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Great Depression

by Gene Smiley

http://www.econlib.org/library/Enc/GreatDepression.html

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A worldwide depression struck countries with market economies at the end of the 1920s.

Although the Great Depression was relatively mild in some countries, it was severe in others,

particularly in the United States, where, at its nadir in 1933, 25 percent of all workers and 37

percent of all nonfarm workers were completely out of work. Some people starved; many others

lost their farms and homes. Homeless vagabonds sneaked aboard the freight trains that crossed

the nation. Dispossessed cotton farmers, the ―Okies,‖ stuffed their possessions into dilapidated

Model Ts and migrated to California in the false hope that the posters about plentiful jobs were

true. Although the U.S. economy began to recover in the second quarter of 1933, the recovery

largely stalled for most of 1934 and 1935. A more vigorous recovery commenced in late 1935

and continued into 1937, when a new depression occurred. The American economy had yet to

fully recover from the Great Depression when the United States was drawn into World War II in

December 1941. Because of this agonizingly slow recovery, the entire decade of the 1930s in the

United States is often referred to as the Great Depression.

The Great Depression is often called a ―defining moment‖ in the twentieth-century history of the

United States. Its most lasting effect was a transformation of the role of the federal government

in the economy. The long contraction and painfully slow recovery led many in the American

POPULATION to accept and even call for a vastly expanded role for government, though most

businesses resented the growing federal control of their activities. The federal government took

over responsibility for the elderly population with the creation of SOCIAL SECURITY and gave the

involuntarily unemployed UNEMPLOYMENT compensation. The Wagner Act dramatically

changed labor negotiations between employers and employees by promoting unions and acting

as an arbiter to ensure ―fair‖ labor contract negotiations. All of this required an increase in the

size of the federal government. During the 1920s, there were, on average, about 553,000 paid

civilian employees of the federal government. By 1939 there were 953,891 paid civilian

employees, and there were 1,042,420 in 1940. In 1928 and 1929, federal receipts on the

administrative budget (the administrative budget excludes any amounts received for or spent

from trust funds and any amounts borrowed or used to pay down the debt) averaged 3.80 percent

of GNP while expenditures averaged 3.04 percent of GNP. In 1939, federal receipts were 5.50

percent of GNP, while federal expenditures had tripled to 9.77 percent of GNP. These figures

provide an indication of the vast expansion of the federal government‘s role during the depressed

1930s.

The Great Depression also changed economic thinking. Because many economists and others

blamed the depression on inadequate demand, the Keynesian view that government could and

should stabilize demand to prevent future depressions became the dominant view in the

economics profession for at least the next forty years. Although an increasing number of

economists have come to doubt this view, the general public still accepts it.

Interestingly, given the importance of the Great Depression in the development of economic

thinking and economic policy, economists do not completely agree on what caused it. Recent

research by Peter Temin, Barry Eichengreen, David Glasner, Ben Bernanke, and others has led

to an emerging consensus on why the contraction began in 1928 and 1929. There is less

agreement on why the contraction phase was longer and more severe in some countries and why

the depression lasted so long in some countries, particularly the United States.

The Great Depression that began at the end of the 1920s was a worldwide phenomenon. By

1928, Germany, Brazil, and the economies of Southeast Asia were depressed. By early 1929, the

economies of Poland, Argentina, and Canada were contracting, and the U.S. economy followed

in the middle of 1929. As Temin, Eichengreen, and others have shown, the larger factor that tied

these countries together was the international GOLD STANDARD.

By 1914, most developed countries had adopted the gold standard with a fixed exchange rate

between the national currency and gold—and therefore between national currencies. In World

War I, European nations went off the gold standard to print money, and the resulting price

INFLATION drove large amounts of the world‘s gold to banks in the United States. The United

States remained on the gold standard without altering the gold value of the dollar. Investors and

others who held gold sent their gold to the United States, where gold maintained its value as a

safe and sound INVESTMENT. At the end of World War I, a few countries, most notably the

United States, continued on the gold standard while others temporarily adopted floating

exchange rates. The world‘s international finance center had shifted from London to New York

City, and the British were anxious to regain their old status. Some countries pledged to return to

the gold standard with devalued currencies, while others followed the British lead and aimed to

return to gold at prewar exchange rates.

This was not possible, however. Too much money had been created during the war to allow a

return to the gold standard without either large currency devaluations or price deflations. In

addition, the U.S. gold stock had doubled to about 40 percent of the world‘s monetary gold.

There simply was not enough monetary gold in the rest of the world to support the countries‘

currencies at the existing exchange rates. As a result, the leading nations established a gold

exchange system whereby the governments of the United States and Great Britain would be

willing, at all times, to redeem the dollar and the pound for gold, and other countries would hold

much of their international reserves in British pounds or U.S. dollars.

The demand for gold increased as countries returned to the gold standard. Because the franc was

undervalued when France returned to the gold standard in June 1928, France began to receive

gold inflows. The undervalued franc made French exports less expensive in foreign countries‘

currencies and made foreign imports into France more expensive in francs. As French exports

rose and French imports fell, their international accounts were balanced by gold shipped to

France. France‘s government, contrary to the tenets of the gold standard, did not use these

inflows to expand its MONEY SUPPLY. In 1928, the FEDERAL RESERVE SYSTEM raised its discount

rate—that is, the rate it charged on loans to member banks—in order to raise INTEREST RATES in

the United States, which would stem the outflow of American gold and dampen the booming

STOCK MARKET. As a result, the United States began to receive shipments of gold. By 1929, as

countries around the world lost gold to France and the United States, these countries‘

governments initiated deflationary policies to stem their gold outflows and remain on the gold

standard. These deflationary policies were designed to restrict economic activity and reduce

price levels, and that is exactly what they did. Thus began the worldwide Great Depression.

The onset of the contraction led to the end of the stockmarket boom and the crash in late October

1929. However, the stock market collapse did not cause the depression; nor can it explain the

extraordinary length and depth of the American contraction. In most countries, such as Britain,

France, Canada, the Netherlands, and the Nordic countries, the depression was less severe and

shorter, often ending by 1931. Those countries did not have the banking and financial crises that

the United States did, and most left the gold standard earlier than the United States did. In the

United States, in contrast, the contraction continued for four years from the summer of 1929

through the first quarter of 1933. During that time real GNP fell 30.5 percent, wholesale prices

fell 30.8 percent, and consumer prices fell 24.4 percent.

In previous depressions, wage rates typically fell 9-10 percent during a one- to two-year

contraction; these falling wages made it possible for more workers than otherwise to keep their

jobs. However, in the Great Depression, manufacturing firms kept wage rates nearly constant

into 1931, something commentators considered quite unusual. With falling prices and constant

wage rates, real hourly wages rose sharply in 1930 and 1931. Though some spreading of work

did occur, firms primarily laid off workers. As a result, unemployment began to soar amid

plummeting production, particularly in the durable manufacturing sector, where production fell

36 percent between the end of 1929 and the end of 1930 and then fell another 36 percent

between the end of 1930 and the end of 1931.

Why had wages not fallen as they had in previous contractions? One reason was that President

Herbert Hoover prevented them from falling. (See HOOVER'S ECONOMIC POLICIES.) He had been

appalled by the wage rate cuts in the 1920-1921 depression and had preached a ―high wage‖

policy throughout the 1920s. By the late 1920s, many business and labor leaders and academic

economists believed that policies to keep wage rates high would maintain workers‘ level of

purchasing, providing the ―steadier‖ markets necessary to thwart economic contractions. When

President Hoover organized conferences in December 1929 to urge business, industrial, and

labor leaders to hold the line on wage rates and dividends, he found a willing audience. The

highly protective Smoot-Hawley Tariff, passed in mid-1930, was supposed to provide protection

from lower-cost imports for firms that maintained wage rates. Thus, it was not until well into

1931 that the steadily deteriorating business conditions led the boards of directors of a number of

larger firms to begin significant wage rate cuts, often over the protest of the firms‘ top

executives, who had pledged to maintain wage rates.

The Smoot-Hawley Tariff was another piece of Hoover‘s strategy. Though there was not a

general call for tariff increases, Hoover proposed it in 1929 as a means of aiding farmers. He

quickly lost control of the bill and it ended up protecting American businesses in general with

much less real protection for farmers. Many of the tariff increases in the Smoot-Hawley Tariff

were quite large; for example, the tariff on Canadian hard winter wheat rose 40 percent, and that

on scientific glass instruments rose from 65 percent to 85 percent. Overall on dutiable imports

the tariff rate rose from 40.1 percent to 53.21 percent. There was some explicit retaliation for the

American tariff increases such as Spain‘s Wais Tariff. Some other countries‘ planned tariff

increases were encouraged and probably expedited by the action of the United States.

Firms also heeded Hoover‘s call to let the contraction fall on PROFITS rather than on dividends.

Dividends in 1930 were almost as large as in 1929, but undistributed corporate profits

plummeted from $2.8 billion in 1929 to −$2.6 billion in 1930. (These numbers may sound small,

but compared with the 1929 U.S. GNP of $103.1 billion, they were substantial.) The value of

firms‘ securities fell sharply, leading to a significant deterioration in the portfolios of banks. As

conditions worsened and banks‘ losses increased, BANK RUNS and bank failures increased. The

first major bank runs and failures occurred in the Southeast in November 1930; these were

followed by more runs and failures in December. There was another flurry of bank runs and bank

failures in the late spring and early summer of 1931. After Great Britain left the gold standard in

September 1931, the Federal Reserve System initiated relatively large increases in the discount

rate to stem the gold outflow. Overseas investors in nations still on the gold standard expected

the United States to either devalue the dollar or go off the gold standard as Great Britain had

done. The result would be that the dollars they held, or their dollar-denominated securities,

would be worth less. To prevent this they sold dollars to obtain gold from the United States. The

Fed‘s policy moves gave overseas investors confidence that the United States would honor its

gold commitment. The rise in American interest rates also made it more costly to sell American

assets for dollars to redeem in gold. The resulting rise in interest rates caused not only more

business failures, but also a sharp rise in bank failures. In the late spring and early summer of

1932, the Federal Reserve System finally undertook open market purchases, bringing some signs

of relief and possible recovery to the beleaguered American economy.

Hoover‘s FISCAL POLICY accelerated the decline. In December 1929, as a means of demonstrating

the administration‘s faith in the economy, Hoover had reduced all 1929 income tax rates by 1

percent because of the continuing budget surpluses. By 1930 the surplus had turned into a deficit

that grew rapidly as the economy contracted. By the end of 1931 Hoover had decided to

recommend a large tax increase in an attempt to balance the budget; Congress approved the tax

increase in 1932. Personal exemptions were reduced sharply to increase the number of taxpayers,

and rates were sharply increased. The lowest marginal rate rose from 1.125 percent to 4.0

percent, and the top marginal rate rose from 25 percent on taxable income in excess of $100,000

to 63 percent on taxable income in excess of $1 million as the rates were made much more

progressive. We now understand that such a huge tax increase does not promote recovery during

a contraction. By reducing households‘ disposable income, it led to a reduction in household

spending and a further contraction in economic activity.

The Fed‘s expansionary MONETARY POLICY ended in the early summer of 1932. After his

election in November 1932, President-elect Roosevelt refused to outline his policies or endorse

Hoover‘s, and he refused to deny that he would devalue the dollar against gold after he took

office in March 1933. Bank runs and bank failures resumed with a vengeance, and American

dollars began to be redeemed for gold as the gold outflow resumed. As financial conditions

worsened in January and February 1933, state governments began declaring banking holidays,

closing down states‘ entire financial sectors. Roosevelt‘s national banking holiday stopped the

runs and banking failures and finally ended the contraction.

Between 1929 and 1933, 10,763 of the 24,970 commercial banks in the United States failed. As

the public increasingly held more currency and fewer deposits, and as banks built up their excess

reserves, the money supply fell 30.9 percent from its 1929 level. Though the Federal Reserve

System did increase bank reserves, the increases were far too small to stop the fall in the money

supply. As businesses saw their lines of credit and money reserves fall with bank closings, and

consumers saw their bank deposit wealth tied up in drawn-out BANKRUPTCY proceedings,

spending fell, worsening the collapse in the Great Depression.

The national banking holiday ended the protracted banking crisis, began to restore the public‘s

confidence in banks and the economy, and initiated a recovery from April through September

1933. President Roosevelt came into office proposing a New Deal for Americans, but his

advisers believed, mistakenly, that excessive COMPETITION had led to overproduction, causing

the depression. The centerpieces of the New Deal were the Agricultural Adjustment Act (AAA)

and the National Recovery Administration (NRA), both of which were aimed at reducing

production and raising wages and prices. Reduced production, of course, is what happens in

depressions, and it never made sense to try to get the country out of depression by reduc ing

production further. In its zeal, the administration apparently did not consider the elementary

impossibility of raising all real wage rates and all real prices.

The AAA immediately set out to slaughter six million baby pigs and reduce breeding sows to

reduce pork production and raise prices. Since cotton plantings were thought to be excessive,

cotton farmers were paid to plow under one-quarter of the forty million acres of cotton to reduce

marketed production to boost prices. Most of the payments went to the landowners, not the

tenants, making conditions desperate for tenant farmers. Though landowners were supposed to

share the payments with their tenant farmers, they were not legally obligated to do so and most

did not. As a result, tenant farmers, and especially black tenants, who were more easily

discriminated against, received none of the payments and less or no income from cotton

production after large portions of the crop were plowed under. Where persuasion was ineffective

in inducing the many independent farmers to reduce production, the federal government intended

to mandate production cutbacks and purchase the product to take it off the market and raise

prices.

The NRA was a vast experiment in cartelizing American industry. Code authorities in each

industry were set up to determine production and investment, as well as to standardize firm

practices and costs. The entire apparatus was aimed at raising prices and reducing, not

increasing, production and investment. As the NRA codes began to take effect in the fall of

1933, they had precisely that effect. The recovery that had seemed so promising in the summer

largely stopped, and there was little increase in economic activity from the fall of 1933 through

midsummer 1935. Enforcement of the codes was sporadic, disagreement over the codes

increased, and, in smaller, more competitive industries, fewer firms adhered to the codes. The

Supreme Court ruled the NRA unconstitutional on May 27, 1935, and the AAA unconstitutional

on January 6, 1936. Released from the shackles of the NRA, American industry began to expand

production. By the fall of 1935 a vigorous recovery was under way.

The introduction of the NRA had initially brought about a sharp increase in money and real wage

rates as firms attempted to comply with the NRA‘s blanket code. As firms‘ enthusiasm for the

NRA waned, money wage rates increased little and real average wage rates actually fell slightly

in 1934 and early 1935. In addition, many workers decided not to join independent LABOR

UNIONS. These factors helped the recovery. Unhappy with the lack of union power, however,

Senator Robert Wagner, in the summer of 1935, authored the National Labor Relations Act to

ensure that union members could force other workers to join their unions with a simple majority

vote, thus effectively monopolizing the labor force. Internal dissension and the new Congress of

Industrial Organizations‘ (CIO) development of strategies to use the new law kept labor unions

from taking advantage of the new act until late in 1936. In the first half of 1937, the CIO‘s

massive organizing drives led to labor union recognition at many large firms. Generally, the new

contracts raised hourly wage rates and created overtime wage rates as real hourly labor costs

surged.

Several other factors also pushed up real labor costs. One factor was the new Social Security

taxes instituted in 1936 and 1937. Also, Roosevelt had pushed through a new tax on

undistributed corporate profits, expecting this to cause firms to pay out undistributed profits in

dividends. Though some firms did pay out part of the retained earnings in larger dividends,

others, such as the firms in the steel industry, also paid bonuses and raised wage rates to avoid

paying their retained earnings in new taxes. As these three policies came together, real hourly

labor costs jumped without corresponding increases in demand or prices, and firms responded by

reducing production and laying off employees.

The second major policy change was in monetary policy. Following the end of the contraction,

banks, as a precaution against bank runs, had begun to hold large excess reserves. Officials at the

Federal Reserve System knew that if banks used a large percentage of those excess reserves to

increase lending, the money supply would quickly expand and price inflation would follow.

Their studies suggested that the excess reserves were distributed widely across banks, and they

assumed that these reserves were due to the low level of loan demand. Because banks were not

borrowing at the discount window and the Fed had no BONDS to sell on the open market, its only

tool to reduce excess reserves was the new one of varying reserve requirements. Between August

1, 1936, and May 1, 1937, in three steps, the Fed doubled reserve requirements for all classes of

member banks, wiping out much of the excess reserves, especially at the larger banks. The

banks, burned by their lack of excess reserves in the early 1930s, responded by beginning to

restore the excess reserves, which entailed reducing loans. Within eighteen months, excess

reserves were almost as large as before the reserve requirement increases, and, necessarily, the

stock of money was lower.

By June 1937, the recovery—during which the unemployment rate had fallen to 12 percent—

was over. Two policies, labor cost increases and a contractionary monetary policy, caused the

economy to contract further. Although the contraction ended around June 1938, the ensuing

recovery was quite slow. The average rate of unemployment for all of 1938 was 19.1 percent,

compared with an average unemployment rate for all of 1937 of 14.3 percent. Even in 1940, the

unemployment rate still averaged 14.6 percent.

Why was the recovery from the Great Depression so slow? A number of economists now argue

that the NRA and monetary policy were important factors. Some maintain that Roosevelt‘s

vacillating policies and new federal regulations hindered recovery (Gary Dean Best, Richard

Vedder and Lowell Gallaway, and Gary Walton), while others emphasize monetary factors

(MILTON FRIEDMAN and Anna Schwartz, Christian Saint-Etienne, and Barry Eichengreen). The

New Deal‘s NRA has received much criticism (Gary Dean Best, Gene Smiley, Richard Vedder

and Lowell Gallaway, Gary Walton, and Michael Weinstein). A now discredited explanation

from Alvin Hansen argued that the United States had exhausted its investment opportunities. E.

Cary Brown, Larry Peppers, and Thomas Renaghan emphasize federal fiscal policies that were a

drag on the return to full employment. Michael Bernstein argues that investment problems

retarded the recovery because the older established industries could not generate sufficient

investment while newer, growing industries had trouble obtaining investment funds in the

depressed environment. Alexander Field argues that the uncontrolled HOUSING investment of the

1920s severely reduced housing investment in the 1930s.

One of the most coherent explanations, which pulls together several of these themes, is what

economic historian Robert Higgs calls ―regime uncertainty.‖ According to Higgs, Roosevelt‘s

New Deal led business leaders to question whether the current ―regime‖ of private PROPERTY

RIGHTS in their firms‘ capital and its income stream would be protected. They became less

willing, therefore, to invest in assets with long lives. Roosevelt had first suspended the

ANTITRUST laws so that American businesses would cooperate in government-instigated

CARTELS; he then switched to using the antitrust laws to prosecute firms for cooperating. New

taxes had been imposed, and some were then removed; increasing REGULATION of businesses

had reduced businesses‘ ability to act independently and raise capital; and new legislation had

reduced their freedom in hiring and employing labor. Public opinion surveys of business at the

end of the 1930s provided evidence of this regime uncertainty. Public opinion polls in March and

May 1939 asked whether the attitude of the Roosevelt administration toward business was

delaying recovery, and 54 and 53 percent, respectively, said yes while 26 and 31 percent said no.

Fifty-six percent believed that in ten years there would be more government control of business

while only 22 percent thought there would be less. Sixty-five percent of executives surveyed

thought that the Roosevelt administration policies had so affected business confidence that the

recovery had been seriously held back. Initially many firms were reluctant to engage in war

contracts. The vast majority believed that Roosevelt‘s administration was strongly antibusiness,

and this discouraged practical cooperation with Washington on rearmament.

It is commonly argued that World War II provided the stimulus that brought the American

economy out of the Great Depression. The number of unemployed workers declined by

7,050,000 between 1940 and 1943, but the number in military service rose by 8,590,000. The

reduction in unemployment can be explained by the draft, not by the economic recovery. The

rise in real GNP presents similar problems. Most estimates show declines in real consumption

spending, which means that consumers were worse off during the war. Business investment fell

during the war. Government spending on the war effort exceeded the expansion in real GNP.

These figures are suspect, however, because we know that government estimates of the value of

munitions spending, to name one major area, were increasingly exaggerated as the war

progressed. In fact, the extensive PRICE CONTROLS, rationing, and government control of

production render data on GNP, consumption, investment, and the price level less meaningful.

How can we establish a consistent price index when government mandates eliminated the

production of most consumer durable goods? What does the price of, say, gasoline mean when it

is arbitrarily held at a low level and gasoline purchases are rationed to address the shortage

created by the price controls? What does the price of new tires mean when no new tires are

produced for consumers? For consumers, the recovery came with the war‘s end, when they could

again buy products that were unavailable during the war and unaffordable during the 1930s.

Could the Great Depression happen again? It could, but such an event is unlikely because the

Federal Reserve Board is unlikely to sit idly by while the money supply falls by one-third. The

wisdom gained in the years since the 1930s probably gives our policymakers enough insight to

make decisions that will keep the economy out of such a major depression.

About the Author

Gene Smiley is an emeritus professor of economics at Marquette University.

Further Reading

Bernstein, Michael. The Great Depression: Delayed Recovery and Economic Change in

America, 1929-1939. New York: Cambridge University Press, 1987.

Best, Gary Dean. Pride, Prejudice, and Politics: Roosevelt Versus Recovery, 1933-1938. New

York: Praeger, 1991.

Bordo, Michael D., Claudia Goldin, and Eugene N. White, eds. The Defining Moment: The

Great Depression and the American Economy in the Twentieth Century. Chicago: University of

Chicago Press, 1998.

Brown, E. Cary. ―Fiscal Policy in the Thirties: A Reappraisal.‖ American Economic Review 46

(December 1956): 857-879.

Brunner, Karl, ed. The Great Depression Revisited. Boston: Martinus Nijhoff, 1981.

Cole, Harold L., and Lee E. Ohanian. ―New Deal Policies and the Persistence of the Great

Depression: A General Equilibrium Analysis.‖ Journal of Political Economy 112 (August 2004):

779-816.

Eichengreen, Barry. Golden Fetters: The Gold Standard and the Great Depression, 1919-1939.

New York: Oxford University Press, 1992.

Field, Alexander J. ―Uncontrolled Land Development and the Duration of the Depression in the

United States.‖ Journal of Economic History 52 (June 1992): 785-805.

Friedman, Milton, and Anna Jacobson Schwartz. A Monetary History of the United States, 1867-

1960. Princeton: Princeton University Press, 1963.

Glasner, David. Free Banking and Monetary Reform. New York: Cambridge University Press,

1989.

Hall, Thomas, and J. David Ferguson. The Great Depression: An International Disaster of

Perverse Economic Policies. Ann Arbor: University of Michigan Press, 1998.

Hansen, Alvin. Full Recovery or Stagnation? New York: Norton, 1938.

Higgs, Robert. Crisis and Leviathan: Critical Episodes in the Growth of American Government.

New York: Oxford University Press, 1987.

Higgs, Robert. ―Regime Uncertainty: Why the Great Depression Lasted So Long and Why

Prosperity Returned After the War.‖ Independent Review 1 (Spring 1997): 561-590.

Higgs, Robert. ―Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s.‖

Journal of Economic History 52 (March 1992): 41-60.

O‘Brien, Anthony Patrick. ―A Behavioral Explanation for Nominal Wage Rigidity During the

Great Depression.‖ Quarterly Journal of Economics 104 (November 1989): 719-735.

Peppers, Larry. ―Full-Employment Surplus Analysis and Structural Change: The 1930s.‖

Explorations in Economic History 10 (Winter 1973): 197-210.

Renaghan, Thomas. ―A New Look at Fiscal Policy in the 1930s.‖ Research in Economic History

11 (1988): 171-183.

Saint-Etienne, Christian. The Great Depression, 1929-1938: Lessons for the 1980s. Stanford:

Hoover Institution Press, 1984.

Smiley, Gene. Rethinking the Great Depression: A New View of Its Causes and Consequences.

Chicago: Ivan R. Dee, 2002.

Temin, Peter. Did Monetary Forces Cause the Great Depression? New York: Norton, 1976.

Temin, Peter. Lessons from the Great Depression. Cambridge: MIT Press, 1989.

Temin, Peter. ―Socialism and Wages in the Recovery from the Great Depression in the United

States and Germany.‖ Journal of Economic History 50 (June 1990): 297-308.

Temin, Peter, and Barrie Wigmore. ―The End of One Big Deflation.‖ Explorations in Economic

History 27 (October 1990): 483-502.

Vedder, Richard K., and Lowell P. Gallaway. Out of Work: Unemployment and Government in

Twentieth-Century America. New York: Holmes and Meier, 1993.

Walton, Gary M., ed. Regulatory Change in an Atmosphere of Crisis: Current Implications of

the Roosevelt Years. New York: Academic Press, 1979.

Weinstein, Michael. Recovery and Redistribution Under the NIRA. Amsterdam: North-Holland,

1980.

Wright, Gavin. ―The Political Economy of New Deal Spending: An Econometric Analysis.‖

Review of Economics and Statistics 56 (February 1974): 30-38.

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In-depth analysis on Credit Writedowns Pro.

You are here: Economy » 1931

1931

by Edward Harrison / on 11 March 2009 at 09:26 /

The following passages are excerpts from Charles Kindleberger‘s book "The World in

Depression."

The Creditanstalt

Just as in May 1873 and July 1914, with tension growing among Germany, France, and Britain,

the crack, when it came, appeared in Austria. In the early spring of 1931, a Dutch bank wrote a

polite letter to the Creditanstalt in Vienna saying that it was obliged to raise the charge on its

acceptance credits from 0.25 percent a month to 0.375 percent. It was a timorous letter, says

Beyen, not a prescient one, and the bank was somewhat surprised when the Creditanstalt chose

to pay off the loan rather than renew at the higher rate. Three months later the Creditanstalt

could have used the money.

The Austrian economy had been in disarray since the Treaty of St. Germain of 1920. Its finances

had required League of Nations loan assistance, which entailed international supervision

between 1922 and 1926…Industrial capital was consumed in the postwar inflation, and financial

capital in the unsuccessful bear speculation against the French franc in 1924 that produced

failures of the Allgemeine Industriebank, the Austro-Polnische Bank, and the Austro-Orientbank,

as well as the private Union Bank owned by one Bosel, with grave difficulties for Kolmar& Co.,

Kettner, and the Brothers Nowak. Maerz calls this episode "the opening shot of a series of bank

failures culminating in the breakdown of the Creditanstalt seven years later."…

In May 1931 losses were still at 140 million schillings, and capital at 125 million plus disclosed

reserves of 40 million for a total of 165 million. Under Austrian law, if a bank lost half its capital

it had to "turn in its balance sheet," or close down. In an effort to rescue the Creditanstalt, the

government, the National Bank, and the House of Rothschild, the last with help of the

Amsterdam branch, furnished 100 million, 30 million, and 22.5 million schillings,

respectively. But the announcement of the support operation on May 11, 1931, started a run,

partly foreign, partly Austrian…

By June 5 the credit [for the entire country] was exhausted and the Austrian National Bank

requested another. Still under pressure, the bank raised its discount rate to 6 percent on June 8

and 7.5 percent on June 16. The new credit was arranged by the BIS, by June 14 this time, but

subject to the condition that the Austrian government should obtain a two-to-three year loan

abroad for 150 million schillings. At this point the French interposed the condition that the

Austrian government should abandon the customs union with Germany. The Austrian

government refused, and it fell…

The demise of the Creditanstalt and the Austrian government was followed by a run on Germany

and an attack on Sterling, which was depreciated a massive 25 percent as a result. Afterwards,

central banks began a run on the U.S. dollar, liquidating it for gold. The banks included the Bank

of France, the National Bank of Belgium, the Netherlands Bank and the Swiss National Bank.

The result was an immediate need to increase the interest rate in the U.S. from 1.5 to 3.5 percent.

These events triggered further panics and bank runs in the U.S.. Later, the U.S. dollar was

depreciated and multiple bank holidays were called to contain the panic. The U.S. economy

bottomed only in April 1933.

About Edward Harrison

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment

banker and technology executive with over twenty years of business experience. He is also a

regular economic and financial commentator on BBC World News, CNBC Television, Business

News Network, CBC, Fox Television and RT Television. He speaks six languages and reads

another five, skills he uses to provide a more global perspective. Edward holds an MBA in

Finance from Columbia University and a BA in Economics from Dartmouth College. Edward

also writes a premium financial newsletter.

The World in Depression: Lessons from the Great

Depression: Part XXIV: Economic Crises Around the World

in Synchronization.

http://www.doctorhousingbubble.com/the-world-in-depression-lessons-from-the-great-

depression-part-xxiv-economic-crises-around-the-world-in-synchronization/

To assume that the worldwide depression in banks and global equity markets started here in the

United States dilutes the magnitude of our current predicament. The interconnectedness of our

global markets makes good and bad ideas spread faster, with deeper and more profound

implications than say a half century ago. I have been reading numerous articles and journals

regarding the lost decade experienced in Japan that permeated throughout the 1990s and is still

lingering today. The latest pieces I have gotten my hands on are Charles Kindleberger‘s The

World in Dpression 1929 – 1939 and a piece by Carmen Reinhart from the University of

Maryland and Kenneth Rogoff from Harvard University, The Aftermath of Financial Crises

presented at the American Economic Association meeting in San Francisco on January 3, 2009.

There are many deeper problems still swimming in the sewer that is our global banking

system. The paper presented at the AEA meeting focuses on historical banking crises instead of

minor recessions. It is safe to say that we are battling with a different kind of economic beast at

the moment. The data presented in the paper is startling and has research from across the

world. I understand that people initially are reluctant to use parallels with the Great

Depression. Yet I believe this aversion to discussing the Great Depression earlier say in 2005,

2006, or even 2007 has caused us to stack this house of cards only higher and higher and the

downfall will now be much more widely felt.

It is rather apparent that exploring Ben Bernanke‘s view of the Great Depression is deeply rooted

in neoclassical economics. This view that all ills can be solved by monetary policy and central

banking is simply a misguided notion in such a complicated and global network of

economies. The problem with Bernanke‘s view of the world is that economic systems have

some kind of inherent equilibrium. Yet I think this notion is false. That in the end, the market

will balance everything out and that there is some ideal level for economies. That is to say that

there is an ideal level of unemployment, an ideal level of inflation, an ideal price for most

assets. Yet economic systems rely on humans who are inherently chaotic and do not follow

orderly systems. Need we point to the current global battles going on to show that we do not

always get along or follow nicely paved roads?

Going back to the paper presented earlier this month, it looks at banking crises and pulls data

looking at housing and unemployment during the economic downturn. What this shows us is

that this crisis can run deeper and has the potential of snow balling into something more

pervasive if it isn‘t handled properly. The unfortunate actions taken by our central bank and U.S.

Treasury leave us wanting. It also leaves us with a bitter taste in our mouth and a blatant

disregard to what history has taught us.

This is part XXXIV in our Lessons from the Great Depression series:

18. Charity for Financial Deviants.

19. The Silent Economic Depression

20. The Four Horsemen of the Economic Apocalypse

21. The Big Change

22. The Infection of Consumerism and Living Fake Lives.

23. The Worst Housing Crash in American History.

Where is the Bottom?

As we approach 2009 with a solemn humility that markets can be chaotic, it is important to first

assess the damage to the global equity markets:

*Click for larger image

Virtually every major equity market in the world is down from its 2007 or 2008 peak by 40

percent. Many are down by 50 percent and some are down 60 percent. Make no mistake, this is

a global crash. Yet looking at historical data this seems to be on par with many banking crises in

our past. What the paper found is equity prices fall on average 55 percent over a downturn of

roughly three and a half years. So assuming this crisis is like those in the past, the above

declines seem about right. Yet we are talking about averages. Given the persisting problems,

this would assume our crisis is closer to the end than the beginning.

It was interesting to hear a poll on MSNBC that 57 percent of Americans believe this crisis will

last 1 to 3 years. So much for the notion going around regarding a second half recovery in

2009. Most people are already bracing for a longer economic downturn. Let us look at some

data presented in the paper:

Incredibly, this housing crisis is already worse than that of the Great Depression. It is also the

case that during the start of the Great Depression homeownership in the country was slightly

over 40 percent while at the peak of our recent real estate bubble, homeownership nearly touched

70 percent (we are now back down from that level). The research found that on average, real

estate housing price declines average 35.5 percent and last 6 years. Let us look at the most

recent Case-Shiller data:

First, the peak was only reached in July of 2006 which means we still have until 2012 for this

thing to run its course if we are to follow the historical average. In addition, we have 12 percent

more to go in terms of price drops. Yet by any standard and measure this has been the biggest

coordinated real estate bubble the world has ever seen so merely reaching the historical average

would be fortunate. My estimate is that we will fall much lower on the downside. If you look

on the chart above, Hong Kong fell over 50 percent which is something resembling the state of

California which is already down 46 percent. I still believe California will not see a bottom until

2011 and this recent budget hot air blowing simply shows how bad conditions are getting.

I think it would be useful to put this into context from a passage from Kindleberger‘s book:

―Samuelson‘s emphasis on the fortuitous character of the depression is not entirely

satisfactory. Financial crises have occurred with great regularity, or at least they did in the

nineteenth century and prior to the end of the Second World War: 1816, 1825, 1836, 1847,

1875, 1866, 1873, 1890, 1907, 1929, 1937. A number of these turned into great

depressions. The great depression of 1873 to 1896, sometimes regarded by economic historians

as the great depression, was perhaps different in origin, characteristics, and effects, so that on

these scores one can regard the period from 1929 to 1939 as unique. Going further back,

however, produces the uniformities that the social scientist searches for. Like the First World

War, the Napoleonic Wars were followed by a short, sharp deflation in 1816, comparable to that

of 1920-21, and a period of monetary adjustment culminating in the restoration of the pound to

par in 1819 and 1821. Then came a spurt of foreign lending from 1821 to 1825, followed by a

stock market crash in 1826 and a depression. If one subtracts 100 plus three to five years from

the major economic events of the 1920s and 1930s, interesting parallels emerge. The 1826

depression was not perhaps as deep or widespread as that of 1929 or as those of 1837 and 1848

that followed it. But the timing is disconcertingly similar.‖

The point of course is that economic shocks occur quite frequently. If we look at history after

the 1929 – 1939 Great Depression, it would look rather tame in comparison. Yet I think that is

where the mistake is being made. Let us look at a chart showing United States‘ recessions dating

back to 1854:

First, the Great Depression lasted 43 months officially on its first stint (1929 – 1933), then fell

back in 1937 and 1938 for another 13 months. However, if you look at the earlier Great

Depression usually referred to as the Long Depression, this lasted 65 months. You‘ll also notice

that since 1933, the longest duration of economic contraction has been 16 months. We are

already on month 14. Do you really see things jumping up by April of this year? If you don‘t,

then we are talking about the longest contraction since the Great Depression.

I would also argue that the recent relatively light recessions have lined us up for a mega

economic contraction. First, we have been cooking the books on unemployment and inflation

for nearly 2 decades. We have jumped from one epic bubble in the 1990s with the technology

boom to the real estate bubble of the 2000s. So for nearly 2 decades, we have operated in a

world where the data understated the true nature of what is really going on. First, most of our

growth has come at the cost of stunning credit expansion. This credit expansion made up for our

loss in productivity and gave us a false sense of growth. Also, the last recession was simply

averted by Alan Greenspan dropping rates in a deregulated climate and created a recipe for

disaster in a world where business ethics simply did not exist.

If you think the Great Depression stock market was horrible, we already have two nations past

that level:

Austria and Iceland are already seeing a much deeper crash in their equity markets than the U.S.

did during the Great Depression. Also, it is early in the game since these occurred recently. The

average peak to trough found in the research is 3.4 years. Assuming our domestic peak of

August of 2007, just to stay with the average we are talking about late 2010 or early 2011 for our

bottom.

The severity of this crisis will shift the field of economics. First, I think the Milton Friedman

school of monetary thought has taken a major hit. Sure, the argument can be made that during

the Great Depression the Federal Reserve did not act as aggressively as possible. This was

debated for decades. We had our first real chance to put Bernanke‘s theory to the test. It failed

horribly. First, a mistake made which I think is made with most neoclassical economist is they

believe in the notion of some ideal equilibrium level. It simply does not exist. This would

presuppose that there is an ideal level to be at. For example, should a Goldman Sachs trader

make $1 million a year or $20,000 a year? Ideally the market would set this price but when you

have the central bank in bed with the government, the salary is whatever the crony capitalist say

it is. That is not equilibrium. That is a plutocracy and we are now in the field of political

science, not economics.

Never have we seen such an incredible and unprecedented action taken by the Federal

Reserve. They have failed. This year we are going to put the neo-Keynesian school of thought

to the test with another spectacular action on the fiscal stimulus side. Will this work? I‘m not

sure. Look, as much as I criticize Bernanke for his ideologue view of monetary policy I would

love to have been proven wrong and seen everyone making beacoup money (all of us and not

just those in the finance sector), real estate at stable levels, and all of us able to afford the fruits

of our labor. But again, the world doesn‘t work that way. That theory is now proven wrong in

the theatre of life.

I‘m sure the vast majority of us want to see the country succeed. If fiscal stimulus does the trick

then I‘m sure few would argue. But even if we look at the fiscal stimulus of the Great

Depression, what we see is that it did improve the lot of many Americans, added some needed

regulations to the market, and gave us some of the social safety nets that we currently have. Yet

we now live in a very different world. Those same safety nets are now a looming problem with

baby boomers starting to retire in force and our workforce stagnating. Families simply aren‘t

having the number of kids that those in the early 1900s did. The fact that we aren‘t even

discussing Social Security or Medicare should tell you how severe this current crisis is. Let us

assume we tackle this problem. Then what? We will need to confront the massive debt of our

country at some point. This is already being acknowledged yet we are also told that we are

going to run massive deficits in the short run.

The fact that we are now battling with deflation tells us that we are probably going to have a

Japan like recession or worse, something like the Great Depression. Why are we to believe

otherwise? We are committing the same actions. Are we trying to make our U.S. dollar, the

currency of our country strong? Absolutely not. Ben Bernanke and the U.S. Treasury are trying

forcefully by holding rates at near zero to devalue our dollar. Take a look at this chart looking at

the CPI:

We are very likely going to see a year over year decline with inflation (aka, deflation). It is hard

to see how we get inflation because that supposes that the government has some mechanism of

forcing wages up. They don‘t. Unions have very little power in our country today. Take a look

at what is happening in California for example. Starting February 1st 2009 the Governor has

placed thousands of state employees on furloughs that will run until June of 2010. This includes

2 days off a month. Sounds good right? Well that is a 10 percent pay cut. So as you can see, we

are not seeing prices rise. In Bernanke‘s ideal world, the flooding of the system with liquidity

and now actual capital to the banks, was to get people back on that hamster wheel and going out

to spend again. The notion was that prices would once again go up because people would start

bidding on these items again. But there is one small problem. Americans are already tapped out

on debt! They need actual real wages to go up. Take a look at the explosion in debt:

American households are still burdened with a historically high amount of debt. So it is hard to

see how deflation doesn‘t occur. As most Americans know it, inflation or deflation is associated

with the price of assets or goods. This is normally the ancillary impact of changes in the money

supply. Yet looking at the CPI, this is a basket of goods and their price so I think it is fair to look

at the price of goods as a sign of inflation or deflation. First, let me give you an anecdotal taste

of deflation. The liquidation of Circuit City and the job losses of 34,000 people. I was driving

to the store today and saw street spinners highlighting the 30 percent off at the local Circuit

City. The fact that they are slashing prices and moving everything out is typical of

deflation. We can expect more of this. In fact, the prices of many items were cheaper. Initially,

this may seem like a blessing but deflation is equally damaging to an economy.

For an economy like ours so dependent on spending and consumption, deflation will make this

into a depression. Just think about it. Why would you buy a home today if you knew it would

be cheaper tomorrow? Why would you buy a car today if you were worried about your

employment? That is the issue with deflation. Bernanke‘s mistake was that he thought he had

the power to induce inflation which he clearly cannot. The consumer psychology has

changed. Even if people had access to credit (which they don‘t) it is wrong to assume they will

spend it again. The gig is up.

The size of the fiscal stimulus may cause some short-term stability in prices in some sectors but

the magnitude of this problem is much larger than that. I simply do not see how a world in a

depression like atmosphere will see prices coming up in the next few years. Even the historical

data doesn‘t show that. Yet I am hopeful things will get better. In fact, the last few months

show the savings rate going up. Hopefully people take this new found austerity in stride and

remember that life isn‘t only about that gigantic McMansion with granite countertops courtesy of

a back breaking mortgage. When we reach the bottom of this, if anyone tries to talk about how

great and infallible real estate is, just try remembering this worldwide depression to temper your

expectations.

Comparing the Great Depression and the

Global Crisis

Derek McKenna, May 1 2013

http://www.e-ir.info/2013/05/01/comparing-the-great-depression-and-the-global-crisis/

This content was written by a student and assessed as part of a university degree. E-IR publishes

student essays & dissertations to allow our readers to broaden their understanding of what is

possible when answering similar questions in their own studies.

Compare and Contrast the Great Depression and the Global Crisis

The 1929 stock market crash and the subsequent ‗Great Depression‘ was the biggest economic

crisis that the world has experienced. The depth and length of the crisis and the suffering that it

caused is legendary. Therefore, when the global financial crisis struck in 2007, many rushed to

proclaim that we were about to experience another depression on a similar scale, or at least what

some have termed a ‗great recession‘. This essay will compare and contrast the two economic

crises to analyse the key similarities and differences between the two. To do this, the essay will

firstly provide an outline of the conditions that led to the 1929 crash in the economy. Moving on

from here, the essay will then look at the policy responses that were implemented to tackle the

crisis before analysing the conditions that precipitated the 2007 financial crisis and the policy

responses; it will draw out similarities and differences of each of the crises, and ascertain any

lessons learned during the current global crisis from the policies of the Great Depression era.

Finally, the essay will conclude with a discussion of the main points raised by the analysis of

both crises and a look at the future prospects for recovery.

Capitalism is a system of economic development that has crises as an inherent feature. Many

crises have occurred both before and after the 1929 stock market crash; however, the length and

depth of the Great Depression has made it the point of reference for judging the severity of a

financial crisis. Much debate has occurred over the causes of the Great Depression. While many

see the late October 1929 New York stock market crash as the defining feature of the crisis, the

reality was much more complex and multifaceted. As Teichova (1990, p.8) suggests, the Great

Depression was ―the deepest, all embracing (agricultural, industrial, financial, social and

political) and longest crisis with catastrophic consequences‖. As well as this, although the United

States led the way, this crisis was global and the rest of the world also experienced depression.

So, any analysis of the Great Depression must look at the various factors that caused and

perpetuated it.

The 1920s in America have been described as the ‗Roaring Twenties‘. After the devastation of

the First World War, from 1920 to 1925, the US and international economies were experiencing

a boom. During that period, world mining and manufacturing output grew by nearly twenty

percent (McNally 2010, p.63). However, in terms of inequality, the poor were less poor but the

rich were getting richer at a rate of four to one. As well as this, four-fifths of Americans had no

savings, compared to twenty-four thousand families at the top who held a third of all savings

combined (Canterbery 2011, p.13). During the boom, ninety percent of all Americans saw their

incomes fall in relative terms (McNally 2010, p.64). A factor in this was an increase in union-

busting and anti-labour laws, which increased income inequality. As well as this, agriculture,

coal mining and textile industries were suffering from a post-war hangover which saw their

profitability decline, and in many instances wiped out. This inequality, which concentrated

wealth in so few hands, led to a huge increase in consumer credit, which in turn sparked off

rising levels of private debt and a massive speculative bubble in the form of a property boom in

Florida (Canterbery 2011, pp.13-14).

The mania of speculation was not confined to property, and between May 1924 and the end of

1925, there was a huge eighty-percent rise in stock prices. The trend continued and as Galbraith

(2009, p.16) has suggested, ―in early 1928, the nature of the boom changed. The mass escape

into make believe, so much a part of the speculative orgy, started in earnest‖. During 1928, the

Times Industrials (a pre-cursor to the DOW) gained a huge thirty-five percent, from two-hundred

and forty-five points to three-hundred and thirty-one points. To maximise their gambling profits,

many investors financed their purchase of stocks with borrowed money, with speculators buying

one-thousand dollars of stock by putting down one-hundred dollars (Canterbery 2011, p.15). Of

course, capitalism‘s bubbles must always burst, and this was no exception.

The US real economy was showing signs on a slowdown long before the stock market crash.

However, on Wednesday October 23, 1929, a drop in the stock market lost four months of

previous gains and the following day panic selling began. This was briefly halted by a meeting of

the nation‘s biggest bankers who promised to pool their resources to halt the slide. Their efforts

however were futile, and on ‗Black Tuesday‘, October 29, the bottom fell out of the market,

giving up all of the gains of the previous year (McNally 2010, p.65). Most economists agree that

the Great Depression that ensued lasted for over ten years. Its economic impact was striking as

GNP fell from a peak of $104.4 billion in mid-1929 to $56.6 billion in 1933. Its social impact

was even more harrowing as twenty-five percent of the US civilian labour force was unemployed

by 1933, the worst point of the depression (Canterbery 2011, p.18). There are a number of

competing explanations as to why the crisis was so severe.

Explanations can be grouped into the two categories of monetarist and non-monetarist. For

example, in a mixture of the two, Ben Bernanke (1983) suggests that there were three interlinked

factors that propagated the Great Depression. The first was the failure of financial institutions, in

particular commercial banks. The percentage of failing banks in 1930 was 5.6%, jumping to

12.9% in 1933, and this left a situation whereby in 1933 there were half the number of banks that

had been operating in 1929 (Ibid, p.259). Bernanke goes on to cite defaults and bankruptcies as

key, with the ratio of debt service to national income going from nine percent in 1929 to nearly

twenty percent in 1933. This was pervasive across all sectors with home mortgages, farm

mortgages, personal debtors and even state governments defaulting on their obligations (Ibid,

p.260). However, key to Bernanke‘s view was the correlation of the financial crisis with

macroeconomic factors. The crux of this view was that the financial crisis affected the macro-

economy by reducing the quality of certain financial services, primarily credit intermediation

(Ibid, p.263). In line with the monetarist view, it could also be argued that the Federal Reserve

did not help matters. Its policy at the time was only to increase the credit base in line with

requirements of trade, which essentially meant that as businesses were afraid to borrow, the

Federal Reserve did not increase the money supply.

Somewhat similar to the monetarist elements of Bernanke‘s analysis is that of Friedman and

Schwartz (1971,pp. 359-60) who argue that the crisis that originated in the United States was a

domestic construct which was prolonged and deepened by a failed policy of failing to cut the

discount rate, which meant a failure to provide credit and expand the currency. Kindleberger

(1986a), taking a similar monetarist position but focusing more on international factors, suggests

that the world depression stemmed from reparations and war debt, the overvaluation of the

pound, the return to the gold standard in Britain and an undervalued French franc. These factors

were aggravated by a fall in commodities and a rise in stocks in New York.

From a non-monetarist perspective, US government actions were no better, with the introduction

of the Smoot-Hawley Tariff in mid-1930, sparking of a wave of protectionist tariffs around the

world and a trade war which saw world trade figures nosedive (Canterbery 2011, p.19). The

deflationary process was exacerbated by the huge levels of unemployment, which combined with

other factors to initiate the ‗multiplier/accelerator‘ interaction, reinforced by wage-cut enforced

under-consumption as wages fell for manufacturing production workers by at least thirty-one

percent between 1929 and 1933, as well as debt deflation and international interactions (Devine

1994, p.166). While this was happening, consumer prices only fell twenty percent during the

1929-33 period. This, as Devine points out, helps to explain that falling consumption was a

major factor in the decline in GNP during this time, more so than previous or subsequent

recessions (Ibid).

There are others such as Temin (1976) who suggests that monetarist explanations are wrong, and

it was consumption and spending that declined first, therefore leading to a tightening of the

money supply. Therefore, it was not monetary factors alone that caused the depression. Taking a

different approach to explaining the depth and length of the depression, Kindleberger cites the

lack of a lender of last resort as the major factor preventing any form of fast recovery

(Kindleberger 1986b, p.4). This, he suggests, was due to Britain‘s inability after the First World

War, and the United States‘ unwillingness to act in that regard. What each of these arguments

above show is there is still no consensus on the policy responses that would have prevented such

a deep depression from occurring. Such a lack of a consensus has also been a feature of the

current global crisis.

Since the global financial crisis broke out, many have rushed to make comparisons between it

and the Great Depression. However, before one makes these comparisons, an analysis of the

fundamental differences in the nature of the capitalist system between now and then must be

undertaken. After the World War boom in output and the post-war move to Keynesian

economics, which essentially saved capitalism from self-implosion, the emergence of neoliberal

capitalism in the latter 1970s in the form of Reaganism in the US and Thatcherism in Britain

ushered in a new era of capitalist development that was distinctly different from its previous

incarnations.

This period of capitalist modification saw the creation of the era of what Canterbury has termed

‗casino capitalism‘ (Canterbery 2011, pp.83-121). He suggests that this era began with three

powerful forces converging. These were: monetarism, which Milton Friedman advised Reagan

would bring down inflation with minimal effect on employment or production; the influence of

the ‗neo-Austrians‘ who sought to reduce state influence over entrepreneurs through

deregulation; and, finally, the pervasive idea that less taxes on the rich produced the trickle-down

effect (Ibid, p.83). Reagan‘s policies during this era, continued under the Clinton administration,

gave huge power over to Wall Street through deregulation, and contributed to a huge shift from

production to financial services. As the financial sector grew its asset base, it became a much

bigger part of the national economy. This can be seen in the fact that between 1978 and 2005, the

financial sector grew from 3.5 percent to 5.9 percent of the US economy in GDP terms. To put

this in perspective, from the 1930s to around 1980, the rate of growth for the financial sector was

roughly the same as that of the non-financial sector. However, from 1980 to 2005, financial

sector profits grew by eight-hundred percent, compared with two-hundred and fifty percent for

the non-financial sector (Ibid, pp.116-117). This form of capitalism, where value and profit are

not ‗produced‘ but the result of speculation, is a form that gives huge power to unelected rating

agencies and bankers to set the agenda, which even governments and international institutions

find difficult to alter. It was under this system of capitalism that the global financial crisis

emerged.

Many different arguments for the causes of the global crisis exist, and whilst it can be difficult to

pin down the exact causality because of its global nature, there is agreement on a number of

factors. Just like its sister crisis, the Great Depression, before the global crisis struck, the global

economy went through a boom period with the world economy growing at a faster rate between

2001 and 2007 than in any other period in the past thirty years (Wade 2008, p.23). Most agree

that the crisis was sparked by the subprime mortgage bubble collapse in the United States.

However this spark was not the sole cause of the crisis. Just like the Great Depression, the

factors that caused the crisis were numerous.

Although signs of an emerging crisis first appeared in 2006-7, it was not until 2008 when banks

such as Lehman Brothers were going to the wall and financial assets were crashing that the full

extent of the crisis was realised. As a result, flows of credit dried up and economies the world

over started to suffer. However, this crisis was not solely a monetary crisis and had deeper

dynamics at play: in particular, the financialisation of capitalism being built upon debts as a

means of making profit (McNally 2010, p.86). The subprime mortgage crisis is illustrative of

this. For example, in the year 2000, there was $130 billion of subprime lending in the US,

backed up with $55 billion of mortgage bonds. Yet by 2005, those figures had jumped to $625

billion in subprime loans backed by $500 billion in securitised bonds (Ibid, p.103). The

‗speculative orgy‘, as Galbraith termed it speaking on the 1929 crash, was back with a bang.

What exacerbated the orgy more was the creating of innovative financial instruments in the form

of credit default swaps (CDS) and other debt securities. For example, by 2006 the CDS on

mortgage bonds was eight times the value of the bonds themselves, so when the crisis hit, that

wealth was wiped out (Ibid, p.103).

The European context experienced similar problems as contagion spread throughout the world

economy. Trade imbalances within the Eurozone created by the power of the German economy,

in particular its exports, produced vast wealth within Germany, generating credit that was more

than was required for domestic demand. The result was an outflow of cheap and easy credit to

peripheral European states. This in turn with low interest rates created the basis for a speculative

property bubble in places such as Ireland and Spain, and a rise in consumer debt across Europe

(Avellaneda and Hardiman 2010, pp.4-5). This, coupled with the ECB having light regulatory

practices and liquidity responsibilities, and the fact that the Euro project created an quasi-federal

state with a centralised monetary and exchange rate policy but had no fiscal control over

individual states, led to a disaster of structural design in the Euro; this in turn prevented adequate

policy responses from individual states, who instead were burdened with a one-size-fits-all,

centralised Franco/German-led response.

It is clear that the immediate causes of the crisis were centred on ―excessive debt leverage or

imprudent lending‖ (Wade 2008, p.27). Much of this debt leveraging was in the form of the

complexly structured credit securities, like the CDS, and when market panic set in following the

collapse of Lehman, and this huge default risk pushed investors towards the tipping point.

However, as Bernanke (2010) has pointed out, many factors were at play. Although the most

prominent was the prospect of losses on the subprime market when the housing bubble burst, the

system vulnerabilities as well as shortfalls in government responses explain the severity of the

crisis. For example, the ―sudden stop‖ in June 2007 of syndicated lending of asset backed

securities to large borrowers. Other factors included the overreliance of banks on short-term

wholesale funding, deficiencies in private sector risk management, an over-reliance on ratings

agencies, excessive leverage on the part of households, businesses and financial firms, statutory

gaps in regulation on special purpose vehicles and a failure of existing regulatory procedures

worldwide (Bernanke 2010).

Although causality had similarities between the United States and Europe, the policy responses

to deal with the crisis have been markedly different. Quite early into the crisis, perhaps learning

from past mistakes from the Great Depression, the US government approved various Keynesian

inspired fiscal stimuli and financial and auto sector bailouts: in particular, the Troubled Asset

Relief Program (TARP), a $700 billion rescue fund for the banking sector which bought toxic

loans at reduced rates (Nguyen and Enomoto 2011). This policy has been seen to be a relative

success with an estimated final cost of $32 billion to the United States taxpayer (Congressional

Budget Office 2012). In contrast to this, the European solution has been overwhelmingly

austerity based, and the cost of the crisis being mainly burdened by the taxpayers of Europe. In

particular, the Irish taxpayer‘s bill for the bailout of one bank, Anglo Irish, will cost the taxpayer

more than the total final cost of the TARP program in the United States. In this regard, it does

not seem that lessons from the Great Depression have been learned in a European context.

When we look to the rates of unemployment over the past number of years, it seems like the

American policy of stimulus may be working slightly better than the European austerity agenda.

For example, in the US, unemployment rose sharply after the onset of the financial crisis, going

from 4.6 percent in 2007 to 7.2 percent in 2008, 9.3 percent in 2009 and 9.7 percent in 2010.

However, in 2011 there has been a decline in unemployment to 9 percent (Index Mundi 2012).

The European Union (twenty seven members) on the other hand has seen its unemployment rate

grow from 8.3 percent in 2006, to 9 percent in 2009 and 9.7 percent in 2011 (United Nations

Economic Commission for Europe 2012) to a current figure of 11.7 percent (Eurostat 2012).

So, how does the global crisis match up to the Great Depression? It is obvious that there are a

number of similarities between the two crises. For example, with both crises there was an

extended period of economic growth preceding the crashes. Each of the crisis periods also saw

speculative bubbles based on the flow of easy credit which fuelled both property based and stock

market excess. Both crises also saw staggering drops in industrial production and increases in

unemployment. However, there are also key differences between the Great Depression and the

global crisis. Primarily, the nature of the capitalist system has changed fundamentally from

productive industrialisation to financial capitalisation. The policy responses of governments have

also showed that lessons have been learned, especially in the American case, where

Keynesianism and central bank intervention has been preferred to the Laissez-faire attitude

during the Great Depression. In a European context, the decision to make taxpayers foot the bill

for the losses of financial speculators marks a departure from the policies of the Great

Depression where speculators suffered heavy losses.

There are, of course, other key differences between the two crises in-so-far as although initially

the global crisis seemed every bit as bad, if not worse than the Great Depression, there are now

signs that this may not be the case. For example, by measuring from the peaks in industrial

production, the decline in industrial production in the nine month period from April 2008 was at

least as severe as in the nine months following the June 1929 peak (Eichengreen and O‘Rourke

2009). Similarly, in that initial nine month period, global stock markets were falling even faster

than in the Great Depression and world trade was also falling much faster than in 1929-30 (Ibid).

However the authors of this study have revised their analysis for 2012 and it paints an altogether

different picture. The levels of industrial production had shown shoots of recovery over the past

couple of years, but growth of global industrial output now appears to be slowing. The upturn

had been promising, but this follows months when production was essentially stagnant. Notably

in the Eurozone, industrial production declined (Eichengreen and O‘Rourke 2012). Since initial

early forecasts, global trade had showed signs of recovery, ―but trade is now also fluctuating

without direction, at levels barely higher than those of April 2008‖ (Ibid). As the authors also

point out, while equity markets have recovered to a large degree compared with their initial drop,

―it is worth observing that world equity markets remain considerably below pre-crisis levels‖

(Ibid). The somewhat gloomy outlook is confirmed by the latest United Nations ‗World

Economic Situation and Prospects‘ pre-release document which states:

Four years after the eruption of the global financial crisis, the world economy is still struggling

to recover. During 2012, global economic growth has weakened further. A growing number of

developed economies have fallen into a double-dip recession. Those in severe sovereign debt

distress moved even deeper into recession, caught in the downward spiralling dynamics from

high unemployment, weak aggregate demand compounded by fiscal austerity, high public debt

burdens, and financial sector fragility (United Nations 2012, p.1).

So, although there are signs that the global crisis may not be as severe as the Great Depression,

recent economic forecasts do not suggest that there will be a clear path to recovery in the near

future. Capitalism has been proven to be susceptible to crises and cycles of boom and bust. The

two cases here have been the most high profile of those crises. It does seem that some of the

lessons of the Great Depression have been learned to reduce the severity of the global crisis.

However, only time will tell if these lessons will ultimately stop a double-dip global recession

and if lessons can be learned from the global crisis for the inevitable next financial crisis that will

come down the line.

Bibliography:

Avellaneda, S.D. and Hardiman, N. 2010. The European Context of Ireland‘s Economic Crisis.

The Economic and Social Review, 41(4),

Bernanke, B.S. 2010. Causes of the recent financial and economic crisis. Statement by Ben

S.Bernanke, Chairman, Board of Governors of the Federal Reserve, before the Financial Crisis

Inquiry Commission, Washington DC,

Bernanke, B.S. 1983. Non-Monetary Effects of the Financial Crisis in the Propagation of the

Great Depression,

Canterbery, E.R. 2011. The Global Great Recession. World Scientific Publishing Company

Incorporated.

Congressional Budget Office 2012. Report on the Troubled Asset Relief Program—March 2012

[Online]. Available from: http://www.cbo.gov/sites/default/files/cbofiles/attachments/03-28-

2012TARP.pdf [Accessed 12/17 2012].

Devine, J. 1994. The causes of the 1929-33 Great Collapse: A Marxian interpretation. Research

in Political Economy, 14pp.119-194.

Eichengreen, B. and O‘Rourke, K.H. 2009. A tale of two depressions. VoxEU.Org, 6

Eichengreen, B. and Rourke, K. 2012. A tale of two depressions redux. VoxEU.Org, 6

Eurostat 2012. Harmonised unemployment rate by sex [Online]. Available from:

http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&language=en&pcode=teilm020&tableSe

lection=1&plugin=1 [Accessed 12/16 2012].

Friedman, M. and Schwartz, A.J. 1971. A monetary history of the United States, 1867-1960.

Princeton University Press.

Galbraith, J.K. 2009. The great crash of 1929. Houghton Mifflin Harcourt.

Index Mundi 2012. United Staes Unemployment Rates [Online]. Available from:

http://www.indexmundi.com/g/g.aspx?c=us&v=74 [Accessed 12/12 2012].

Kindleberger, C.P. 1986a. International Capital Movements and Foreign-Exchange Markets in

Crisis: The 1930s and the 1980s. The Impact of the Depression of the 1930s and its Relevance

for the Contemporary World.Budapest: Karl Marx University, pp.437-455.

Kindleberger, C.P. 1986b. The world in depression, 1929-1939. University of California Press.

McNally, D. 2010. Global slump: The economics and politics of crisis and resistance. PM Press.

Nguyen, A.P. and Enomoto, C.E. 2011. The Troubled Asset Relief Program (TARP) And The

Financial Crisis Of 2007-2008. Journal of Business & Economics Research (JBER), 7(12),

Teichova, A. 1990. The Debate about the Causes of the Crisis 1929-33. UPPSALA PAPERS IN

ECONOMIC HISTORY, pp.7.

Temin, P. 1976. Did monetary forces cause the Great Depression? Norton New York.

United Nations 2012. World Economic Situation and Prospects 2013 [Online]. Available from:

http://www.un.org/en/development/desa/policy/wesp/wesp_current/2013Chap1_embargo.pdf

[Accessed 12/18 2012].

United Nations Economic Commission for Europe 2012. Economic Statistics / Labour Force &

Wages / Unemployment Rate by Country and Year [Online]. Available from:

http://w3.unece.org/pxweb/dialog/Saveshow.asp?lang=1 [Accessed 12/16 2012].

Wade, R. 2008. The First-World debt crisis of 2007-2010 in global perspective. Challenge,

51(4), pp.23-54.

—

Written by: Derek McKenna

Written at: Dublin City University

Written for: Dr. Michael Breen

Date written: January 2013

The ascent of money

A financial history of the world

One way to make sense of the present

financial chaos is to look back at the past

Oct 9th 2008 | From the print edition

http://www.economist.com/node/12376642

THE typical career of a Wall Street banker lasts about a quarter of a century, enough to span just

one big financial crisis. As Niall Ferguson explains in his new book, ―The Ascent of Money‖,

which will be published next month, today's senior financiers would have started out in 1983,

fully ten years after oil and gold prices first began the surge that had ruined the previous

generation of money men. That, he concludes, is a ―powerful justification for the study of

financial history.‖

Mr Ferguson is right. The world needs a book that puts today's crisis into context. It is too late

now to warn investors about expensive houses and financiers about cheap credit. But perhaps the

past can help make sense of the wreckage of banks, brokers and hedge funds that litters the

markets. Looking back may help suggest what to do next. And when the crisis is over and it is

time for the great reckoning, the lessons of history should inform the arguments about what must

change.

This rushed, uneven book, by a British-born Harvard University professor who made his name a

decade ago with a history of the Rothschild banking dynasty, will contribute less than expected

to that debate. It has strengths, including a tidy account of the run-up in housing markets and of

the symbiotic rivalry between America and China. But in the earlier chapters—the history, oddly

enough, where you would expect Mr Ferguson's ambitions for his subject to quicken his

judgments—the words rarely come to life, either as a source of ideas or as narrative.

Perhaps the book was bound to be flawed, given the pace with which today's crisis has torn

through the markets. As the debacle has unfolded, from a housing crisis, to a credit bust, a bank

run and what now looks ominously like a global recession, each episode has posed different

questions. Finishing his manuscript in May this year, Mr Ferguson must have been dizzy with

the unravelling of certainties. And yet, he is at his strongest in his reading of the news. His story

of what is happening today shows prescience, even if it is necessarily incomplete.

It may be that Mr Ferguson was too distracted by the present to pay enough attention to the past.

Claiming to be ―A Financial History of the World‖, the book dutifully dabbles in societies, such

as the Inca, who did not see gold and silver as money, and in the pre-Christian Mesopotamian

clay tablets that served as credit notes for commodities. He traces the transformation of

banchieri, named for the benches where money was changed, into the families that dominated

the political and cultural life of Renaissance Italy and from there into modern bankers. He

explains how the bond market had its origins in the state's need for money to finance war. He

describes how manias have repeatedly engulfed greedy investors over the centuries—

concentrating on John Law, whose schemes ruined 18th-century France. And he rehearses the

story of financial risk from its origins in Enlightenment Scotland.

Yet the reader is left wondering quite who the book is aimed at. The finance specialist will not

find enough here to begin to compete with the work of Charles Kindleberger, an economic

historian. And the reader who wants to know how finance is interwoven with general history

would do better to turn to Jeffry Frieden's excellent 2006 work, ―Global Capitalism‖.

Mr Ferguson may seem to be speaking to a general audience, given that he has taken his title

from ―The Ascent of Man‖, Jacob Bronowksi's book and television series of a quarter-century

ago which analysed the contribution of science to civilisation. Yet these readers will be baffled

by passages that breezily toss around ideas like ―sterilisation‖—the issue of bonds by a

government to mop up the inflation-inducing money it prints to buy foreign currency. And they

may be put off by Mr Ferguson's attempt to be jolly. After two and half pages on the

mathematics of bond yields, for example, comes this quip: ―So how did this ‗Mr Bond' become

so much more powerful than the Mr Bond created by Ian Fleming? Why, indeed, do both kinds

of bond have a licence to kill?‖

Of far greater interest is Mr Ferguson's general theory, which does not emerge until the end of

the book. He thinks that finance evolves through natural selection. Although the professor

cautions against the sort of Darwinism that sees evolution as progress, he believes that new sorts

of finance are constantly coming into being as the environment changes. The sequence of

creation, selection and destruction is what has generated many of the financial techniques that

modern economies depend on.

This leads Mr Ferguson to make two timely points. One is to remember that evolution depends

on extinction as well as creation. You have to allow ill-adapted techniques to fail if you are

going to get something new. As the world rushes around rescuing every bank in sight, it is a

reminder that the guarantor-state will later have to administer painful medicine.

The other is to observe the wonder of what financial evolution has created. Just now it is only

natural to think of the ―roller-coaster ride of ups and downs, bubbles and busts, manias and

panics, shocks and crashes.‖ But Mr Ferguson sees something else too: ―From ancient

Mesopotamia to present-day China…the ascent of money has been one of the driving forces

behind human progress: a complex process of innovation, intermediation and integration that has

been as vital as the advance of science or the spread of law in mankind's escape from the

drudgery of subsistence agriculture and the misery of the Malthusian trap.‖ Amid this financial

bust, cleave to that.

From the print edition: Books and arts

New preface to Charles Kindleberger, The

World in Depression 1929-1939

J. Bradford DeLong, Barry Eichengreen 12 June 2012

http://www.voxeu.org/article/new-preface-charles-kindleberger-world-depression-1929-1939

Charles Kindleberger‘s classic book on the Great Depression was originally published 40 years

ago. In the preface to a new edition, two leading economists argue that the lessons are as relevant

as ever.

The parallels between Europe in the 1930s and Europe today are stark, striking, and increasingly

frightening. We see unemployment, youth unemployment especially, soaring to unprecedented

heights. Financial instability and distress are widespread. There is growing political support for

extremist parties of the far left and right.

Both the existence of these parallels and their tragic nature would not have escaped Charles

Kindleberger, whose World in Depression, 1929-1939 was published exactly 40 years ago, in

1973.1 Where Kindleberger‘s canvas was the world, his focus was Europe. While much of the

earlier literature, often authored by Americans, focused on the Great Depression in the US,

Kindleberger emphasised that the Depression had a prominent international and, in particular,

European dimension. It was in Europe where many of the Depression‘s worst effects, political as

well as economic, played out. And it was in Europe where the absence of a public policy

authority at the level of the continent and the inability of any individual national government or

central bank to exercise adequate leadership had the most calamitous economic and financial

effects.2

These were ideas that Kindleberger impressed upon generations of students as well on his

reading public. Indeed, anyone fortunate enough to live in New England in the early 1980s and

possessed of even a limited interest in international financial and monetary history felt compelled

to walk, drive or take the T (as metropolitan Boston‘s subway is known to locals) down to MIT's

Sloan Building in order to listen to Kindleberger‘s lectures on the subject (including both the

authors of this preface). We understood about half of what he said and recognised about a quarter

of the historical references and allusions. The experience was intimidating: Paul Krugman, who

was a member of this same group and went on to be awarded the Nobel Prize for his work in

international economics, has written how Kindleberger's course nearly scared him away from

international macroeconomics. Kindleberger's lectures were surely ―full of wisdom", Krugman

notes. But then, ―who feels wise in their twenties?" (Krugman 2002).

There was indeed much wisdom in Kindleberger‘s lectures, about how markets work, about how

they are managed, and especially about how they can go wrong. It is no accident that when

Martin Wolf, dean of the British financial journalists, challenged then former-US Treasury

Secretary Lawrence Summers in 2011 to deny that economists had proven themselves useless in

the 2008-9 financial crisis, Summers's response was that, to the contrary, there was a useful

economics. But what was useful for understanding financial crises was to be found not in the

academic mainstream of mathematical models festooned with Greek symbols and complex

abstract relationships but in the work of the pioneering 19th century financial journalist Walter

Bagehot, the 20th-century bubble theorist Hyman Minsky, and "perhaps more still in

Kindleberger" (Wolf and Summers 2011).

Summers was right. We speak from personal experience: for a generation the two of us have

been living – very well, thank you – off the rich dividends thrown off by the intellectual capital

that we acquired from Charles Kindleberger, earning our pay cheques by teaching our students

some small fraction of what Charlie taught us. Three lessons stand out, the first having to do with

panic in financial markets, the second with the power of contagion, the third with the importance

of hegemony.

First, panic. Kindleberger argued that panic, defined as sudden overwhelming fear giving rise to

extreme behaviour on the part of the affected, is intrinsic in the operation of financial markets. In

The World in Depression he gave the best ever ―explain-and-illustrate-with-examples‖ answer to

the question of how and why panic occurs and financial markets fall apart. Kindleberger was an

early apostate from the efficient-markets school of thought that markets not just get it right but

also that they are intrinsically stable. His rival in attempting to explain the Great Depression,

Milton Friedman, had famously argued that speculation in financial markets can‘t be

destabilising because if destabilising speculators drive asset values away from justified, or

equilibrium, levels, such speculators will lose money and eventually be driven out of the

market.3 Kindleberger pushed back by observing that markets can continue to get it wrong for a

very, very long time. He girded his position by elaborating and applying the work of Minsky,

who had argued that markets pass through cycles characterised first by self-reinforcing boom,

next by crash, then by panic, and finally by revulsion and depression. Kindleberger documented

the ability of what is now sometimes referred to as the Minsky-Kindleberger framework to

explain the behaviour of markets in the late 1920s and early 1930s – behaviour about which

economists otherwise might have arguably had little of relevance or value to say. The Minsky

paradigm emphasising the possibility of self-reinforcing booms and busts is the organising

framework of The World in Depression. It then comes to the fore in all its explicit glory in

Kindleberger‘s subsequent book and summary statement of the approach, Mania, Panics and

Crashes.4

Kindleberger‘s second key lesson, closely related, is the power of contagion. At the centre of

The World in Depression is the 1931 financial crisis, arguably the event that turned an already

serious recession into the most severe downturn and economic catastrophe of the 20th century.

The 1931 crisis began, as Kindleberger observes, in a relatively minor European financial centre,

Vienna, but when left untreated leapfrogged first to Berlin and then, with even graver

consequences, to London and New York. This is the 20th century‘s most dramatic reminder of

quickly how financial crises can metastasise almost instantaneously. In 1931 they spread through

a number of different channels. German banks held deposits in Vienna. Merchant banks in

London had extended credits to German banks and firms to help finance the country‘s foreign

trade. In addition to financial links, there were psychological links: as soon as a big bank went

down in Vienna, investors, having no way to know for sure, began to fear that similar problems

might be lurking in the banking systems of other European countries and the US. In the same

way that problems in a small country, Greece, could threaten the entire European System in

2012, problems in a small country, Austria, could constitute a lethal threat to the entire global

financial system in 1931 in the absence of effective action to prevent them from spreading.This

brings us to Kindleberger‘s third lesson, which has to do with the importance of hegemony,

defined as a preponderance of influence and power over others, in this case over other nation

states. Kindleberger argued that at the root of Europe‘s and the world‘s problems in the 1920s

and 1930s was the absence of a benevolent hegemon: a dominant economic power able and

willing to take the interests of smaller powers and the operation of the larger international system

into account by stabilising the flow of spending through the global or at least the North Atlantic

economy, and doing so by acting as a lender and consumer of last resort. Great Britain, now but

a middle power in relative economic decline, no longer possessed the resources commensurate

with the job. The rising power, the US, did not yet realise that the maintenance of economic

stability required it to assume this role. In contrast to the period before 1914, when Britain acted

as hegemon, or after 1945, when the US did so, there was no one to stabilise the unstable

economy. Europe, the world economy‘s chokepoint, was rendered rudderless, unstable, and

crisis- and depression-prone. That is Kindleberger‘s World in Depression in a nutshell. As he put

it in 1973:

―The 1929 depression was so wide, so deep and so long because the international economic

system was rendered unstable by British inability and United States unwillingness to assume

responsibility for stabilising it in three particulars: (a) maintaining a relatively open market for

distress goods; (b) providing counter-cyclical long-term lending; and (c) discounting in crisis….

The world economic system was unstable unless some country stabilised it, as Britain had done

in the nineteenth century and up to 1913. In 1929, the British couldn't and the United States

wouldn't. When every country turned to protect its national private interest, the world public

interest went down the drain, and with it the private interests of all…‖

Subsequently these insights stimulated a considerable body of scholarship in economics,

particularly models of international economic policy coordination with and without a dominant

economic power, and in political science, where Kindleberger‘s ―theory of hegemonic stability‖

is perhaps the leading approach used by political scientists to understand how order can be

maintained in an otherwise anarchic international system.5

It might be hoped that something would have been learned from this considerable body of

scholarship. Yet today, to our surprise, alarm and dismay, we find ourselves watching a rerun of

Europe in 1931. Once more, panic and financial distress are widespread. And, once more,

Europe lacks a hegemon – a dominant economic power capable of taking the interests of smaller

powers and the operation of the larger international system into account by stabilising flows of

finance and spending through the European economy. The ECB does not believe it has the

authority: its mandate, the argument goes, requires it to mechanically pursue an inflation target –

which it defines in practice as an inflation ceiling. It is not empowered, it argues, to act as a

lender of the last resort to distressed financial markets, the indispensability of a lender of last

resort in times of crisis being another powerful message of The World in Depression. The EU, a

diverse collection of more than two dozen states, has found it difficult to reach a consensus on

how to react. And even on those rare occasions where it does achieve something approaching a

consensus, the wheels turn slowly, too slowly compared to the crisis, which turns very fast.

The German federal government, the political incarnation of the single most consequential

economic power in Europe, is one potential hegemon. It has room for countercyclical fiscal

policy. It could encourage the European Central Bank to make more active use of monetary

policy. It could fund a Marshall Plan for Greece and signal a willingness to assume joint

responsibility, along with its EU partners, for some fraction of their collective debt. But

Germany still thinks of itself as the steward is a small open economy. It repeats at every turn that

it is beyond its capacity to stabilise the European system: ―German taxpayers can only bear so

much after all‖. Unilaterally taking action to stabilise the European economy is not, in any case,

its responsibility, as the matter is perceived. The EU is not a union where big countries lead and

smaller countries follow docilely but, at least ostensibly, a collection of equals. Germany‘s own

difficult history in any case makes it difficult for the country to assert its influence and authority

and equally difficult for its EU partners, even those who most desperately require it, to accept

such an assertion.6 Europe, everyone agrees, needs to strengthen its collective will and ability to

take collective action. But in the absence of a hegemon at the European level, this is easier said

than done.

The International Monetary Fund, meanwhile, is not sufficiently well capitalised to do the job

even were its non-European members to permit it to do so, which remains doubtful. Viewed

from Asia or, for that matter, from Capitol Hill, Europe‘s problems are properly solved in

Europe. More concretely, the view is that the money needed to resolve Europe‘s economic and

financial crisis should come from Europe. The US government and Federal Reserve System, for

their part, have no choice but to view Europe‘s problems from the sidelines. A cash-strapped US

government lacks the resources to intervene big-time in Europe‘s affairs in 1948; there will be no

21st century analogue of the Marshall Plan, when the US through the Economic Recovery

Programme, of which the young Charles Kindleberger was a major architect, extended a

generous package of foreign aid to help stabilise an unstable continent. Today, in contrast, the

Congress is not about to permit Greece, Ireland, Portugal, Italy, and Spain to incorporate in

Delaware as bank holding companies and join the Federal Reserve System.7

In a sense, Kindleberger predicted all this in 1973. He saw the power and willingness of the US

to bear the responsibility and burden of sacrifice required of benevolent hegemony as likely to

falter in subsequent generations. He saw three positive and three negative branches on the then-

future's probability tree. The positive outcomes were: "[i] revived United States leadership… [ii]

an assertion of leadership and assumption of responsibility... by Europe…‖ [sitting here, in 2013,

one might be tempted to add emerging markets like China as potentially stepping into the

leadership breach, although in practice the Chinese authorities have been reluctant to go there,

and] [iii] cession of economic sovereignty to international institutions….‖ Here, in a sense,

Kindleberger had both global and regional – meaning European – institutions in mind. ―The

last‖, meaning a global solution, ―is the most attractive‖, he concluded,‖ but perhaps, because

difficult, the least likely…" The negative outcomes were: "(a) the United States and the [EU]

vying for leadership… (b) one unable to lead and the other unwilling, as in 1929 to 1933… (c)

each retaining a veto… without seeking to secure positive programmes…"

As we write, the North Atlantic world appears to have fallen foul to his bad outcome (c), with

extraordinary political dysfunction in the US preventing its government from acting as a

benevolent hegemon, and the ruling mandarins of Europe, in Germany in particular, unwilling to

step up and convince their voters that they must assume the task.

It was fear of this future that led Kindleberger to end The World in Depression with the

observation: ―In these circumstances, the third positive alternative of international institutions

with real authority and sovereignty is pressing.‖

Indeed it is, more so now than ever.

References

Eichengreen, Barry (1987), ―Hegemonic Stability Theories of the International Monetary

System‖, in Richard Cooper, Barry Eichengreen, Gerald Holtham, Robert Putnam and Randall

Henning (eds.), Can Nations Agree? Issues in International Economic Cooperation, The

Brookings Institution, 255-298.

Friedman, Milton (1953), ―The Case for Flexible Exchange Rates‖, in Essays in Positive

Economics, University of Chicago Press.

Friedman, Milton and Anna J Schwartz (1963), A Monetary History of the United States, 1967-

1960, Princeton University Press.

Gilpin, Robert (1987), The Political Economy of International Relations, Princeton University

Press.

Keohane, Robert (1984), After Hegemony, Princeton University Press.

Kindleberger, Charles (1978), Manias, Panics and Crashes, Norton.

Krugman, Paul (2003), ―Remembering Rudi Dornbusch‖, unpublished manuscript,

www.pkarchive.org, 28 July.

Lake, David (1993), ―Leadership, Hegemony and the International Economy: Naked Emperor or

Tattered Monarch with Potential?‖, International Studies Quarterly, 37: 459-489.

Wolf, Martin and Lawrence Summers (2011), ―Larry Summers and Martin Wolf: Keynote at

INET‘s Bretton Woods Conference 2011‖, www.youtube.com, 9 April.

1 Kindleberger passed away in 2003. A second modestly revised and expanded edition of The World in Depression

was then published, also by the University of California Press, in 1986. The second edition differed mainly by

responding to the author‘s critics and commenting to some subsequent literature. We have chosen to reproduce the

‗unvarnished‘ 1973 Kindleberger, where the key points are made in unadorned fashion.

2 The book was commissioned originally for a series on the economic history of Europe, with each author writing

on a different decade. This points to the question of why the title was not, instead, ―Europe in Depression.‖ The

answer, presumably, is that the author – and his publisher wished to acknowledge that the Depression was not

exclusively a European phenomenon and that the linkages between Europe and the US were also critically

important.

3 Friedman‘s great work on the Depression, coauthored with Anna Jacobson Schwartz (1963), was in

Kindleberger‘s view too monocausal, focusing on the role of monetary policy, and too U.S. centric. See also

Friedman (1953)

4 Kindleberger (1978). Kindleberger amply acknowledged his intellectual debt to Minsky. But we are not alone if

we suggest that Kindleberger‘s admirably clear presentation of the framework, and the success with which he

documented its power by applying it to historical experience, rendered it more impactful in the academy and

generally.

5 A sampling of work in economics on international policy coordination inspired by Kindleberger includes

Eichengreen (1987) and Hughes Hallet, Mooslechner and Scheurz (2001). Three important statements of the

relevant work in international relations are Keohane (1984), Gilpin (1987) and Lake (1993).

6 The European Union was created, in a sense, precisely in order to prevent the reassertion of German hegemony.

7 The point being that the US, in contrast, does possess a central bank willing, under certain circumstances, to

acknowledge its responsibility for acting as a lender of last resort. Nothing in fact prevents the Federal Reserve,

under current institutional arrangements from, say, purchasing the bonds of distressed Southern European sovereigns. But this would be viewed as peculiar and inappropriate in many quarters. The Fed has a full plate of

other problems. And intervening in European bond markets, the argument would go, is properly the responsibility of

the leading European monetary authority.

January 03, 2009

Charles Kindleberger: Anatomy of a Typical Financial Crisis

Kindleberger: The Model

http://delong.typepad.com/egregious_moderation/2009/01/charles-kindleberger-anatomy-of-a-

typical-financial-crisis.html

We start with the model of the late Hyman Minsky, a man with a reputation among monetary

theorists for being particularly pessimistic, even lugubrious, in his emphasis on the fragility of

the monetary system and its propensity to disaster. Although Minsky was a monetary theorist

rather than an economic historian, his model lends itself effectively to the interpretation of

economic and financial history. Indeed, in its emphasis on the instability of the credit system, it

is a lineal descendant of a model, set out with personal variations, by a host of classical

economists including John Stuart Mill, Alfred Marshall, Knut Wicksell, and Irving Fisher. Like

Fisher, Minsky attached great importance to the role of debt structures in causing financial

difficulties, and especially debt contracted to leverage the acquisition of speculative assets for

subsequent resale.

According to Minsky, events leading up to a crisis start with a "displacement," some exogenous,

outside shock to the macroeconomic system. The nature of this displacement varies from one

speculative boom to another. It may be the outbreak or end of a war, a bumper harvest or crop

failure, the widespread adoption of an invention with pervasive effects---canals, railroads, the

automobile---some political event or surprising financial success, or debt conversion that

precipitously lowers interest rates. An unanticipated change of monetary policy might constitute

such a displacement and some economists who think markets have it right and governments

wrong blame "policy-switching" for some financial instability. But whatever the source of the

displacement, if it is sufficiently large and pervasive, it will alter the economic outlook by

changing profit opportunities in at least one important sector of the economy. Displacement

brings opportunities for profit in some new or existing lines and closes out others. As a result,

business firms and individuals with savings or credit seek to take advantage of the former and

retreat from the latter. If the new opportunities dominate those that lose, investment and

production pick up. A boom is under way.

In Minsky‘s model, the boom is fed by an expansion of bank credit that enlarges the total money

supply. Banks typically can expand money, whether by the issue of bank‘s notes under earlier

institutional arrangements or by lending in the form of addictions to bank deposits. Bank credit

is, or at least has been, notoriously unstable, and the Minsky model rests squarely on that fact.

This feature of the Minsky model is incorporated in what follows, but we go further. Before

banks had evolved, and afterward, additional means of payment to fuel a speculative mania were

available in the virtually infinitely expansible nature of personal credit. For a given banking

system at a given time, monetary means of payment may be expanded not only within the

existing system of banks but also by the formation of new banks, the development of new credit

instruments, and the expansion of personal credit outside of banks. Crucial questions of policy

turn on how to control all these avenues of monetary expansion. But even if the instability of old

and potential new banks were corrected, instability of personal credit would remain to provide

means of payment to finance the boom, given a sufficiently throughgoing stimulus.

Let us assume, then, that the urge to speculate is present and transmuted into effective demand

for goods or financial assets. After a time, increased demand presses against the capacity to

produce goods or the supply of existing financial assets. Prices increase, giving rise to new profit

opportunities and attracting still further firms and investors. Positive feedback develops, as new

investment leads to increases in income that stimulate further investment and further income

increases. At this stage we may well get what Minsky called "euphoria." Speculation for price

increases is added to investment for production and sale. If this process builds up, the result is

often, though not inevitably, what Adam Smith and his contemporaries called "overtrading."

Now, overtrading is by no means a clear concept. It may involve pure speculation for a price

rise, an overestimate of prospective returns, or excessive "gearing." Pure speculation, of course

involves buying for resale rather than use in the case of comodities or for resale rather than

income in the case of financial assets. Overestimation of profits comes from euphoria, affects

firms engaged in the production and distributive processes, and requires no explanation.

Excessive gearing arises from cash requirements that are low relative both to the prevailing price

of a good or asset and to possible changes in its price. It means buying on margin, or by

installments, under circumstances in which one can sell the asset and transfer with it the

obligation to make future payments. As firms or households see others making profits from

speculative purchases and resales, they tend to follow: "Monkey see, monkey do." In my talks

about financial crisis over the last decades, I have polished one line that always gets a nervous

laugh: "There is nothing so disturbing to one‘s well-being and judgment as to see a friend get

rich. When the number of firms and households indulging in these practices grows large,

bringing in segments of the population that are normally aloof from such ventures, speculation

for profit leads away from normal, rational behavior to what has been described as "manias" or

"bubbles." The word mania emphasizes the irrationality; bubble foreshadows the bursting. In the

technical language of some economists, a bubble is any deviation from "fundamentals," whether

up or down, leading to the possibility and even the reality of negative bubbles, which rather gets

away from the thrust of the metaphor. More often small price variations about fundamental

values (as prices) are called "noise." In this book, a bubble is an upward price movement over an

extended range that then implodes. An extended negative bubble is a crash.

As we shall see in the next chapter the object of speculation may vary widely from one mania or

bubble to the next. It may involve primary products, especially those imported from afar (where

the exact conditions of supply and demand are not known in detail), or goods manufactured for

export to distant markets, domestic and foreign securities of various kinds, contracts to buy or

sell goods or securities, land in the country or city, houses, office buildings, shopping centers,

condominiums, foreign exchange. At a late stage, speculation tends to detach itself from really

valuable objects and turn to delusive ones. A larger and larger group of people seeks to become

rich without a real understanding of the processes involved. Not surprisingly, swindlers and

catchpenny schemes flourish.

Although Minsky‘s model is limited to single country, overtrading has historically tended to

spread from one country to another. The conduits are many. Internationally traded commodities

and assets that go up in price in one market will rise in others through arbitrage. The foreign-

trade multiplier communicates income changes in a given country to others through increased or

decreased imports. Capital flows constitute a third link. Money flows of gold, silver (under gold

standard or bimetallism), or foreign exchange are a fourth. And there are purely psychological

connections, as when investor euphoria or pessimism in one country infects investors in others.

The declines in prices on October 24 and 29, 1929, and October 19, 1987, were practically

instantaneous in all financial markets (except Japan), far faster than can be accounted for by

arbitrage, income changes, capital flows, or money movements.

Observe with respect the money movements that in an ideal world, a gain of specie for one

country would be matched by a corresponding loss for another, and the resulting expansion in

the first case would be offset by the contraction in the second. In the real world, however, while

the boom in the first country may gain speed from the increase in the supply of reserves, or

"high-powered money," it may also rise in the second, despite the loss in monetary reserves, as

investors respond to rising prices and profits abroad by joining in the speculative chase. In other

words, the potential contraction from the shrinkage on the monetary side may be overwhelmed

by the increase in speculative interest and the rise in demand. For the two countries together, in

any event, the credit system is stretched tighter.

As the speculative boom continues, interest rates, velocity of circulation, and prices all continue

to mount. At some stage, a few insiders decide to take their profits and sell out. At the top of the

market there is hesitation, as new recruits to speculation are balanced by insiders who withdraw.

Prices begin to level off. There may then ensue an uneasy period of "financial distress." The term

comes from corporate finance, where a firm is said to be in financial distress when it must

contemplate the possibility, perhaps only a remote one, that it will not be able to meet its

liabilities. For an economy as a whole, the equivalent is the awareness on the part of a

considerable segment of the speculating community that a rush for liquidity---to get out of other

assets and into money---may develop, with disastrous consequences for the prices of goods and

securities, and leaving some speculative borrowers unable to pay off their loans. As distress

persists, speculators realize, gradually or suddenly, that the market cannot go higher. It is time to

withdraw. The race out of real or long-term financial assets and into money may turn into a

stampede.

The specific signal that precipitates the crisis may be the failure of a bank or firm stretched too

tight, the revelation of a swindle or defalcation by someone who sought to escape distress by

dishonest means, or a fall in the price of the primary object of speculation as it, at first alone, is

seen to be overpriced. In any case, the rush is on. Prices decline. Bankruptcies increase.

Liquidation sometimes is orderly but may degenerate into panic as the realization spreads that

there is only so much money, not enough to enable everyone to sell out at the top. The word for

this state---again, not from Minsky---is revulsion. Revulsion against commodities or securities

leads banks to cease lending on the collateral of such assets. In the early nineteenth century this

condition was known as discredit. Overtrading, revulsion, discredit—all these terms have a

musty, old-fashion flavor. They are imprecise, but they do convey a graphic picture.

Revulsion and discredit may go so far as to lead to panic (or as the Germans put it,

Torschlusspanik. "door-shut-panic"), with people crowding to get through the door before it

slams shut. The panic feeds on itself, as did the speculation, until one or more of three things

happen: (1) prices fall so low that people are again tempted to move back into less liquid assets;

(2) trade is cut off by setting limits on price declines, shutting down exchanges, or otherwise

closing trading; or (3) a lender of last resort succeeds in convincing the market that money will

be made available in sufficient volume to meet the demand for cash. Confidence may be restored

even if a large volume of money is not issued against other assets; the mere knowledge that one

can get money is frequently sufficient to moderate or eliminate the desire.

Whether there should be a lender of last resort is a matter of some debate. Those who oppose the

function argue that it encourages speculation in the first place. Supporters worry more about the

current crisis than about forestalling some future one. There is also a question of the place for an

international lender of last resort. In domestic crises, government or the central bank (when there

is one) has responsibility. At the international level, there is neither a world government nor any

world bank adequately equipped to serve as a lender of last resort, although some would contend

that the International Monetary Fund since Bretton Woods in 1944 is capable of discharging the

role.

Dilemmas, debates, doubts, questions abound. We shall have more to say about these questions

later on.

Recommended Reading

http://neilirwin.com/recommended-reading/

These are resources that helped shape my understanding of both the current crisis and the history

of central banking while researching The Alchemists. Taken together, they amount to a reading

list for those hoping to understand the economic forces that have buffeted the world over the last

few years, and the central bankers who have tried with mixed success to contain them.

On the origins of the current crisis, Bethany McLean and Joe Nocera‘s All the Devils Are

Here is the most authoritative version of the ―how we got here‖ story. Michael Lewis‘s The Big

Short is a quick and entertaining look at the idiosyncratic investors who bet against the mortgage

securities that almost brought down the global economy. The best nonfiction accounts of the

2007-2008 phase of the crisis are David Wessel‘s In Fed We Trust and Andrew Ross Sorkin‘s

Too Big to Fail which tell the story from the vantage point of the Federal Reserve and Wall

Street titans, respectively. Memoirs by two key finance ministers of this period, Hank Paulson

(On the Brink) and Alistair Darling (Back from the Brink), are important pieces of the historical

record as well.

For a more dramatic telling, try the movie version of Too Big to Fail or the fictional-but-realistic

movie Margin Call. Both are more riveting than a movie about financial calamity has any right

to be.

For the detailed story of the crisis that has enveloped Europe since 2010, threatening to undo half

a century of progress toward a united Europe, Carlo Bastasin‘s Saving Europe, published in

2012, is the most detailed treatment to date, including the work of European Central Bank

president Jean-Claude Trichet. Michael Lewis‘s Boomerang is a more impressionistic, unfair,

and hilarious account of a troubled Europe. Dan Conaghan‘s The Bank tells the full story of the

Bank of England under the reign of Sir Mervyn King.

To understand the world‘s contemporary challenges, it helps to understand some key moments in

economic history, which I deal with in some detail in The Alchemists. For further reading, Walter

Bagehot‘s Lombard Street: A Description of the Money Market remains surprisingly engaging

and understandable to the modern reader. There is a reason that nearly 150 years after it was

published it remains something of a bible for central bankers. Geoffrey Elliott‘s The Mystery of

Overend & Gurney tells the detailed story of the proto–Lehman Brothers. Robert F. Bruner and

Sean D. Carr tell the story of the financial crisis that led to the creation of the Fed in their The

Panic of 1907, and H. W. Brands‘s The Money Men is a brief history of American central

banking up to that point.

Ben Bernanke once wrote that ―to understand the Great Depression is the Holy Grail of

macroeconomics,‖ and fortunately there is a wealth of both popular and scholarly efforts to do

just that. Liaquat Ahamed‘s Lords of Finance covers the era through the window of its leading

central bankers. Adam Fergusson‘s When Money Dies is a brisk and accessible account of the

German hyperinflation of the early 1920s, and Gerald D. Feldman‘s The Great Disorder an

exhaustive and authoritative version. On the economics of the Great Depression, A Monetary

History of the United States by Milton Friedman and Anna Jacobson Schwartz is hard to surpass,

and Charles Kindleberger‘s The World in Depression and Barry Eichengreen‘s Golden Fetters

also offer rich pictures of the period.

On the creation of the eurozone, David Marsh‘s The Euro and Otmar Issing‘s The Birth of the

Euro are essential reading, and Kenneth Dyson and Kevin Featherstone‘s The Road to

Maastricht is a richly detailed scholarly account. John Maynard Keynes‘s Economic

Consequences of the Peace was written in 1919, yet is essential reading for anyone wishing to

understand European history in the century since.