A Very Large Invisible College Indeed: Analogies to teh Great Depression

So I surf to Mark Thoma's website physically located 400 miles north of my office in order to find the smart things being written eight feet to my north, on the other side of my office wall. Barry Eichengreen:

From Wall Street to Main Street: Lessons from the Great Depression: A couple of months ago at lunch with a respected Fed watcher, I asked, “What are the odds are that US unemployment will reach 10% before the crisis is over?” “Zero,” he responded, in an admirable display of confidence. Watchers tending to internalise the outlook of the watched, I took this as reflecting opinion within the US central bank.... The Fed and Treasury were on the case. US economic fundamentals were strong. Comparisons with the 1930s were overdrawn.

The events of the last week have shattered such complacency. The 3 month treasury yield has fallen to “virtual zero” for the first time since the flight to safety following the outbreak of World War II. The Ted Spread, the difference between borrowing for 3 months on the interbank market and holding three month treasuries, ballooned at one point to five full percentage points. Interbank lending is dead in its tracks. The entire US investment banking industry has been vaporised. And we are in for more turbulence. The Paulson Plan, whatever its final form, will not bring this upheaval to an early end.... So comparisons with the Great Depression.... Which ones have content, and which are mainly useful for headline writers? 

First, the Fed now, like the Fed in the 1930s, is very much groping in the dark. Every financial crisis is different, and this one is no exception. It is hard to avoid concluding that the Fed erred disastrously when deciding that Lehman Bros. could safely be allowed to fail. It did not adequately understand the repercussions for other institutions of allowing a primary dealer to go under. It failed to fully appreciate the implications for AIG’s credit default swaps. It failed to understand that its own actions were bringing us to the brink of financial Armageddon.

If there is a defence, it has been offered [by] Rick Mishkin, the former Fed governor, who has asserted that the current shock to the financial system is even more complex than that of the Great Depression. There is something to his point. In the 1930s the shock to the financial system came from the fall in the general price level by a third and the consequent collapse of economic activity. The solution was correspondingly straightforward. Stabilise the price level, as FDR did by pumping up the money supply, and it was possible to stabilise the economy, in turn righting the banking system.

Absorbing the shock is more difficult this time because it is internal to the financial system. Central to the problem are excessive leverage, opacity, and risk taking in the financial sector itself. There has been a housing-market collapse, but in contrast to the 1930s there has been no general collapse of prices and economic activity. Corporate defaults have remained relatively low, which has been a much-needed source of comfort to the financial system. But this also makes resolving the problem more difficult. Since there has been no collapse of prices and economic activity, we are not now going to be able to grow or inflate our way out of the crisis, as we did after 1933.

In addition, the progress of securitisation complicates the process of unravelling the current mess....

That said, we are not going to see 25% unemployment rates like those of the Great Depression. Then it took breathtaking negligence by the Fed, the Congress and the Hoover Administration to achieve them. This time the Fed will provide however much liquidity the economy needs. There will be no tax increases designed to balance the budget in the teeth of a downturn, like Hoover’s in 1930. Where last time it took the Congress three years to grasp the need to recapitalise the banking system and provide mortgage relief, this time it will take only perhaps half as long. Ben Bernanke, Hank Paulson and Barney Frank are all aware of that earlier history and anxious to avoid repeating it.  

And what the contraction of the financial services industry taketh, the expansion of exports can giveth back.... The ongoing decline of the dollar will be the mechanism bringing about this reallocation of resources. But the US economy, notwithstanding the admirable flexibility of its labour markets, is not going to be able to move unemployed investment bankers onto industrial assembly lines overnight. I suspect that I am now less likely to be regarded as a lunatic when I ask whether unemployment could reach 10%.

Three points. (1) We could inflate our way out of it--in the 1930s we had a 30% product price deflation, and now we have had a 30% housing price deflation. Balanced inflation would remove the debt overhang in both cases. We may well not want to resolve the problem via inflation--and I suspect that even by raising the theoretical possibility I have reduced my chances of attaining high office in the Eccles Building to something indistinguishable from zero--but we could.

(2) Barry is right. Particularly, it looks as though Barry is right about Lehman Brothers. In retrospect, the decision to let Lehman fail without rescue, control, or supervision looks to be the first significant misstep that Bernanke and Paulson have made in the past fifteen months. Clearly it looked to them to be a good idea at the time, and clearly they have more information than I do, and it is impossible to dance this dance and put every foot right. I'm sure that had I been at the Treasury or the Fed I would have made worse mistakes by now than they have made. But:

It looks like it is the failure to cushion the losses of the creditors of Lehman than has produced the need for emergency action. If the Fed and the Treasury had offered Sunday night to buy as much of Lehman debt as the market offered at 75% of the previous Friday's market price, I don't think we would be staring into this particular abyss right now.

(3) Nevertheless, I said a year ago that if the unemployment rate stays below ten percent then it is a win for monetary policy. And I still think we have an 80% chance of achieving that...

Comments

[elliottg]

Why not a surtax on incomes above $1 million and repeal of the inheritance tax giveaway? Why are those not on the table?

[Matt]

If a late night decision by two people condemned the world economy to the edge of the abyss, then something more drastic is wrong, perhaps our very tendency to look to two men is wrong. How did the American tax system become the growth engine of last resort?

If the federal government is to absorb the shock, the volatility; then how do we expect Congress to operate? They operate under the assumption of risk free, long term; while the economy is asking them operate with increased volatility in federal financing.

If Congress did what we asked, then Congress should be managing federal financing with short term debt, and they would have to minutely manage programs, scrap the indexes and price fixes and manage month by month as short term rates show high volatility.

You have overloaded Congress and Congress will fail. We are in that miracle period when progressives are perfectly happy investing SS funds into the stock market. You will end up with a new deal laden Congress, endless hearings while the economy is put on hold.

[Walt]

What about encouraging banks to hold preferred stock in Fannie and Freddie, and then cutting the preferred dividend?

[marc sobel]

Do you remember during the Impeachment "Crisis" how the refrain was rule-a-law ? Well the right wing has been using "Moral Hazard" as a war cry to avoid health care reform, bankruptcy reform, and veteran educational benefits. I think our war cry should be "More-a-Hazard" and keep on pushing it because frankly I think the idea of "why negotiate with Buffet when the Government will give it to you free" http://tinyurl.com/4ujehl is very believable. Too big to fail means no accountability.

Personally, I favor the Republican methods in this case. http://shakespearessister.blogspot.com/2008/09/temerity-size-of-texas.html

[Kato Bernanke]

Outlaw corporate contributions to congress critters. Individual donations and limited in that too.

[Davis X. Machina]

Outlaw corporate contributions to congress critters. Individual donations and limited in that too.

Already done. Corporations can't contribute, and individual contributions are capped at $2400.

[Gene O'Grady]

Fairly trivially, Eugene is about 550 miles north of Berkeley, not 400.

[jim]

We'd be staring into a different abyss. Letting Lehman fail concentrated the minds of Morgan Stanley and Goldman Sachs wonderfully. Had Paulson and Bernanke "saved" Lehman, in the way they saved Bear, we'd probably be on a Morgan Stanley deathwatch now. Who knows if we wouldn't still have ended up in a $700B bailout situation. AIG was toast either way, I think.

It is an error to assume that because the consequences of one choice were bad, the consequences of the alternative must have been good.

[ken]

Walt is right.

The first disasterous decision of the Treasury was to stop paying dividends on Fannie and Freddie preferred stock. This put a 30 billion dollar hole in bank balance sheets and was completely unnecessary. After that the bancrupcy of Lehman set the credit markets in free fall. Then recently we had WaMu given to JPM by the FDIC leaving the bondholders out in the cold. If the government wants to send a message telling private capital to get lost this is exactly the way to do it.

[Sandwichman]

Apples and oranges. Today's unemployment rate doesn't measure the same thing an unemployment rate from the 1930s did. It isn't really comparable with unemployment in the 1960s or 70s. Just to mention a few of the biggies, there was no social security old-age pension in 1930, medical insurance was not tied to employment but health care costs were less relative to other expenses, government employment (not to mention incarceration) was a much smaller component.

The unemployment rate was only ever meaningful as an indicator of something else: how well people could maintain their accustomed standard of living. Considering that over the past 30 years American families have maintained their standard of living by increasing indebtedness and working longer hours, it's quite likely there will be economic distress whether or not it is reflected in the unemployment rate.

[Paul J. Reber]

The demonization of inflation probably has as much to do with the political success of Republicans since 1980 as any other factor (e.g., race).

I've tried pointing out that it is effectively a "tax on wealth" to people on all sides of the political divide and I get incredulity or occasionally a stunned "that's an interesting idea." In general, I find people are outright terrified of inflation. I try to point out that historically, wages pace inflation and as long as you have some modicum of bargaining power to ensure that continues, inflation isn't going to kill you. I try to point out that if you live on your wages and your retirement money is diversified in accounts that ought to earn roughly inflation+GDP growth (e.g., index funds) you're fine. In fact, you do a little better in higher-growth/higher-inflation scenarios that you see under Democratic presidents.

If you have a *lot* of wealth, you should fear inflation and vote for low-growth/low-inflation Republican policies. And they do. But that fact that there's been this ability to get large numbers of low-wealth people living paycheck-to-paycheck to live in mortal fear of inflation seems to have done a lot towards getting people to vote against their economic self-interest.

I do think we need some brave economists to push back against this fear of inflation, even if it means occasionally sacrificing the chance of gaining high positions in the Eccles Building.

P.S. Yes, I do understand that this only works across a range of fairly low inflation values and you get destructive spirals when inflation hits higher values like 10%. But inflation seems likely to stay around 4% for awhile instead of the 2% target and that shouldn't ruin any non-wealthy person who is able to obtain 4% raises to salary instead of 2%.

[gelboak]

As best I can tell, the www.voxeu.org site is hosted in the UK.

[Alex]

It is amazing that people advocate "pushing back the fear of inflation" when lack of inflation fear was a good component of what got us into this mess.

Joanne Robinson was right -- you need to learn economics in order to avoid being fooled by economists.

[CSTAR]

Names.

What do we call this thing that's more than a recession but less than a depression? Repression? The Blues? Blusession?

I think the financial sector has bipolar disorder.

[SKapusniak]

I'm probably being completely unfair, but I'm a bit boggled by the idea lurking in there that seems to be saying that things are super difficult in this crisis and *extra complicated* because:

"There has been a housing-market collapse, but in contrast to the 1930s there has been no general collapse of prices and economic activity. Corporate defaults have remained relatively low, which has been a much-needed source of comfort to the financial system. But this also makes resolving the problem more difficult. Since there has been no collapse of prices and economic activity, we are not now going to be able to grow or inflate our way out of the crisis, as we did after 1933."

..whereas our problem today is that:

"Absorbing the shock is more difficult this time because it is internal to the financial system. Central to the problem are excessive leverage, opacity, and risk taking in the financial sector itself."

...a situation that strikes me as much more reminiscent of the completely different non-1930s crisis our forebears had to deal with, the utterly forgotten Wall Street crisis of late 1929 which also -- in contrast to the Great Depression which started on 00:00 EST January 1st 1930 and not a second before -- also didn't entail a general collapse of prices and economic activity. Well, at least probably not, if you consider US economic activity for 1929 as a whole.

*rolls eyes*

[LA-C]

"There will be no tax increases designed to balance the budget in the teeth of a downturn, like Hoover’s in 1930."

This is probably true. But it is also true that Senator McCain is contemplating the possibility of freezing public spending. The effects may not be that different...

[Fermi Pyle]

I miss Mr. Reber's understanding of how inflation hurts the wealthy more than the poor. He says that historically wages have paced inflation due to some modicum of bargaining power, but with collapse of union power, globalization's rush to the bottom, and Republican adversion to adjusting minimum wage, that isn't true of recent history, is it?

If wealth is invested in things like real estate, commodity production, or ownership shares of multinational companies, don't these investments follow inflation? Isn't it dollar fixed investments that take the hit? So isn't it just the investment choices of the wealthy that we are talking about?

Even with bonds, aren't they inflation neutral if inflation and inflation expectations are a long term constant, in single digits? Isn't it just that the returns from bonds and dollar investments rise/fall sharply as inflation rises/falls beyond expectations?

And last, suggesting people can vote for "low-growth/low inflation Republican policies" sounds nice, but you vote for candidates, and their policies have not followed them into office.

[Maynard Handley]

"Why not a surtax on incomes above $1 million and repeal of the inheritance tax giveaway? Why are those not on the table?"

Along with splitting large financial companies. If we have a situation where the collapse of one or two companies can destroy society, then surely the sensible thing is to put a cap on the maximum possible size of an institution?
Exactly how is the (supposed) .0001% loss in efficiency that this cap might produce worse than what we have now?

[Popular Economics]

Don't we already have a 10% jobless rate--certainly when including the parttimers and those who are discouraged from looking for work? And isn't the jobless rate notoriously inaccurate? Firstly, an estimate of new job formation is added in based on population growth, then the actual total is given a seasonal adjustment masking the huge monthly turnover in jobs that can top 1 million. So the revisions to jobless totals are usually upward, which is why the NBER waits so long to declare a beginning and end to recessions...I believe this one began last November, since that was the top of this business cycle. Editor@populareconomics.com

[Denis Drew]

I like the "inflate our way out of it" part...

...perfect timing with my megalo plan to shift 12.5% of overall income share from top 3 percentile incomes back to the lower 90 percentile incomes (2001 numbers; may be worse now) by what amounts to using inflation (plus some serious top taxing) -- by doubling the minimum wage and instituting sector-wide labor agreements in this, one of the last economies in the first world (or even second or third world) yet to institute it. With 40% of overall income now spent by the top 10 percentile (up from 27.5% over previous decades) there is plenty of headroom to carve share back -- and it would be providential if the usually feared inflation were actually doing double duty. All things come to he who is megalomaniac.

[Forensic economist]

UNEMPLOYMENT RATE IS INACCURATE

To follow up on Sandwichman's comment on the unemployment rate - the unemployment rate has become less and less accurate over the years as the BLS insists that more and more people are dropping out of the labor force (labor force is defined as people working or actively looking for work). The labor participation rate (people in the labor force divided by population) has dropped over the last ten years, so the unemployment rate doesn't count the millions who would have been working if the participation rate was the same is it was in 1999. For example, the number of people working today in the San Francisco and San Jose MSAs (Silicon Valley) is less than were working in 2000, but the unemployment rate is about the same, which tells me that something is wrong with the way it is measured. If the rate was measured the way it was measured 20 years ago we would now have a national rate of over 8%.