panic, rendering increased public expenditures rather ineffective. We learned the limitation of Keynesianism in the 1970s. In recent decades, some former communist and Latin American countries have shown how the expansion of public expenditure beyond the permissible can lead to state default.

In the 1930s, states did not go bankrupt, fearful of the consequences of those who had done so in the wake of the First World War.

Now, major states, such as Italy, have public debt of more than 100 percent of GDP even before the crisis, rendering major state bankruptcies a real danger. Fiscal and monetary stimulation are needed and deflation must be avoided, but currently fiscal considerations are disregarded altogether, which is a recipe for disaster. State default can easily lead to hyperinflation, which is far worse than deflation.

The global financial system is so much deeper and more sophisticated than in the 1920s, but that is a problem. The 1920s had its version of subprime loans, but it did not have nontransparent collateralized debt obligations. The many derivatives have created the mother of all bubbles. The deeper the financial system, the harder we may fall.

Although the Great Depression had worldwide reach, it largely emanated from two countries, the United States and Germany. Never before has the world seen such a monstrous and truly global bubble. The real estate bubble is probably worst in the Persian Gulf and Moscow, while also extreme in Britain, Spain, and Ireland.

Never have big financial institutions been as overleveraged as Fannie Mae and Freddie Mac or the former US investment banks, not to mention the hedge funds. The excessive leverage is now being unwound by financial panic, apart from what is countered with recapitalization.

The 1930s protectionism must not be repeated, but frozen finances have already left countries such as Iceland and Ukraine temporarily outside of the world financial system. Such exclusion must not be allowed to become permanent.

In the 1920s, both the US dollar and gold were unchallenged sources of value. Today, the US dollar is neither stable nor an uncontested world currency. At 10, the euro is too young to be a debutant, and the biggest question is will it hold together in this rough financial weather, especially if one or several euro countries default.

Everybody from Milton Friedman to John Kenneth Galbraith has criticized the Federal Reserve and US President Herbert Hoover for their policies during the Depression, but at least they were policymakers and stood for principles. As if to illustrate their impotence, President George W. Bush is assembling the political leaders of the group of 20 large countries for a photo opportunity in Washington on November 15.

Their failure to come up with anything but vanity could unleash untold financial panic. This crisis envelops the whole world, but global financial governance is missing.

Finally, the 1920s had neither television nor the internet. Information, decisions, and implementation can now be carried out in seconds, which harms the quality of decisions and nerves. Transparency is usually preferable, but unmitigated speed might be harmful. CNBC and Bloomberg can spread worldwide panic instantly.

We must not repeat the mistakes of the Great Depression, but we need to ascertain that new policies are not even worse.


Originally published at Financial Times and reproduced at the Peterson Institute’s web site and here with the author’s permission.

12 Responses to "It Can Be Worse than the Great Depression"

  1. devils advocate   November 7, 2008 at 2:36 pm

    Dr. Aslundglobal financial/economic stability requires global financial/economic coordinationhow to achieve this is the crucial questionhow much time is left to set up the New International Order?

    • devils advocate   November 7, 2008 at 2:48 pm

      just after I posted, I read that less than an hour ago, EU leaders are pushing for the New order within 100 days——————the time is fleeing — the president-elect of the USA is 3 months away from power-question: are “they” looking to push “their” agenda NOW before the new President takes power?I believe so – what is your opinion?

      • gmermer   November 7, 2008 at 5:08 pm

        I think they just see that the situation is terrible and want to do something. Today Hungary’s credit rating is lowered and it is negative now. Even the backing of IMF couldn’t help Hungary in its downward spiral… And you know who is next; other eastern european countries like Romania that has let banks give loans to anyone who wanted in Euros and Swiss Franks. Now that the crisis depreciated these countries’ currencies, many of those loans are simply junk! Even IMF’s money will not be enough to bail out many economies. So probably Europeans are meeting to discuss how to get Arab’s and Chinese involved in the losers’ game…

        • Guest   November 8, 2008 at 6:48 am

          Today Hungary’s credit rating is lowered and it is negative now.

          Funny that US of A’s credit rating has not been lowered?

      • Guest   November 8, 2008 at 10:05 am

        not directed to me but there is no question this is EU’s opportunity whilst there is a vacuum in the US. Note that yesterday during his press conference that Obama kept arms length from this mess and will do so for the next 73 days – Sarkozy is a formidable player and I expect by the time Obama takes over that if the EU has framework in place, that things will be so bad that Obama will be boxed in. Check(mate)

  2. Dave   November 8, 2008 at 1:51 am

    The problem is the debt based monetary system that was foisted upon this country and the world by the introduction of the artificial system of credit and bank notes as legal tender.The current schemes and attempts to cure the problems of wrongly extended credit and resulting bad debt with more debt is not a solution, it is a deferment of the problem and the ultimate solution. The bailouts and the Fed acting as lender of last resort, is based upon additional lending, more debt.“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” –Ludwig von MisesPerhaps a return to a stable system should be considered instead.http://www.safehaven.com/article-11769.htmMonetary Reform: Gold And Bills Of Exchange by Antal E. FeketeAddress before the Civil Society Institute at Santa Clara UniversityNovember 3, 2008The Great Depression of the 1930’s was not due to the ‘contractionist propensities’ of the gold standard as alleged by John M. Keynes. Nor was it due to fractional reserve banking as alleged by Murray Rothbard. Rather, it was due to the government’s sabotaging the clearing system of the international gold standard, the bill market.Adam Smith’s Real Bills Doctrine reigned supreme in monetary science throughout the 19th century, and rightfully so. …

  3. Guest   November 8, 2008 at 6:20 am

    Governments lowering reserve interest rates is just another swindle – pay nothing for the money they borrow. If people don’t have to pay for the use of money then you get no growth of capital only growth of debt.

  4. Guest   November 8, 2008 at 6:22 am

    p.s. Which ends up as bad debt.

    • devils advocate   November 9, 2008 at 3:46 pm

      the least worthy banks will lend to the least worthy borrowers

  5. Anonymous   November 14, 2008 at 8:41 am

    Below is a good article on what’s going on.http://dows.com/documents/MarketLetter_Fall2008.pdf http://www.dows.com/articles.htm

  6. GUY FOX in Havana c/o: R.R.R. Key West/Tampa Bay   November 14, 2008 at 10:10 pm

    Derivatives? Collateral debt obligations? Credit default $waps? There is 1250 quadrillion dollars of bad paper floating around out there.We are at the incipience of bedlam and anarchy due to the lack of proper regulation of free market $ystems. A free market without proper regulation is ruthless and heartless… and it invites perfidy and corruption. It is a beast fueled by grrreeeeed!Allow me to give the following two caveats.1. BEWARE! WHOM THE GODS WOULD DESTROY, THEY FIRST MAKE MAD! And there is much madness in the land. I rest my case with the re-$ellection of George W. Bush in 2004. Old Coyote Knose that Bush is a dry drunk $ociopath. A full blown criminal. President Cheney is even worse.2. WHERE THERE IS NO INSIGHT, THE PEOPLE PERISH!Good luck! You’re going to need it

  7. James   November 17, 2008 at 9:27 am

    There must be something seriously wrong with the financial markets when it seems that every ten years or so the markets are allowed to create another disaster and government once again must go to the rescue??? The problem is that the 10 year crisis continues to grow further each time around, those responsible undersetimating the domestic, and now the international consequenses. Besides having faltered in proper “risk management”, overleveraging, credit markets, hedging, commodities bookmaking, does anyone spend any time thinking about the “NATIONAL SECURITY IMPLICATIONS” to our country.??? To witness what is currently happening in our financial institutions, and cascading into all sectors of Corporate America is mind boggling. While it may be in the world’s best interest (those with lots and lots of dollars) to have a multitude of global markets providing safe havens, and new opportunities to allow these to embark in new financial concoctions, this may not be in the interest of the common mainstreet investor nor to the country that may ultimately have to assume the responsibility for imprudent behavior in these markets, by market makers. It should not be surprising to all those working in the economic and financial sectors to realize that the common folk has been exposed to a once in a life time shocker, that these folks have awoken and are asking where is their money, where has ten trillion dollars disappeared too???