23/01/2009: The Great Depression’s “lessons” are no roadmap

The Great Depression is probably the most discussed and written about episode of modern economic history. Despite a few dissenting voices, economists can offer some rather compelling explanations about why it happened and why it lasted so long.

What is much less well understood, though, is exactly what finally brought the US economy back to life. Was it the result of policy, or politics, or providence?

In other words, economists have a good idea about what governments should do to avoid an economic depression. But they can offer far less certainty about how to get out of a depression once it occurs.

In his distinguished academic career, Federal Reserve Chairman Ben Bernanke intensively studied the origins of the Great Depression. According to most economists, and to Bernanke, there were two main causes.

First, as argued by Milton Friedman and Anna J. Schwartz in their pivotal study, A Monetary History of the United States, the Great Depression was induced by a severe monetary contraction that was the consequence of poor policy decisions by the Federal Reserve. In a speech honoring Friedman on his ninetieth birthday in 2002, then-Fed Governor Bernanke apologized: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

The Depression’s second main cause — and here Bernanke has made some lasting scholarly contributions — were the bank runs that started in 1930 and lasted until 1933. These runs, unchecked by the Fed and the US government, severely disrupted the credit supply and turned a nasty recession into a full-blown depression.

The first factor, too little money in circulation, explains why the Fed and other central banks have slashed their interest rates, in some cases to zero, and why they are willing to take other unorthodox measures to ensure that enough money is created. The second factor, broken lenders and credit lines, explains why governments around the world are bailing out financial institutions. The failure of Lehman Brothers last year was a scary reminder that bank runs are not a thing of the past.

Popular history offers one explanation of how the Great Depression came to an end: with his New Deal fiscal activism, President Franklin Roosevelt’s big spending programs managed to kick-start the US economy back to life by 1933-34. In The General Theory of Employment, Interest and Money, the British economist John Maynard Keynes provided the theoretical underpinnings for the fiscal “magic bullet,” albeit somewhat belatedly, in 1936.

But this explanation may be a bit too simple. Christina Romer, a well-known economic historian and the new Chairwoman of the Council of Economic Advisers in the Obama administration, argued in a widely cited article published in 1992 that fiscal policy played only a minor role in escaping from the Depression. In her view, first and foremost, if not exclusively, the swelling money supply that followed the end of the gold standard and the dollar’s devaluation was in fact the engine of recovery between 1933 and 1942.

Acknowledging this well-argued view suggests that the current debate raging globally about the size, forms and durations of fiscal stimulus is fundamentally flawed. Economists just don’t have the answers here. They are guessing like everyone else. They may be able to tell us how to avoid getting lost, but once it happens, they can offer no trusty map to get us out of the woods.

09/01/2009: Remember, it’s only paper

In Japanese, the word “kamikaze” means divine wind. It originally referred to the typhoons that repelled the invading fleets of Kublai Kahn, the Mongol founder of the Yuan dynasty in 13th century China.

Kublai Kahn financed his wars with fiat money — paper money assigned a value by government decree (fiat). Fiat money has no intrinsic value; rather, its status as legal tender relies solely on the confidence market participants have in the issuing government. The Mongols were quite persuasive on this point: refusing to honor their paper money was punishable by death.

The first widely circulated paper money was issued in China around 960 AD, during the Song dynasty. Five hundred years later, hyperinflation put an end to both paper money and the Yuan dynasty. China, of course, also pioneered the printing process, thus enabling this unhappy tale.

Our own reliance on fiat money began only in 1973, with the collapse of the Bretton Woods system that followed World War II. Before that, most of the world’s currencies were fixed to the US dollar, which in turn was backed by gold.

The early years of fiat money were characterized by soaring inflation in developed countries, and even hyperinflation in some emerging economies. Happily, since the beginning of the 1990s, inflation has been held in check around the globe. But we should remember that we only have a few decades of experience with paper money, compared with China’s five centuries of fiat money.

Governments find paper money awfully convenient. It has a face value as legal tender but since it has no intrinsic value. Governments are free to create as much as they want, or dare. The Republic of Zimbabwe has been testing the limits of this freedom in recent years. With an inflation rate of 13 billion percent per month at the end of 2008, which means prices double every 15.6 hours, new and ever bigger bank notes are printed regularly in a hyperinflationary spiral of historic and, on a human level, tragic dimensions.

Given the inherently inflationary nature of paper money – more can always be printed - it may seem odd that markets and the media currently obsess about deflation, a fearsome spiral of steadily declining prices that chokes off economic growth. Aren’t governments around the world doing everything they can to revive their slumbering economies? Interest rates are near zero in the US, Japan and Switzerland, and at their lowest level in the UK since the Bank of England was founded in 1694. Government deficits on both sides of the Atlantic are reaching levels never before seen in peace time. The printing presses are primed and ready, too.

But the bizarre experience of Japan in the 1990s should remind us that, even when the printing presses are running, deflation can still prevail.

Why? Paper money is built on the psychological factor of confidence. Inflation and deflation reflect another psychological factor, namely, our expectations for the future. And these can sometimes become self-fulfilling.

In the 1990s, Japan never managed to convince market participants that it was serious about combating deflation. Its policies stuttered, one year focusing on fiscal stimulus, the next on fiscal discipline. Such an erratic course did a poor job of managing expectations, at home and abroad.

The Japanese experience explains why the US government, among others, is responding so vigorously, and visibly, to the financial crisis. They want the world to know that they are not asleep at the wheel. Between the lines of every statement, the message is, “You can be confident in our actions.” We wish them every success, with the important proviso that we fervently hope they will not overshoot and print themselves into a sea of trouble. Remember, it’s only paper.