QE2 and History

In my previous post, I wrote that the case for a second round of quantitative easing (QE2) is warranted, given the current economic climate. Why should we expect QE2 to help more than it hurts? The answer is based in part on interpreting recommendations by Milton Friedman in the late-1990s regarding Japan’s struggle with deflation as it relates to current conditions. Of course, Japan never really conquered its deflationary problems, but that’s due in no small degree to the fact that Japan never really embraced Friedman’s advice wholeheartedly. Without going into detail here, let’s just say that Japan’s focus was on price stability rather than engineering a dose of inflation to correct for the deflationary bite. The distinction was and remains a critical factor for assessing what’s happened in the Japanese economy, and why, ever since.

We can also look to the history of U.S. policy in the 1930s for additional support for thinking that QE2 is warranted in the here and now. Let’s start by noting that there was a dramatic change in the fortunes of the U.S. economy in March 1933. A fair amount of analysis by economic historians over the years offers compelling evidence for identifying the catalyst for the economic rebound starting in March 1933 to what might now be called quantitative easing.

Consider the chart below, which shows the trend in U.S. industrial production in the early 1930s. For nearly three years in the thirties, the Great Depression squeezed the economy, as indicated by a virtually non-stop drop in industrial production, which was cut roughly in half between between early 1930 and mid-1932. Although the trend stabilized in the second half of 1932 and early 1933, there was no rebound of significance…until the spring of 1933.


As the chart above illustrates, there was a dramatic rise in industrial production starting in March 1933. In fact, the sharp increase in industrial activity was tied to the U.S. government’s abandonment of the gold standard. Why is that relevant? The short answer, as economist Barry Eichengreen explains in Golden Fetters: The Gold Standard and the Great Depression, 1919-1939ir?t=thecapitalspe-20&l=as2&o=1&a=0195101138, is that the gold standard, contrary to popular perception, “was the principal threat to financial stability and economic prosperity between the wars [World Wars I and II].” How so? The gold standard effectively forced tight money on the economy at a time when the opposite was needed.

Eichengreen doesn’t reach that conclusion casually. Indeed, he spends the better part of his 1992 book (along with a number of additional research studies and commentaries in subsequent years) reviewing the evidence in support of his thesis.

Eichengreen is in good company. Milton Friedman and Anna Schwartz offer a similar view in their monumental A Monetary History of the United States, 1867-1960ir?t=thecapitalspe-20&l=as2&o=1&a=0691003548 (or in the condensed version: The Great Contraction, 1929-1933ir?t=thecapitalspe-20&l=as2&o=1&a=0691137943).

Economist Scott Sumner has also written extensively on the causes and consequences of the Great Depression. On his blog from earlier this year he writes:

When FDR took office in early March 1933 we were in the midst of the worst banking panic in American history. Some states had already shutdown their entire banking system and FDR was about to close all of America’s banks. Yes, the contraction ended in March 1933, but only because FDR made it end with the most expansionary monetary policy in American history—which caused both prices and output to rise rapidly in the months immediately after March 1933.

Sumner is no idle observer making outlandish claims. Rather, here is an economist who for years has studied the finer points of what happened in the thirties. Among his more detailed essays on this point in history are those here and here, for instance. Sumner’s basic point: there was a strong case for quantitative easing then, and now.

Okay, but if quantitative easing is so compelling, why did the rebound in industrial production after March 1933 falter later that year? Eichengreen explains in Golden Fetters: “The recovery of American output was not more sustained because the stimulus lent by policy was so limited. While authorizing the Treasury to intervene with purchases of gold on the international market, Roosevelt could not compel the Fed to support his action with extensive purchases of government securities designed to increase the money supply.”

In other words, there wasn’t a sufficiently strong and sustained application of quantitative easing in the second half of 1933 and beyond. Yes, that sounds a lot like what’s happening these days re: the arguments against QE2.

The attacks on QE2 may be misguided, but they’re not surprising. Liquat Ahamed, writing in Lords of Finance: The Bankers Who Broke the Worldir?t=thecapitalspe-20&l=as2&o=1&a=B002WTC8UC, a popular economic history of the events that created the Great Depression, observes:

Roosevelt’s decision to take the dollar off gold rocked the financial world. Most people could not understand why a country with the largest gold reserves in the world should have to devalue. It seemed so perverse. Indignant bankers lamented the loss of the one anchor that could keep the government honest…

But in the days after the Roosevelt decision, as the dollar fell against gold, the stock market soared by 15 percent. Financial markets gave the move an overwhelming vote of confidence. Even the Morgan bankers, historically among the most staunch defenders of the gold standard, could not resist cheering. “Your action in going off gold saved the country from complete collapse,” wrote Russell Leffingwell to the president.

The situation in 2010 is different from 1933, of course. Different, but with parallels. Every economic crisis is different, but history can teach us a few things…if we listen. But the danger of making the same mistakes is always lurking.

Yes, QE2 carries many risks. But we have to deal with the pressing threats as they arrive, and worrying about runaway inflation today is premature, and perhaps more than a little dangerous. The day for fighting that battle will come. But not now. 

Originally published at The Capital Spectator and reproduced here with the author’s permission.