A tale of two depressions

Alasdair Macleod – 26 June 2009
On 16th June, Martin Wolf in the FT published an article titled “The recession tracks the Great Depression”. His article reproduced four charts from a joint paper published by Barry Eichengreen of University of California at Berkeley and Kevin O’Rourke of Trinity College Dublin. The four charts showed that from the start of the Great Depression, world industrial output, world stock markets, volume of world trade and central bank discount rates are being tracked pretty accurately by the trends of this recession. The full article was circulated last week by John Maudlin, who sends a letter out to over one million readers, so it has had a wide circulation to fireside economists.

The original article can be found here: http://www.voxeu.org/index.php?q=node/3421.

This tells us what many of us know, that we are not in a recession, but a depression. In spite of the rhetoric, politicians and central bankers either know or suspect it, which is why they are going to extraordinary lengths to stop it. Indeed, Helicopter Ben is famed for being a student of the Great Depression, and he is determined to ensure it does not happen again, having worked out what went wrong.

It is logical to assume that lessons have been learned from the mistakes of the past, but the logic is only valid if those mistakes have been properly interpreted. There are two versions of experience and conclusion, one spun by Keynesians and one spun by monetarists. The Keynesians tell us that the excesses of naked capitalism were responsible for boom and bust, and by intervening to ensure that “aggregate demand” in the economy is maintained, another depression will be avoided. Aggregate demand is to be maintained through increased public spending. The monetarists however tell us that money should be sprayed at the economy, through quantitative easing for example, to stop prices falling. So Keynesians imply governments have the solution, while monetarists imply the central banks have. Unfortunately both interpretations are incorrect.

The Keynesians ignore the fact that Herbert Hoover was a great interventionist, and have instead spun him as a laissez-faire president. Nothing could be further from the truth. Hoover himself said to the American Bankers’ Association eleven months after the Wall Street Crash:

“The Government has expanded public works, assisted in credit to agriculture and has restricted immigration. These measures have maintained a higher degree of consumption than would otherwise have been the case. Our present experience in relief should form the basis of even more amplified plans in the future.”

Bearing in mind that agriculture was 70% of the US economy in 1929, the context of the stimulus was appropriate in Keynesian terms. Not only did these Keynesian policies fail completely, they made things worse through mismanagement, and distortion of the whole economy. Precisely the same problems have occurred with every attempt by governments to “improve” the functioning of the private sector through Keynesian intervention ever since. The reason is simple: recessions are an adjustment process, whereby the inefficiencies and excesses generated by the preceding boom are corrected. Without interference, economic adjustments are over relatively quickly; with interference they are prolonged and always made worse.

The monetarists are also wrong, and the preceding slump under Coolidge illustrates the reality. It is a forgotten fact that the slump of 1921 was brief in spite of interest rates being raised. The expansion of money supply in WW1 had led to inflation of 20% in late 1919. Rather like Volker sixty years later, the Fed jacked up the discount rate from 4¾% to 6% in January 1920, and then to a record 7% five months later. Even though unemployment averaged 11.7% in 1921, the Fed did not cut rates until May 1921, by which time the economy was recovering. The reality is sound money policies were more successful than the easy monetary policies of the Great Depression.

The monetarists, ignoring this lesson from history and the more recent Volker experience, maintain that the Fed did not expand money supply sufficiently. It was not for want of trying. Interest rates were dropped, and the Fed bought government debt, exactly the same policies of today. Unfortunately, people did what they could to pay down debt and hold on to cash – just like today.

Economists of both persuasions are now trying to convince us that things are different. The charts in Professors Eichengreen’s and O’Rourke’s article show us they are remarkably similar. Of greater concern is the myth that this time policy responses by governments and central banks are different and will succeed: they are not, so far they are also following similar paths. The inevitable conclusion is that this recession will turn into a slump, and neither maintaining aggregate demand nor quantitative easing will produce any benefits whatever. The true lesson from history is they can be expected to make things considerably worse.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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