Bordo Great Depression and Great Recession

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The Gr eat Depress i on and t he Gr eat Recessi on: What Have We

Lear nt ?

Mi chael Bordo

Rut ger s Uni ver si t y

Harol d J ames

Pr i ncet on Uni ver si t y

Paper pr epar ed f or t he conf er ence, “Past and Pr esent : From t he

Gr eat Depr essi on of 1929 t o t he Gr eat Recessi on of 2009”

December 2010 r evi si on



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The Gr eat Depress i on Anal ogy

Mi chael Bordo and Harol d J ames

I n t he di scussi on of our cont emporary economi c di sease, t he

Gr eat Depr essi on anal ogy r ef uses t o go away. Al most every

pol i cy- maker r ef er r ed t o condi t i ons t hat had “not been seen

si nce t he Gr eat Depr essi on, ” even bef ore t he f ai l ur e of Lehman.

Some even went f ur t her – t he Deput y Gover nor of t he Bank of

Engl and not abl y cal l ed t he cri si s t he wor st “f i nanci al cr i si s i n

human hi st or y”. I n i t s Apr i l 2009 Wor l d Economi c Out l ook, t he

I MF l ooked expl i ci t l y at t he anal ogy not onl y i n t he col l apse of

f i nanci al conf i dence, but al so i n t he r api d decl i ne of t r ade and

i ndust r i al acti vi t y across t he wor l d. I n gener al , hi st or y

r ather t han economi c t heory seems t o of f er a gui de i n

i nt er pr et i ng wi l dl y sur pr i si ng and i nher ent l y unpr edi ct abl eevent s. Some obser ver s, not abl y Paul Kr ugman, concl uded t hat a

Dark Age of macr oeconomi cs has set i n ( Kr ugman 2009) . There are

however subst ant i al uncer t ai nt i es about what pr eci sel y t he

l essons of hi st or y mi ght be. Char l es Pl osser , pr esi dent of t he

Feder al Reser ve Bank of Phi l adel phi a, r ecent l y sai d t el l i ngl y

t hat : “We ar e st i l l r ewr i t i ng t he nar r at i ve, and gai ni ng an

underst andi ng, of what happened i n t he Gr eat Depr essi on and

why. No doubt i t wi l l be at l east 50 years bef ore we under st and

very wel l what happened i n 2008 and 2009 and whet her t he Feder al

Reser ve under t ook t he r i ght pol i ci es or t he wr ong pol i ci es. ”

( New Yor k Ti mes, 2010)



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Thi s paper exami nes t hr ee ar eas i n whi ch anal ogi es have

been made between t he i nt erwar depr essi on and t he f i nanci al

cr i si s of 2007 whi ch reached a dr amat i c cl i max i n Sept ember 2008

wi t h t he col l apse of Lehman Br other s and t he r escue of AI G: t hey

can be l abel ed macro- economi c, mi cr o- economi c, and gl obal .

Fi r st , t he paper consi der s t he st or y of monet ar y pol i cy

f ai l ur es; second, t her e f ol l ows an exami nat i on of t he mi cr o-

economi c i ssues concerned wi t h bank regul at i on and t he

r eor gani zat i on of banki ng f ol l owi ng t he f ai l ur e of one or mor e

maj or f i nanci al i nst i t ut i ons and t he t hr eat of syst emi c

col l apse; t hi r d, t he paper t ur ns t o t he i ssue of gl obal

i mbal ances and asks whet her t her e are paral l el s t hat mi ght bef ound i n t hi s domai n too bet ween the 1930s and t he event s of

t oday.

Monet ar y Pol i cy

Al most every cont emporary use of t he depr essi on anal ogy

t akes t he year 1929 as a r ef er ence poi nt . But t her e ar e r eal l y

t wo compl et el y di f f er ent pat hol ogi es dur i ng t he Gr eat

Depr essi on, whi ch i nvol ve di f f er ent di agnoses and di f f er ent

cur es.

The f i r st , and t he most f amous, pat hol ogy i s t he U. S. st ock

market cr ash of Oct ober 1929. No ot her count r y had a st ock

market pani c of t he magni t ude of t he Amer i can one, i n l arge part

because no ot her count r y had exper i enced t he euphor i c r un- up of

st ock pr i ces t hat sucked l ar ge number s of Amer i cans, f r om ver y

di f f er ent backgr ounds, i nt o f i nanci al specul at i on. The second



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si ckness, cont agi ous banki ng pani cs, was deci si ve i n t ur ni ng a

bad r ecessi on i nt o t he Gr eat Depr essi on. A ser i es of bank

pani cs begi nni ng i n Oct ober 1930 i n t he Uni t ed St ates conver t ed

a not unusual r ecessi on f r om 1929- 1930 i nt o a ser i ous sl ump.

Through t he f i xed exchange r at e gol d st andar d t he U. S.

depr essi on al so af f ect ed t he r est of t he wor l d. Event s t ook a

t ur n f or t he wor st af t er t he col l apse and r escue of t he

Cr edi t anst al t bank i n Vi enna i n May 1931 and a maj or banki ng

cr i si s i n Ger many i n J une. Thi s spr ead f i nanci al cont agi on t o

Gr eat Br i t ai n, t o France and back t o t he US .

The 1929 pani c has domi nat ed a great deal of t he anal ysi s

of t he depr essi on f or t wo r at her pecul i ar r easons. Fi r st , no

one has ever sat i sf act or i l y been abl e t o expl ai n t he col l apse of

t he mar ket i n Oct ober 1929 i n t er ms of a rat i onal expl anat i on,

i n whi ch mar ket par t i ci pant s r eact ed t o a speci f i c news event .

So t he cr ash pr esent s an i nt r i gui ng i nt el l ect ual puzzl e, and

economi st s can bui l d r eput at i ons on t r yi ng t o f i nd i nnovat i ve

account s. Some peopl e j ust concl ude t hat market s are si mpl y

i r r at i onal . I ndeed, t her e i s consi der abl e evi dence t hat t hemost di st ur bi ng shocks t o mar ket expect at i ons do not ar i se f r om

i dent i f i abl e “news” ( Bouchaud 2010) . Ot her s ( not abl y Whi t e)

have ar gued that i nvest ors mi ght have been abl e t o f oresee t he

Depr essi on, or t hat t hey wer e ponder i ng t he l i kel i hood of

pr ot ect i oni st r eact i ons i n ot her count r i es t o t he Amer i can

( Smoot Hawl ey) t ar i f f act whi ch had not yet even been cast i n

i t s f i nal f orm.

The second r eason t hat 1929 has been popul ar wi t h academi c

and pol i t i cal comment at or s i s t hat t he af t er mat h of t he col l apse

pr ovi des a cl ear mot i ve f or t aki ng par t i cul ar pol i cy measur es.

St ock exchange col l apses or t he end of asset bubbl es do not



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necessari l y l ead t o pr ol onged r ecessi ons of deep depr essi on. I n

Oct ober 1987 and agai n i n Mar ch 2000 shar p st ock mar ket

col l apses t r i gger ed bot h an ext ensi on of l i qui di t y by t he

cent r al bank and f i scal easi ng. Keynesi ans t hought t hat

gover nment f i scal demand can st abi l i ze t he expect at i ons of t he

mar ket , and t hus provi de an over al l f r amewor k of st abi l i t y.

Monet ar i st s saw monet ar y st abi l i t y as t he key t o avoi di ng

dr amat i c out put cont r act i ons. Much of t hi s debat e has f ocused

on t he Uni t ed St at es: i n ot her count r i es, especi al l y debt or

count r i es, t he gol d st andar d const r ai ned monet ar y pol i cy so that

i t i s har d t o speak of pol i cy opt i ons. The onl y count r y wher e

t her e was an equi val ent r oom f or maneuver t o t he Uni t ed St atesi s Fr ance.

The Gr eat Cont r act i on of 1929- 1933 i n t he Uni t ed St at es

dur i ng whi ch pr i ces, r eal out put and money suppl y decl i ned by

about a t hi r d, and whi ch spr ead t o the r est of t he wor l d, was

pr eci pi t at ed by pol i cy f ai l ur es at t he Feder al Reser ve. A t i ght

monet ar y pol i cy t o ki l l st ock mar ket specul at i on i n 1928 l ed t o

a recessi on begi nni ng i n August 1929. Thi s pol i cy was based ont he r eal bi l l s vi ew t hat st ock mar ket specul at i on woul d l ead t o

i nf l at i on, a bust and t hen def l at i on. The st ock mar ket crash i n

Oct ober exacer bat ed t he downt ur n but di d not cause t he

depr essi on. The f ai l ur e of t he Fed t o f ol l ow i t s mandat e f r om

t he Feder al Reserve Act of 1913 t o act as l ender of l ast r esor t

and t o al l ay a ser i es of f our banki ng pani cs begi nni ng i n

Oct ober 1930 l ed t o the ser i ous downt ur n t hat f ol l owed. The Fed

adher ed t o the f l awed Bur gess Ri ef l er doct r i ne ( Mel t zer 2003)

whi ch vi ewed l ow l evel s of i t s bor r owed r eser ves( i . e di scount

wi ndow bor r owi ng) and shor t - t er m i nt er est r at e i ndi cat or s as

si gns of monet ary ease and hence di d not act . I n addi t i on some



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Fed of f i ci al s bel i eved i n t he l i qui dat i oni st doctr i ne and saw

bank f ai l ur es as benef i ci al . A maj or hi ke i n t he di scount r at e

i n t he f al l of 1931 t o pr ot ect t he dol l ar af t er st er l i ng exi t ed

f r om t he gol d st andar d added f uel t o t he f i r e.

Recovery began i n March 1933 wi t h Roosevel t ’ s banki ng

hol i day, endi ng t he f our t h banki ng pani c. The nat i on’ s banks

were cl osed f or a week dur i ng whi ch an ar my of bank exami ner s

separ at ed t he i nsol vent f r om t he r est . I nsol vent banks wer e

cl osed endi ng t he uncer t ai nt y dr i vi ng t he pani c. Thi s act i on was

qui ckl y f ol l owed by FDR t aki ng t he U. S. of f t he gol d st andar d i n

Apr i l , Tr easur y gol d ( and si l ver ) pur chases desi gned t o r ai se

gol d pr i ces and pr i ces i n gener al , and f or mal deval uat i on of t he

dol l ar by cl ose to 60% i n J anuar y 1934. These pol i ci es pr oduced

a bi g r ef l at i onar y i mpul se f r om gol d i nf l ows whi ch wer e

unst er i l i zed passi ng di r ect l y i nt o t he money suppl y. They al so

hel ped conver t def l at i onar y expect at i ons i nt o i nf l at i onar y ones

( Egger t sson 2008) . Al so of key i mpor t ance i n pr event i ng f ut ur e

banki ng pani cs was t he i nst i t ut i on of f eder al deposi t

i nsurance(FDI C) i n t he Banki ng Act of 1933 whi ch went i nt oef f ect J anuary 1 1934.

The r ecover y of 1933 t o 1941 i n t he Uni t ed St at es was

l ar gel y dr i ven by gol d i nf l ows ( i ni t i al l y r ef l ecti ng Tr easur y

pol i cy and t he deval uat i on, l at er r ef l ecti ng capi t al f l i ght f r om

Eur ope as war l oomed) . Expansi onar y f i scal pol i cy, despi t e the

convent i onal wi sdom, pl ayed onl y a mi nor r ol e i n t he r ecover y of

t he 1930s ( Romer 1992) . Recover y was i mpeded somewhat by NewDeal car t el i zat i on pol i ci es l i ke t he NI RA whi ch i n an at t empt t o

r ai se wages and pr i ces ar t i f i ci al l y reduced l abor suppl y and

aggregat e suppl y ( Col e and Ohani an 2004) . Over t he per i od 1933-

1937 out put i ncr eased by 33%.



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The Federal Reser ve was l ar gel y passi ve i n t he 1930s.

Al ong wi t h the banker s, i t had been bl amed by t he Roosevel t

admi ni st r at i on f or t he f ai l ur es of t he 1920s and ear l y 1930s.

Maj or r ef orms i n t he Banki ng Act s of 1933 and 1935 gr eat l y

i ncr eased t he powers of t he Federal Reser ve Boar d i n Washi ngt on

at t he expense of t he Reser ve banks and especi al l y t he New Yor k

Fed. Despi t e i t s i ncr ease i n power , t he r econst i t ut ed Boar d of

Governors under Chai r man Mar i ner Eccl es was passi ve and l argel y

subservi ent t o the di ct at es of Tr easur y Secr et ar y Mor gent hau.

The Fed i n t he 1930s cont i nued t o f ol l ow t he same precept s as i t

di d i n t he 1920s and ear l y 1930s. I t s pol i cy i ndi cat or cont i nued

t o be t he l evel of f r ee r eser ves( excess r eser ves l essborr owi ngs f r om t he Fed) . I n t he 1930s bor r owed r eserves wer e

negl i gi bl e so excess r eserves became t he i ndi cat or . As t he

decade wor e on member banks l argel y absor bed t he gol d i nf l ows

i nt o excess r eserves, hel d as a pr ecaut i on agai nst a r epeat of

t he t ype of t ur bul ence exper i enced i n t he ear l y t hi r t i es. By

1935 excess r eserves amount ed t o 50% of t otal r eser ves. Fed

of f i ci al s i ncreasi ngl y vi ewed t he bui l d up of excess r eser ves as

a t hr eat t o f ut ur e specul at i on and i nf l at i on. They al so saw t he

pr esence of si zabl e excess r eser ves as pr event i ng t hem f r om

f ut ur e t i ght eni ng. Si mi l ar concer ns have been voi ced about t he

bui l d up i n bank excess r eser ves i n 2008- 2009. Accordi ng t o t he

Bur gess Ri ef l er doct r i ne whi ch pr evai l ed at t he Fed, t he way t he

Fed coul d cont r ol i nt er est r at es was by f or ci ng banks t o bor r ow

f r om t he Fed. Once bor r owed r eser ves were l ess t han t he open

mar ket port f ol i o, t hen open mar ket sal es coul d f orce t he bankst o bor r ow. Banks woul d t hen want t o reduce thei r i ndebt edness by

cont r act i ng t hei r l endi ng ( Mel t zer 2003 pp 520- 521) .



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The Recessi on of 1937- 1938: The r ecovery was i nt er r upt ed by

a ser i ous r ecessi on ( t he t hi r d wor st of t he t went i et h cent ur y)

f r om May 1937 to J une 1938. Fr i edman and Schwar t z ( 1963) and

Mel t zer ( 2003) and ot her s at t r i but e t he r ecessi on t o a ser i ous

pol i cy mi st ake by t he Feder al Reserve. Mount i ng concer n by t he

Fed over t he bui l d up i n excess r eser ves i n member banks l ed t he

Boar d t o doubl e reserve r equi r ement s i n t hr ee st eps bet ween

August 1936 and May 1937. The rat i onal e f or t hi s act i on was t o

r est ore t he Fed’ s cont r ol over monet ary pol i cy and r emove t he

i nf l at i onar y thr eat posed by t he excess r eserves. The Fed used

t he bl unt i nst r ument of r ai si ng r eser ve r equi r ement s r at her t han

conduct i ng an open market sal e of secur i t i es because excessr eser ves exceeded t he Fed’ s por t f ol i o of secur i t i es and sal es

woul d r educe t he i ncome earned f r om i t . Accordi ng t o Fr i edman

and Schwar t z t he banks were hol di ng excess r eser ves as a

pr ecaut i on agai nst a repeat of t he banki ng pani cs of t he 1930s.

When t he Fed l ocked up t hese r eserves t he banks cut back on

l endi ng and sol d ear ni ng assets t o rest or e the pr ecaut i onar y

cushi on t hey had hel d. The Fed’ s cont r act i onar y pol i cy act i on

was compl ement ed by t he Treasur y’ s deci si on i n l at e 1936 t o

st er i l i ze gol d i nf l ows i n or der t o r educe excess r eser ves. These

pol i cy act i ons l ed t o a spi ke i n shor t - t er m i nt er est r at es and a

sever e decl i ne i n money suppl y pr eci pi t at i ng a 5 % decl i ne i n

r eal GDP.

Ot her expl anat i ons gi ven f or t he r ecessi on of 1937- 38

i ncl ude: a t i ght eni ng of f i scal pol i cy when t he Admi ni st r at i on

ended a generous vet eran’ s bonus, i ncr eased i ncome tax r at es and

i mposed a tax on undi st r i but ed pr of i t s; gol d hoar di ng br ought

about by f ear s of anot her dol l ar deval uat i on coupl ed wi t h a

boost t o money wages by t he Wagner Act ( Sumner 2009) and a



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swi t ch back f r om i nf l at i onar y to def l at i onar y expect at i ons

( Eggert sson and Pugsl ey 2006) .

The r ecessi on ended af t er FDR i n Apr i l 1938 pressured t he

Fed t o rol l back reserve r equi r ement s, t he Tr easury st oppedst er i l i zi ng gol d i nf l ows and dest er i l i zed al l t he r emai ni ng gol d

st er i l i zed si nce December 1936, and t he Admi ni st r at i on began

pur sui ng expansi onar y f i scal pol i cy. The r ecover y f r om 1938 t o

1942 was spect acul ar , out put gr ew by 49% f uel ed by gol d i nf l ows

f r om Eur ope and a maj or def ense bui l d up.

The Li qui di t y Tr ap: The 1930s were char act er i zed by ver y

l ow i nt er est r at es. Shor t - t er m r at es wer e cl ose t o zer o t hr oughmuch of t he decade. Long- t erm r at es were cl ose t o 2%. The

t r adi t i onal Keynesi an vi ew has been t hat monet ary pol i cy was

i mpot ent because t he U. S. economy was i n a l i qui di t y t r ap. Li ke

t he 1930s a Feder al Funds r at e i n 2008 cl ose t o zer o( t he zero

l ower bound) has agai n rai sed t he i ssue of pol i cy i mpot ence.

Subsequent r esear ch by Br unner and Mel t zer ( 1968) f ound no

evi dence f or t he l i qui di t y t r ap. Ther e was a spect r um of r at eswel l above zer o thr oughout t he 1930s and t he Fed coul d j ust as

easi l y have bought secur i t i es ot her t han shor t - t er m Tr easur y

bi l l s ( Basi l e and Rockof f 2009) . The r eal pr obl em was not t hat

Fed pol i cy di dn’ t wor k but r at her t hat t he Fed was unwi l l i ng t o

use t he t ool s t hat i t had t o conduct expansi onary monet ary

pol i cy because i t f eared a r esur gence of asset market

specul at i on and i nf l at i on ( Or phani des 2004) .

Lessons f or Today: The hi st ory of t he 1930s exper i ence has

sever al l essons f or t he pr esent di scussi on over t he pol i ci es



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t hat t he Fed coul d f ol l ow t o ensur e a rapi d r ecover y wi t hout

engender i ng i nf l at i on.

The f i r st l esson i s t hat t he Fed l i ke i t s pr edecessor

sevent y years ago has t he tool s t o ref l ate the economy and t opr event a r esur gence of i nf l at i on. I n t he 1930’ s t he Fed was

onl y a mi nor pl ayer i n t he r ecover y because i t was rel uct ant t o

use expansi onar y open mar ket pur chases f or f ear of r eki ndl i ng

specul at i on and i nf l at i on. I t was not i n r eal i t y st uck i n a

l i qui di t y t r ap or hamper ed by t he zer o l ower bound. I nst ead t he

Tr easur y t hrough i t s pol i ci es t owar ds gol d and t he consequence

of deval ui ng t he dol l ar di d mor e of t he heavy l i f t i ng t o pr omot e

r ecover y.

I n t he r ecent cr i s i s t he Fed’ s pol i cy of st er i l i z i ng t he

ef f ect s on t he monet ar y base of i t s di ver se l i qui di t y oper at i ons

t hrough much of 2008 ( unt i l September ) made monet ary pol i cy

t i ght er t han i t had t o be and l i kel y exacer bat ed t he r ecessi on

whi ch began i n December 2007( Het zel 2009) . However si nce

Oct ober 2008 t he base gr eat l y expanded and the pol i cy adopt ed i n

J anuar y 2009 of quant i t at i ve easi ng ( and cont i nued i n November

2010) by pur chasi ng l ong- t erm Treasur i es and mor t gage backed

secur i t i es can be vi ewed as a r epl ay of t he expansi onar y

Tr easur y gol d pol i cy of t he 1930s.

Second, t he Fed wi l l event ual l y have to t i ght en as t he

economy r ecovers and excess capaci t y i s r educed. Some have

r ai sed t he f ear t hat t hi s coul d pr oduce a r epeat of t he

r ecessi on of 1937- 1938 were t he Fed to at t empt t o r educe t he

excess r eser ves and t he banks ( st i l l gun- shy f r om t he r ecent

cr i si s) t o scr ambl e t o r epl ace t hem. Thi s shoul d not be a

pr obl em f or a number of r easons. Fi r st t he excess r eserves wer e



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bui l t up i n t he t wo er as under ver y di f f er ent Fed oper at i ng

pr ocedur es. I n t he 1930s t he Fed coul d not t ar get t he i nt er est

r at e as i t had done i n t he 1920s because t he banks were

r el uct ant t o bor r ow r ef l ect i ng a st i gma f r om doi ng so. Mor eover

t he bui l d up of excess r eser ves was a consequence of t he gol d

i nf l ows and, gi ven t he Fed’ s pr ef er r ed oper at i ng pr ocedur es,

creat ed a pr obl em f or i t .

Today t he Fed f ol l ows an i nt er est r at e t ar get and i t can

pay i nt er est on r eser ves ( I OR) . The bui l d up of r eser ves

r ef l ect ed ster i l i zat i on of t he Fed’ s l i qui di t y oper at i ons usi ng

i nt er est on r eser ves, ( when t he f eder al f unds r at e was cl ose to

zer o) , as t he mechani sm t o get banks t o hol d t hem. Were t he Fed

t o wi sh t o t i ght en i t can separ at e i t s monet ar y pol i cy

oper at i ons f r om i t s l i qui di t y pol i cy by changi ng t he spr ead

bet ween t he f unds r ate and t he I OR. ( Goodf r i end 2009) . Unl i ke

t he Fed of t he 1930s, t oday’ s Fed can use r everse r epos or open

mar ket sal es of i t s l ong- t er m secur i t i es t o do t he t i ght eni ng.

Were i t t o wi sh t o r educe excess r eser ves t o encour age banks t o

l end i t coul d pay negat i ve i nt er est on r eserves as was doner ecent l y by t he Ri ksbank i n Sweden.

The mai n concer n f or t oday i s not t hat t he Fed can not

exi t f r om i t s pr esent st r at egy because i t can, but t hat when i t

exi t s and begi ns t i ght eni ng t hat i f unempl oyment wer e st i l l t o

be hi gh and wer e t o begi n t o r i se agai n i n t he f ace of t he

t i ght eni ng, t hat t he Fed woul d come under pol i t i cal pr essur e t o

abandon i t s ef f or t s and cave i n under t he pr essur e. I n t hat casei nf l at i onary pr essur es woul d bui l d up as t he bond market s and

t he publ i c began t o doubt t he Fed’ s r esol ve. Thi s i s what

happened i n 1966 and 1969 under Wi l l i am McChesney Mar t i n and i n

1973 under Ar t hur Bur ns, l eadi ng t o the Gr eat I nf l at i on.



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The Fi nanci al Sect or

Banki ng col l apses pl ayed a cr uci al r ol e i n t he deepeni ng of

t he gl obal cr i si s i n 1931. Unl i ke t he Uni t ed St at es, wher e

banki ng was hi ghl y l ocal i zed, cont i nent al Eur opean economi es

were domi nat ed by f i nanci al syst ems i n whi ch a smal l number of

ver y l arge banks domi nat ed t he economy. I n Aust r i a, where t he

cr i si s began i n May 1931, t he Cr edi t anst al t cont r ol l ed some 60

per cent of Aust r i an f i r ms t hr ough owner shi p st akes ( Nöt el 1984) .

The f ai l ur e or pot ent i al f ai l ure of ver y l ar ge f i nanci al

i nst i t ut i ons t hus posed a maj or pol i cy pr obl em.

The col l apses wer e t he r esul t of t he shocks of t he

i nt er nat i onal depr essi on i mposed upon bank weakness i n count r i es

t hat had been wr ecked by t he af t er math of bad pol i ci es t hat

pr oduced i nf l at i on, hyper - i nf l at i on, and a dest r uct i on of banks’

bal ance sheet s. An i nt r i nsi c vul ner abi l i t y made f or a

hei ght ened exposur e t o pol i t i cal shocks, and di sput es about a

cent r al Eur opean cust oms uni on and about t he post war r eparat i ons

i ssue was enough t o t oppl e a house of cards.

Banks i n 1931 were vul ner abl e as a r esul t of poor monetary

pol i cy, and t hey wer e vi ct i ms of monet ar y def l at i on ( Temi n

2007) . But t her e wer e pl ent y of speci f i c i ssues whi ch l ong-

ant edated t he col l apses of t he ear l y 1930s ( J ames 1986) . They

ar e t he r esul t of speci f i c desi gn f eat ur es of t he f i nanci al

syst em t hat coul d not si mpl y be cor r ect ed by macro- economi c

pol i cy, whet her monet ar y or f i scal . U. S. banki ng was hi ghl y

l ocal i zed, and t hus vul ner abl e to geogr aphi cal l y l i mi t ed shocks



13

( such as t he agr i cul t ur al depr essi on) ; whi l e l ar ger nat i onwi de

banki ng i n Canada was much mor e r esi l i ent . Banks i n many debtor

count r i es i n Sout h Amer i ca and Cent r al Eur ope accumul at ed

mi smat ches bet ween asset s ( i n l ocal cur r ency) and l i abi l i t i es

( i n dol l ar s or ot her key cur r enci es) , t hat made f or a

vul ner abi l i t y t o cur r ency t ur moi l . Uni ver sal banks suf f er ed

l ar ge l osses on t hei r shar ehol di ngs, and as t hei r capi t al i zat i on

f el l , cut back on t hei r l endi ng. Some Br i t i sh banks ( t he so-

cal l ed merchant banks) had heavy over seas exposur es t hat made

t hem vul ner abl e t o f or ei gn cr i ses ( J ames 2001, Accomi not t i

2009) .

One of t he st r i ki ng f eat ur es of t he Depr essi on anal ogy i s

how many of t he answers r egar di ng t he banki ng sect or are popul ar

agai n t oday: i n par t i cul ar , t he pr ovi si on of st at e guar ant ees t o

at t empt t o r evi ve t he i nt er bank market and bank l endi ng;

r ecapi t al i zat i on of banks wi t h publ i c money; and t he

est abl i shment of “bad banks” t o t ake pr obl emat i c asset s of f

banks’ bal ance sheet s. Al l of t hese pol i cy r esponses wer e t r i ed

i n t he 1930s, most not abl y i n t he epi cent er of t he cent r alEur opean col l apse, i n Germany.

Some of t he i ni t i at i ves t hat t he German government t ook had

a qui t e modern r i ng t o them. I ndeed t hi s was an area i n whi ch

t he German government appear ed t o act swi f t l y i n order t o

i mpl ement a cr i si s management st r at egy. Fi r st , t he government

r eor gani zed t he banks, mergi ng t he t wo weakest ones, Danat and

Dr esdener Bank, t hat had been at t he or i gi n of t he banki ngcol l apse, and i nj ect i ng gover nment money i nt o al l of t hem.

I ni t i al l y, t he gover nment had t r i ed har d t o get pr i vat e money as

wel l , and t her e wer e i nt ense negot i at i ons wi t h t he l eadi ng

f i gur es of t he power f ul Rhi ne- Ruhr s t eel l obby. I n t he end t he



14

busi ness l eaders onl y agr eed i f t he government woul d put i n more

money, and i f t he gover nment advanced them t he sums t hat t hey

wer e supposed t o i nvest i n t he r ecapi t al i zat i on of Danat Bank.

By 1932, 91 per cent of t he Dr esdner Bank’ s capi t al , 70 per cent

of Commerzbank’ s and 35 per cent of Deut sche Bank’ s was i n publ i c

owner shi p.

Second, t he German cent r al bank ( t he Rei chsbank) pushed f or

a new i nst i t ut i on whi ch woul d al l ow i t t o di scount bi l l s f r om

banks whi ch coul d not be t r aded because t he i nterbank market had

st opped oper at i ng. Thi s i nst i t ut i on, named t he Akzept - und

Gar ant i ebank, was est abl i shed wi t h br eat h- t aki ng speed. I t was

gi ven a publ i c guar ant ee i n order t o pr ovi de t he addi t i onal

si gnat ur e t hat made bi l l s el i gi bl e f or Rei chsbank l endi ng

( r edi scount i ng) .

Thi r d, t he Rei chsbank event ual l y ( i n December 1932) cr eat ed

what woul d now be cal l ed a “bad bank” t o t ake over t r oubl ed

assets whose pr i ces no l onger corr esponded t o t he val ue at whi ch

t hey wer e set i n t he banks’ bal ance sheet . Two new i nst i t ut i ons

woul d t ake asset s of f f i r ms’ and banks’ bal ance sheet s: t he

f i r st , t he Deut sche Fi nanzi er ungsi nst i t ut AG t ook over up t o

t hr ee quart er s of t he bad asset s of a bank, but r equi r ed an

annual amor t i zat i on at 3 per cent . The second, t he Ti l gungskasse

f ür gewer bl i che Kr edi t e, r equi r ed a much l ower r ate of

ser vi ci ng, onl y 1 per cent , f or an i ni t i al t hr ee year per i od,

f ol l owed by hi gher r at es as economi c r ecover y set i n.

Lessons f or t oday

The consequence of t he l ong academi c and popul ar di scussi on

of t he 1929 cr i si s and t he appr opr i at e pol i cy r esponse i s t hat

peopl e have come to t he expect at i on t hat t her e must be easy



15

answers. But t he col l apse of Lehman Br ot hers i n Sept ember 2008

was a 1931- l i ke event , t he f ai l ur e of a l ar ge f i nanci al

i nst i t ut i on. The answer s requi r ed ar e l ess obvi ous t han i n t he

domai n of monet ar y or f i scal pol i cy, wher e l essons of t he Gr eat

Depr essi on are much cl ear er .

Fi ndi ng a way out of t he damage creat ed by t he col l apse of

a syst emi cal l y i mpor t ant f i nanci al i nst i t ut i on was and i s ver y

t ough. Unl i ke i n t he case of a 1929- t ype event , t her e ar e no

obvi ous macr o- economi c answer s t o f i nanci al di st r ess,

par t i cul ar l y when i t i nvol ves i nst i t ut i ons t hat ar e deemed t o be

“t oo bi g t o f ai l ”. Some f amous macr o- economi st s, i ncl udi ng

Lar r y Summers, t he chi ef economi c t hi nker of t he Obama

admi ni st r at i on unt i l l at e 2010, i n consequence t r i ed t o pl ay

down t he r ol e of f i nanci al sect or i nst abi l i t y i n causi ng

depr essi ons. Rober t Lucas’ s cl ai m i n 2003 t hat t he “cent r al

pr obl em of depr essi on- pr event i on has been sol ved” i s one of t he

cent r al pi eces of evi dence f or Kr ugman’ s onsl aught on

convent i onal macro- economi cs.

1. A key pr obl em at t he hear t of bot h t he 1931 cr i si s i n

Cent r al Eur ope ( but not i n t he Uni t ed St at es) and of 2008 i n t he

U. S. and Eur ope was the doct r i ne of “t oo bi g t o f ai l ”. For t he

U. S. , t hi s doct r i ne was bor n onl y i n t he af t er mat h of t he Lat i n

Amer i can debt cr i si s of 1982, whi ch t hr eatened t he sol vency of

al most al l f i nanci al i nst i t ut i ons i n t he i ndustr i al count r i es.

I n 1984 t he doct r i ne was appl i ed t o j ust i f y t he deci si on t o bai l

out Cont i nent al I l l i noi s, t he f our t h bi ggest U. S. bank whi ch wasi nsol vent . As banks grew i n t he 1990s and 2000s, and t hei r

i nt er connect edness i ncr eased, t he doct r i ne evol ved and was

augment ed by an ar gument about banks bei ng “t oo i nt erconnect ed

t o f ai l ”. I n 2008 t he doct r i ne cont r i but ed t o t he wor seni ng of



16

f i nanci al cri si s, as t he bel i ef t hat l ar ge commer ci al banks

woul d not be al l owed t o f ai l was ext ended t o i nvest ment banks

wi t h t he r escue of Bear Stear ns i n March 2008. Then i n September

when Lehman Br ot her s was al l owed t o f ai l and AI G was r escued t he

r esul t i ng conf usi on l ed t o pani c. Too bi g t o f ai l has al so

hamper ed t he r ecovery by pr event i ng t he use of t he good bank/ bad

bank sol ut i on ( t hat had been used so successf ul l y i n t he past by

Sweden and ot her count r i es) t owards Ci t i gr oup, Bank of Amer i ca

i n the US and some bi g banks i n Europe: RBOS, Ll oyds- HBOS, UBS.

I n consequence, gover nment s t ook on t oo l arge shares i n

f i nanci al i nst i t ut i ons i n or der t o r ecapi t al i ze t hem, a move

anal ogous t o what happened i n 1931 i n Germany. And as i nGermany i n 1931 sever al government s have al r eady been r epai d by

some of t he banks whi ch were rescued at a pr of i t . A maj or

col l apse of a l ar ge par t of t he f i nanci al syst em r equi r es a sl ow

and pai nf ul cl eani ng up of bal ance sheet s; and i n mi cr o- economi c

r est r uct ur i ng, whi ch cannot be sol el y i mposed f r om above by an

al l - wi se pl anner but al so requi r es many busi nesses and

i ndi vi dual s to change t hei r out l ook and behavi or . The

i mpr ovement of r egul at i on and super vi si on, whi l e a good i dea, i s

bet t er sui t ed t o avoi di ng f ut ur e cr i ses t han deal i ng wi t h t he

consequences of a cat ast r ophe t hat has al r eady occur r ed.

3. The i nvol vement of gover nment i n f i nanci al r escues

t r ansf er s pr i vat e debt i nt o t he publ i c sect or , and creat es

di f f i cul t i es f or publ i c f i nance unl ess t her e i s a dr amat i c and

qui ck r ecover y of t he pr i ces of f i nanci al asset s. The Aust r i an

gover nment ’ s answer t o t he 1931 Cr edi t anst al t cr i si s i nvol ved

t aki ng over t he bank, and event ual l y mer gi ng i t wi t h ot her

weakened Aust r i an banks, t he Wi ener Bankver ei n and t he

Ni eder öst er r ei chi sche Escompt e Gesel l schaf t . The gover nment



17

subsi dy was expensi ve, amount i ng t o 9 t o 10 per cent of GNP,

subst ant i al l y l ess t han t he cost of bai l out s f or Mexi co or J apan

i n t he 1990s, but much l ess t han t he cost of t he I r i sh

gover nment ’ s i l l - concei ved guar ant ee of I r i sh bank deposi t s i n

2008, whi ch was r esponsi bl e f or sendi ng t he gover nment def i ci t

t o over 30 per cent of GDP i n 2010. I n t he 1930s, t he af t er math

of t he bai l out par al yzed Aust r i an pol i cy t hr oughout t he 1930s

and made t he count r y vul ner abl e t o i nt er nal ext r emi sm and

ext ernal at t ack. I t i s l i kel y t hat I r i sh pol i t i cs wi l l be

pr of oundl y t r ansf ormed i n t he wake of 2011 el ect i ons.

4. Bai l out s cr eat e pol i t i cal economy pr obl ems. Bai l out s

ar e i nher ent l y cont r over si al , because t hey di st r i but e publ i c

money i n an ar bi t r ar y way, t o one reci pi ent r at her t han anot her .

I n t he Uni t ed St at es, Her ber t Hoover ’ s i nnovat i ve Reconst r uct i on

Fi nance Corporat i on of 1932 qui ckl y ran i nt o pr obl ems because of

t hi s i ssue: i t t ur ned out t hat t he credi t s wer e goi ng t o banks,

f arms and busi nesses t hat were wel l connect ed wi t h Republ i can

pol i t i cs. Ger many of f er s an even more dr amat i c exampl e of t hi s

ki nd of pr obl em. As par t of t he bank bai l out i n t he af t er mat hof t he 1931 cr i si s, 2. 5 m. Rei chsmarks was put i nt o a smal l

Ber l i n i nst i t ut i on, Har dy & Co. , t hat was a subsi di ar y of t he

Dr esdner Bank. Thi s money was pr i mar i l y i nt ended t o f l ow i nt o

t he el ect or al campai gn cof f er s of Paul von Hi ndenbur g, t he

vet eran Fi r st Wor l d War commander who had been el ect ed Pr esi dent

of Germany and was st andi ng f or r eel ect i on i n 1932 ( Bähr and

Zi egl er ) .

I n the f r agi l e si t uat i on of Wei mar Ger many, t he bai l out

t hat was at t he cent er of t he gover nment ’ s r esponse t o t he

banki ng cri si s r an i nt o ever y ki nd of obj ect i on. The cl ai m t hat

t he gover nment had been engaged i n t he “soci al i zat i on of l osses”



18

became an i mport ant part of t he tur bul ent el ect oral campai gns of

1932. I n or der t o get suppor t f r om t he Akzept bank, banks had t o

demonst r at e that “i mport ant economi c i nt er est s” wer e at st ake,

and i n pr act i ce t he maj or i t y of Akzept bank credi t went t o t he

savi ngs banks ( Sparkassen) . I t was al so used t o suppor t

ent er pr i ses i n st r at egi cal l y vi t al ar eas, not abl y Si l esi a. The

speci al i ssues i nvol ved i n t he suppor t of Si l esi an i ndust r y, and

t he f ear of an oppor t uni st i c t akeover by f or ei gn i ssues, l ed t o

t he Chancel l or Hei nr i ch Br üni ng’ s most pr obl emat i cal and i ndeed

scandal ous r escue oper at i on, t he so- cal l ed Gel senber g pur chase

concl uded on the l ast day t hat Br üni ng and hi s Fi nance Mi ni st er

Her mann Di et r i ch, t he dr i vi ng f or ce of t hi s bai l out , wer e i nof f i ce. I n t hi s t r ansact i on, t he gover nment , whi ch as a r esul t

of t he banki ng cr i si s had become Fl i ck’ s l ar gest credi t or ,

bought out Fl i ck’ s i nt er est i n t he st eel gi ant Ver ei ni gt e

St ahl wer ke. Di et r i ch’ s f or mer St at e Secr et ar y Hans Schäf f er

r ef er r ed t o t he oper at i on as “ext r eme st upi di t y”.

The r escue of t he Cr edi t anst al t was al so accompani ed by

massi ve cor r upt i on, t he r evel at i on of whi ch became t he st ock- i n-t r ade of t he opposi t i on Nazi movement i n Aust r i a. Then, as now,

t her e was massi ve publ i c host i l i t y t o t he i dea of a bai l out , i n

t hat i t appear ed t o be a f or m of suppor t f or t he i nst i t ut i ons

and peopl e who r eal l y bor e t he r esponsi bi l i t y f or t he cr i si s.

The cost of bai l out s, even when t hey seemed t o have been

admi ni st ered pr ompt l y and wi t h hi gh ef f i ci ency as i n t he Ger man

case, t hus exceeded t he si mpl e f i scal ar i t hmet i c. They br oughtt he st at e i nt o a ser i es of cont ent i ous mi cro- l evel deci si ons on

t he heal t h of par t i cul ar ent er pr i ses and on t he f at e of

i ndi vi dual bank di r ect or s. Gi ven t he poi sonous i deol ogi cal

backdr op of ant i - Semi t i sm i n t he cont ext of Cent r al Eur ope i n



19

t he 1930s, i t i s unsur pr i si ng t hat t hi s r adi cal doct r i ne was

f anned by t he char act er of t he government ’ s r esponse t o banki ng

cr i ses, and t hat bot h i n Ger many and mor e expl i ci t l y i n Aust r i a

a pr ocess of expr opr i at i ng J ewi sh pr oper t y ( “ar yani zat i on”) t hat

was at f i r st cal l ed Ger mani zat i on or Aust r i ani zat i on set i n even

bef or e t he Nazi s t ook power i n those count r i es. The epi sodes of

managi ng bank f ai l ur es i n r et r ospect l ook l i ke t he begi nni ng of

a pr ocess of st at e- domi nat i on, cor r upt i on, and even r aci al

per secut i on t hat woul d r ol l on l i ke an ever more menaci ng

snowbal l .

The pol i t i cs of bank and i ndust r i al bai l out s af t er 2008

r ai sed f ear s of a new f i nanci al and economi c nat i onal i sm, as

government s become more di r ect l y i nvol ved i n t he mi cr o-

management of t he economy. Banks i n st at e owner shi p of wi t h a

subst ant i al degr ee of publ i c i nvest ment – Ci t i gr oup, Ll oyds-

HBOS, RBS, Commerzbank –cut back on f orei gn act i vi t i es and sol d

f or ei gn asset s, at l east i n par t because of gover nment pr essure

t hat t axpayer money shoul d not be used f or t he benef i t of

f orei gn borr ower s. Economi c nat i onal i sm was even more evi denti n the debat e about government r escues of t he aut omobi l e

i ndust r y i n 2009, wher e domest i c j obs are pr otect ed at t he cost

of f or ei gn j obs i n an i ndust r y deal i ng wi t h gl obal over capaci t y.

Gl obal I mbal ances

Gl obal i mbal ances pl ayed a maj or r ol e i n t he or i gi ns of t he

Gr eat Depr essi on and many ar gue that t hey ar e al so a si gni f i cant

cause of t he Gr eat Recessi on. I n t he Gr eat Depr essi on, t he



20

i mbal ances were unwound and r eversed: capi t al af t er 1931- 33

f l owed back t o t he cr edi t or count r i es, above al l t o t he U. S.

The unwi ndi ng of i mbal ances i nvol ved an asymmet r i c adj ust ment .

Cr edi t or count r i es di d l i t t l e, whi l e t he def i ci t count r i es

r educed t hei r l evel of economi c act i vi t y i n or der t o make

t r ansf er s.

Of cour se not al l i mbal ances ar e bad or unsust ai nabl e. I n

t he ni net eent h cent ur y, some count r i es r an per si st ent def i ci t s

because t hey wer e gr owi ng more qui ckl y (Aust r al i a or t he U. S. )

and ot her s had subst ant i al surpl uses because of hi gh savi ngs

accumul at i on i n a mat ure economy ( UK and Fr ance) . Some

count r i es ( such as t he Ot t oman empi r e or Russi a, or Gr eece) had

publ i c debt i nduced def i ci t s t hat wer e unsust ai nabl e, and whi ch

l ed t o i sol at ed debt cr i ses but no gener al r ever sal of capi t al

f l ows. I n t he 1920s, t he i mbal ances that bui l t up i n cent r al

Eur ope wer e heavi l y dr i ven by unsust ai nabl e expansi ons of publ i c

spendi ng and pr i vat e consumpt i on; and the si mul t aneous col l apse

l ed t o a gener al r ever sal of capi t al f l ows.

There was i n t he Gr eat Depress i on a great deal of

di scussi on about t he need f or mor e and bet t er i nt er nat i onal

cooper at i on. I n 1930, t he Bank f or I nt er nat i onal Set t l ement s

began wor k i n Basel . I t s creat or s, above al l t he i nf l uent i al

Governor of t he Bank of Engl and, Mont agu Norman, envi saged i t s

r ol e as not onl y ar r angi ng f or t he saf e and pai nl ess t r ansf er of

Ger man r epar at i ons ( i t s pr i mar y r ol e) but al so i n devi si ng

cr i si s suppor t mechani sms f or t r oubl ed debt or s.

The hi ghpoi nt of i nt er nat i onal cooperat i on was supposed t o

be t he 1933 London Wor l d Economi c Conf er ence. But i t s f ai l ur e

was al most pr edest i ned. The pl enary meet i ng was par al yzed by t he



21

way i n whi ch t he preparat ory commi ss i ons had worked. Monet ary

exper t s argued t hat an agr eement on cur r ency st abi l i zat i on woul d

be hi ghl y desi r abl e, but t hat i t r equi r ed a pr i or agr eement on

t he di smant l i ng of t r ade bar r i er s – al l t he hi gh t ar i f f s and

quotas t hat had been i nt r oduced i n t he cour se of t he depr essi on.

Tr ade exper t s met i n paral l el and made t he mi r r or i mage of

t hi s argument . They agr eed t hat pr ot ect i oni sm was obvi ousl y a

vi ce, but t hought t hat i t was a necessar y one t hat coul d not be

addr essed wi t hout monet ar y st abi l i t y. Onl y l eader shi p by a

det er mi ned gr eat power , pr epar ed t o sacr i f i ce i t s par t i cul ar

nat i onal i nt er est s i n or der t o br eak t he r esul t i ng i mpasse,

mi ght concei vabl y have saved t he meet i ng. But such l eadershi p

was as unl i kel y t hen as i t i s now.

A f ur t her l esson of t he London Conf er ence of 1933 consi st s

i n gover nment s’ unwi l l i ngness i n t i mes of gr eat economi c

di f f i cul t y t o make sacri f i ces t hat mi ght ent ai l a shor t - t er m

cost . Even i f t he r esul t woul d have been l onger - t er m st abi l i t y,

t he i mmedi at e pol i t i cal consequences wer e t oo unpl easant . I nadver se economi c ci r cumst ances, government s f el t vul nerabl e and

unsur e, and t hey coul d not af f or d t o al i enat e publ i c suppor t .

Fi nal l y, f aced by a r eal i zat i on of i nevi t abl e f ai l ur e,

par t i ci pant s l ook f or a scapegoat . The 1933 Conf er ence l ooked

l i ke a cl assi c det ect i ve novel i n whi ch ever y par t y had a reason

t o be a suspect . Br i t ai n and Fr ance had t ur ned away f r om

i nt er nat i onal i sm, adopt i ng t r ade syst ems known as “I mper i alPr ef er ence, ” whi ch f avor ed t hei r vast over seas empi r es.

Ger many’ s pr esi dent had j ust appoi nt ed Adol f Hi t l er ’ s r adi cal

and aggressi ve government . The German del egat i on was l ed by

Al f r ed Hugenber g, who was not a Nazi but want ed t o show t hat he



22

was an even mor e i mpl acabl e nat i onal i st t han Hi t l er hi msel f . The

J apanese gover nment had j ust sent t r oops i nt o Manchur i a. Of al l

t he maj or powers i n London, t he Uni t ed St at es l ooked the most

r easonabl e and i nt er nat i onal i st by f ar . I t had a new,

char i smat i c presi dent , who was known as an Angl ophi l e and a

cosmopol i t an spi r i t . Frankl i n Roosevel t was al r eady t aki ng

vi gor ous act i on agai nst t he depr essi on, and was t r yi ng t o

r eorder t he f ai l ed US banki ng syst em. Roosevel t di d not know

what l i ne t o t ake at t he conf er ence, and hi s st r eam of advi ser s

of f er ed i nconsi st ent counsel . At l ast , he l ost pat i ence and

announced that f or t he moment t he US had no i ntent i on of

st abi l i zi ng t he dol l ar . Thi s message, del i ver ed on J ul y 3, 1933,was known as “ t he bombshel l . ” Roosevel t t al ked about t he need to

r est or e “t he sound i nt er nal economi c syst em of a nat i on” and

condemned t he “ol d f et i shes of so- cal l ed i nt er nat i onal banker s. ”

Ever yone pr et ended t o be shocked at t he f ai l ur e of

i nt er nat i onal i sm. But , at t he same t i me, t hey wer e del i ght ed t o

have f ound someone who coul d be bl amed f or t he f ai l ur e of t he

conf erence.

Lessons f r om t he Fai l ur e of I nt er nat i onal Cooper at i on:

The most obvi ous l esson f r om t he hi st or y of t he Gr eat

Depr essi on concer ned t he desi r abi l i t y of an i nst i t ut i onal

mechani sm t o pr event a col l apse of t r ade as a r esul t of

pr ot ect i ve and r et al i at or y measur es – t ar i f f s and quot as. The

i nt er nat i onal t r ade r egi me has been i nst i t ut i onal i zed, f i r stt hrough t he GATT and t hen t hrough t he WTO. Al t hough a l arge

number of count r i es i nt r oduced some pr ot ect i ve measur es i n t he

wake of t he f i nanci al cr i si s, onl y about 1 per cent of wor l d

i mport s wer e af f ect ed by t he new t r ade measur es i nst i t ut ed



23

bet ween Oct ober 2008 and Oct ober 2009, i n ot her words i n t he

most sever e phase of t he cr i si s ( OECD 2010) . G- 20 meet i ngs i n

November 2008 and Apr i l and Sept ember 2009 pr oduced agreement s

on ant i - pr ot ect i oni st measur es, and some count r i es ( not abl y

Aust r al i a, Mexi co and Canada) i nst i t ut ed a syst emat i c r educt i on

of t ar i f f s ( t hough Mexi co, l i ke Russi a, t ook measur es t o

r est r i ct t he i mpor t of f or ei gn aut omobi l es) .

There was a r api d col l apse of t r ade i n t he si x mont hs af t er

t he col l apse of Lehman i n Sept ember 2008, whose maj or cause was

t he unavai l abi l i t y of t r ade f i nance r at her t han t r ade pr ot ect i on

measur es. OECD expor t s f el l by 12. 9 per cent i n t he l ast quar t er

of 2008 and by 30. 0 per cent i n t he f i r st quar t er of 2009. Af t er

Apr i l 2009, t r ade r ecover ed r api dl y. Never t hel ess, wor l d t r ade

i n 2009 was around 12. 5 percent l ower t han i n 2008 al t hough i t

has al most r ecover ed i n 2010. ( OECD 2010)

I n the debat es bef ore t he Wor l d Economi c Conf erence, a

cr i t i cal i ssue was how t r ade and f or ei gn exchange pol i cy

i nt er act ed. Mul t i l at er al i nst i t ut i ons i n t he Gr eat Recessi on bycont r ast have deal t l ar gel y wi t h a di f f er ent coor di nat i on

exer ci se: t hey have been concerned both wi t h t he coordi nat i on of

f i scal st i mul us and wi t h exchange r at e coor di nat i on. I n

addi t i on, cent r al banks extended swaps, l ess as an act of

monet ar y pol i cy coor di nat i on but r at her l ar gel y i n or der t o deal

wi t h t he cur r ency r equi r ement s r esul t i ng f r om l ar ge cur r ency

mi smatches i n t he bal ance sheet s of maj or cr oss- nat i onal banki ng

groups.

Bot h t he f i scal and t he exchange r at e si des of t he

coor di nat i on exer ci se ar e pot ent i al l y pr obl emat i c. The emphasi s

on f i scal st i mul us i n t he ear l y phase of t he cr i si s made some



24

count r i es vul ner abl e t o doubt s about f i scal sust ai nabi l i t y i n

t he second par t of t he cr i si s. I n t he Eur opean Uni on, Gr eece

and Spai n at f i r st pr esent ed thei r st i mul us packages as

cont r i but i ons t o Eur opean r ecover y rat her t han as sour ces of

f r agi l i t y.

More i mport ant l y, t he moder n di scussi on of f orei gn exchange

pol i cy i s much mor e cont r over si al and di f f i cul t t o r esol ve t han

t r ade i ssues, and t he i nt er nat i onal i nst i t ut i onal set t i ng – t he

I nt er nat i onal Monet ar y Fund - whi ch or i gi nal l y managed t hi s

i ssue i n t he Br et t on Woods era has l argel y l ost compet ence i n

t hi s f i el d. Ther e has been a gr eat deal of di scussi on of

st r engt heni ng mul t i l at er al sur vei l l ance i n t he wake of t he

cr i si s, but such sur vei l l ance has not had a maj or pol i cy i mpact .

I nst ead, t her e ar e r epeat ed accusat i ons t hat exchange r at es are

bei ng mani pul ated i n or der t o achi eve t r ade advant ages,

accusat i ons whi ch r ecal l t he bi t t er pol emi cs of t he 1930s. The

Uni t ed St at es bel i eves t hat Chi na i s under val ui ng t he r enmi nbi

i n or der t o dr i ve expor t s; Eur opeans compl ai n t hat quant i t at i ve

easi ng i s a t r ade pol i cy desi gned t o dr i ve down t he dol l ar ;

Amer i cans asser t t hat t he Eur o t r oubl es are a mechani sm f or

l ower i ng t he Eur opean exchange r at e; and even more t r oubl i ngl y,

i n t he Eur opean cont ext , sout her n Eur opeans ar e begi nni ng t o

i nt er pr et t he st or y of t he l ocked exchange r at e of t he si ngl e

cur r ency as a devi ce t o obtai n expor t advant ages by Germany ( and

ot her nor t her n Eur opean st at es) .

The r esul t of t hese cont r oversi es has been an er osi on of

i nt er nat i onal economi c cooper at i on. I n t he hal f year f ol l owi ng

t he 2008 col l apse of Lehman, dur i ng the most i nt ense phase of

t he cur r ent f i nanci al cr i s i s, t he wor l d’ s pol i t i cal l eader s

r eassur ed t hemsel ves t hat t hi s t i me i nt er nat i onal cooper at i on



25

was wor ki ng spl endi dl y – by cont r ast wi t h t he gr i m pr ecedent of

t he nat i onal i st i c and aut ar ki c 1930s. The gl obal el i t e

const ant l y r ehearsed and r epl ayed a soot hi ng mant r a. Her oi c

f i gur es, l ed by Gordon Br own, wer e r escui ng t he wor l d t hr ough

f ar - si ght ed and benef i cent publ i c act i on. But si nce t hen, i n an

uncanny echo of t he ear l i er col l apse of i nt er nat i onal ef f or t s at

under st andi ng, t he pr ospect s f or sust ai ned cooper at i on and f or

agr eement on who shoul d adj ust have f aded. Gr owt h i s r etur ni ng

f or bot h t he maj or sur pl us and t he def i ci t count r i es, and i t

mi ght i n consequence be ar gued t hat t he coor di nat i on f ai l ur e

does not mat t er . But t he gl obal i mbal ances ar e st i l l t her e, and

t o t he ext ent t o whi ch t hey ar e dr i ven by t he expansi on of publ i c debt l i abi l i t i es may be “bad” i mbal ances capabl e of

l eadi ng t o a 1930s st yl e r ever sal .

The 2010 equi val ent of Roosevel t ’ s bombshel l has come f r om

t he Republ i can “shel l acki ng” of Pr esi dent Obama i n t he mi d- t er m

el ect i ons. The out come i s a r est or at i on f or t he l ogi cal and

beaut i f ul l y desi gned syst em of checks and bal ances t hat t he

ei ght eent h cent ur y const i t ut i onal f at her s dr ew up. That syst em

can work as i nt ended and pr oduce an accur ate r ef l ect i on of t he

concer ns of or di nar y Amer i cans. I t i s l i kel y t o pr event f ur t her

bi g bai l out s, f ur t her economi c st i mul us measur es, but al so to

bl ock ef f or t s at gover nment budget bal anci ng. The f i nal

conf i r mat i on of t he new U. S. st ance came one day l ater , wi t h t he

Fed’ s announcement of t he new $600 bn. quant i t at i ve easi ng

pr ogr am ( QE2) . The Fed was qui t e r i ght t o cl ai m t hat t he

pr ogr am was not unusual , and t hat i t r epr esent ed mer el y monet ary

pol i cy as usual . I t may be t hat i t i s exact l y what t he U. S.

economy needs at t he moment – i n pr eci sel y t he same way as i n

1933 t he U. S. needed a f l exi bl e exchange r ate and benef i t ed f r om



26

escapi ng f r om gol den f et t ers. Some comment at ors however argue

t hat t he pace of r ecover y as a resul t of t he pr i vat e sect or ’ s

own ener gy and cont i nuous monet ary st i mul us si nce l at e 2008 may

have made QE2 r edundant . The deci si on however was j ust i f i ed by

Fed of f i ci al s by ref er ence t o t he dual mandat e of t he Fed, t o

mai nt ai n pr i ce st abi l i t y ( wher e f or t he moment t her e i s no

t hr eat of ei t her si gni f i cant i nf l at i on or of any def l at i on) and

al so a l evel of economi c act i vi t y t hat mi ght gener at e an

i mprovement i n t he l abor market .

I t i s onl y when i t comes t o t he i nt er nat i onal ar ena t hat

t he Fed’ s act i ons ar e i nconsi st ent wi t h pr i ce st abi l i t y i n ot her

count r i es – or “cl uel ess” as Ger man Fi nance Mi ni st er Wol f gang

Schäubl e undi pl omat i cal l y put i t . A howl of out r age about U. S.

monet ar y pol i cy f ol l owed f r om t he f i nance mi ni st r i es of ever y

emer gi ng market economy. The Br azi l i an Fi nance Mi ni st er , Gui do

Mant ega spoke of a new “cur r ency war” i nvol vi ng compet i t i ve

deval uat i on ( Fi nanci al Ti mes, 2010) . The Amer i can compl ai nt

t hat Chi na was del i ber at el y under - val ui ng i t s exchange rat e

l ooked out of pl ace as expansi onary Fed pol i cy may have f uel l ed

curr ency wars by weakeni ng t he dol l ar and pr ovi di ng cheap f unds

t hat woul d sur ge i n a wave of l endi ng t o f uel pot ent i al emer gi ng

market bond bubbl es. U. S. monetary pol i cy i s havi ng an i mpact

on emer gi ng market s. Low U. S. r ates are f uel i ng a new ver si on

of t he car r y t r ade, and set t i ng of f i nf l at i onar y booms i n east

Asi a whi ch ar e di f f i cul t t o cont r ol by convent i onal means. The

new U. S. pol i cy mi x i s l i kel y t o be i nt er pr et ed by some as a

r et ur n t o t he 1930s exper i ence, when t he U. S. t ur ned on i n

i t sel f , abandoni ng at t empt s t o st eer a gl obal economy.

The f ai l ure of cur r ency coor di nat i on whi ch woul d go agai nst

per cei ved sover ei gn i nt er est i s not sur pr i si ng f r om a pol i t i cal



27

economy vi ewpoi nt , and t he l ogi c f or i t i n a r egi me of f l oat i ng

exchange r at es compar ed t o t he i nterwar gol d exchange st andar d

i s not compel l i ng i n t er ms of economi c t heory. Ther e wer e

si mi l ar f ai l ur es i n t he ear l y 1970s, af t er t he Smi t hsoni an

meet i ng t o determi ne a set of new exchange rat es, or i n t he mi d-

1980s, when at t empt s at coor di nat i on i n the Pl aza and Louvre

Fi nance Mi ni st er s’ meet i ngs i ncr eased r at her t han decr eased

f i nanci al i nst abi l i t y. The onl y maj or r eason t o wor r y about

such f ai l ur es t oday i s t hat f r ust r at i on about t he cur r ency

r egi me can t r ansl at e pot ent i al l y i nt o power f ul demands i n

par l i ament s and ot her r epr esent at i ve assembl i es f or t r ade

r et al i at i on as a r esponse t o a cur r ency war . So f ar , t hi s t r adecount er bl ast r emai ns a t opi c f or di scussi on r at her t han a

real i t y.

Mor eover , t he consequence of f ai l ur e of i nt er nat i onal

cooper at i on has not been near l y as negat i ve as i n t he 1930s,

because t here has as yet been no sudden r eversal of capi t al

f l ows. So f ar , i n t he af t er mat h of 2008, some smal l er debt or

count r i es have been obl i ged t o undert ake a sharp adj ust ment( Lat vi a moved f r om a cur r ent account def i ci t of 13. 1 per cent i n

2008 t o a 8. 6 per cent surpl us i n 2009, and Hungary f r om – 7. 1

per cent t o + 0. 2 per cent ) ) . But t her e has been no r ever sal of

t he posi t i on of t he l ar gest debt or s, t he Uni t ed St at es or t he

Uni t ed Ki ngdom. Even t he Eur ozone pr obl em cases, Gr eece,

I r el and and Spai n cont i nue t o r un a subst ant i al cur r ent account

def i ci t , wi t h ( i ncreasi ngl y ner vous) f or ei gn i nvest or s st i l l

buyi ng government debt ( at a subst ant i al pr emi um) .

I n t he Gr eat Depr essi on, t he maj or i nt er nat i onal pol i cy

pr obl em l ay i n t he expor t of def l at i on by t he sur pl us count r i es,

France and t he U. S. Today’ s equi val ent t o France’ s



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st er i l i zat i on of gol d i nf l ows i n t he 1920s woul d be t he ar gument

t hat Chi na i s expor t i ng def l at i on t hr ough t he st er i l i zat i on of

f orei gn exchange pur chases. But t he other si de of t he moder n

st or y, t he cont i nued l ar ge def i ci t s of t he maj or def i ci t

economi es ( US, UK et c. ) do not paral l el t he dr amat i c adj ust ment

of t he 1930s. I n t he Gr eat Recessi on, i nst ead t he expor t of

i nf l at i on r ecal l s t he exper i ence of t he l at e 1960s and t he ear l y

1970s r ef l ect i ng t he exor bi t ant pri vi l ege ( i n t he event s t hat

produced t he breakdown of t he par val ue or Br et t on Woods

syst em) . Agai n, t hi s 1970s anal ogy woul d poi nt t o t he danger

t hat cur r ency uncer t ai nt y may l ead t o new t r ade pol i ci es.

Why Lessons are Pai nf ul

There ar e many l essons f r om t he Gr eat Depressi on t hat can

and shoul d be l ear nt i n r espect t o t he management of our curr ent

cr i si s; but t hey ar e of t en not as si mpl e or as easy as many

comment at or s bel i eve. The most i mpor t ant and most unprobl emat i c

l esson i s concer ned wi t h t he avoi dance of t he monet ary pol i cyer r or of not i nt er veni ng i n t he f ace of banki ng cr i ses. The

pol i ci es of t he maj or cent r al banks – t he Feder al Reser ve, t he

Eur opean Cent r al Bank, t he Bank of Engl and – suggest t hat t hi s

i s a l esson t hat has been i n t he mai n l earnt . However t he Fed

af t er expandi ng l i qui di t y i n t he f al l of 2007 t hen f ol l owed t oo

cont r act i onar y a pol i cy i n t he f i r st t hr ee quar t er s of 2008

whi ch may have exacerbat ed t he recessi on that began i n December

2007. Some maj or economi es, not abl y t he Uni t ed St at es and

Chi na, have al so embarked on l arge f i scal st i mul us progr ams

al t hough t he j ur y i s st i l l out on how ef f ect i ve t hey wer e . I n

t he Chi nese case, t her e i s an acut e danger of i nf l at i onar y



29

over heat i ng; i n t he U. S. case, t her e i s t he f ear t hat t he f i scal

st i mul us wi l l si gni f i cant l y wor sen al r eady f undament al l y

unsust ai nabl e debt dynami cs.

Learni ng f r om t he Gr eat Depr essi on i n ot her ar eas i s muchhar der . A maj or f i nanci al col l apse has l ong- l ast i ng

consequences, whi ch cannot easi l y be r emoved. Bot h t he l esson

f r om t he Gr eat Depr essi on about t he sl owness and t he pai nf ul ness

of bank r econst r uct i on, and t he l esson about dependence on a

l ar ge ext er nal pr ovi der of capi t al , ar e unpal at abl e. Li mi t i ng

t he si ze of banks t hat ar e t oo bi g or t oo i nt er connect ed t o f ai l

i s a maj or pol i t i cal pr obl em, especi al l y as such i nst i t ut i ons

const i t ut e a power f ul l obbyi ng f or ce. The cur r ent s t r at egy of

guarant eei ng banks, but al so deposi t s and a br oad range of other

l i abi l i t i es, i s l i kel y t o encour age a f ur t her ext ensi on r at her

t han a r ol l - back of t he t oo- bi g- t o- f ai l doct r i ne. Bank r escues

have al so had a si gni f i cant i mpact on t he det er i or at i on of t he

f i scal posi t i on of many count r i es.

Tr ade i s another ar ea where maj or vul nerabi l i t i es wi l l

cont i nue. Cur r ency br eakdowns ar e of t en f ol l owed by t r ade

f i ght s. Monet ar y pol i cy i s not per cei ved any l onger as sol el y

pr omot i ng a st abl e measur e of val ue, but al so ( as i n t he

1930’ s) as a t ool wi t h whi ch count r i es can f i ght each ot her f or

t r ade advant ages.

For a l ong t i me, i t was much easi er t o repeat t he soot hi ng

mant r a t hat col l ect i vel y t he wor l d communi t y has l earned how t o

avoi d a 1929- t ype of col l apse, and t hat t he wor l d’ s cent r al

banks i n 1987 or 2001 cl ear l y showed t hat t hey had l ear ned t he

r i ght l esson. I t i s undoubt edl y mer i t or i ous of gover nment s t o

st abi l i ze expect at i ons, and t o pr event a wor se spi r al i ng of



30

cri si s. But pol i cy- maker s and t hei r advi ser s wi l l creat e

i nappr opr i ate expect at i ons when some si mpl e pol i cy pr oposal s are

bui l t up as t he basi s f or t he hope t hat t hey al one can guar ant ee

r ecover y. As bot h Eur ope and t he Uni t ed St at es ar e l i kel y t o

cont i nue t o have r at her anemi c r ecover i es, i t i s as i mpor t ant t o

t ake a sober and r eal i st i c appr oach t o t he unpal at abl e l essons

of t he Gr eat Depr essi on as i t i s t o cel ebr at e t he f undament al

poi nt t hat we do know more about monet ary pol i cy.



31

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