The lessons of the Great Depression is our theme today. You are an expert on that topic. By all accounts, that’s one of the reasons why Barack Obama asked you to join his cabinet in the autumn of 2008. How well did economists understand the toll that the financial crisis of 2008 would take on the US economy as you prepared to chair the White House Council of Economic Advisers?
In the middle of the financial crisis, it was hard to estimate just how much damage had already been done to the economy and how widespread the impacts would be. But what economists certainly understood from history was that the crisis could be absolutely devastating if policymakers didn’t take steps to stop it and to mitigate the damage.
Right-wing websites are rife with references to “Obama’s Depression”. I know economists and partisan bloggers wield the word “depression” differently. When economists use the word, what precisely do they mean?
The word “depression” doesn’t really have a well-defined meaning, unlike the words “recession” and “expansion”. The National Bureau of Economic Research defines a recession, for example, as a time when economic activity is declining. Often what economists mean by depression is the same thing other people mean – a really bad and exceptionally prolonged recession. Importantly, as bad as the current recession has been, it has been far less severe and prolonged than the episode we all agree was a depression, the Great Depression of the 1930s. To give you one indicator, in 2009 the US unemployment rate peaked at 10%. In the early 1930s it hit 25%.
Your second selection is Golden Fetters by Barry Eichengreen. How did this book contribute to our understanding of the Great Depression?
It’s important for helping to answer the question, why was the Depression a worldwide phenomenon? Friedman and Schwartz and other studies have shown that what caused the Depression here in the US was largely domestic shocks – a terrible stock market crash and a series of uncontrolled banking crises. But if that is the case, why was the Depression so terrible in Great Britain, France and basically throughout the entire world?Golden Fetters, by my colleague Barry Eichengreen, gives a definitive explanation of the role that the gold standard played in transmitting the shocks centered in the US to lots of other countries.
The basic story is that if something happened in the US that pushed up our interest rates or pushed down our prices, it would draw gold from other countries toward the US. In the Depression, other countries were worried about their gold reserves and they didn’t want gold to flow toward the US. So they basically had to have a monetary contraction as well. You saw countries deliberately pushing up interest rates to try to prevent gold from flowing out of their economies. Golden Fetters explains that because of the gold standard, a monetary shock in the US led to a worldwide monetary contraction.
Eichengreen shows that a bad economic idea can have devastating consequences. The fact that policymakers throughout the world were determined to remain on the gold standard caused them to follow the US into the Great Depression.
At the time of the Great Depression, did economists understand the downsides of the gold standard and warn against it? Or did people only come to understand it in retrospect?
There were some who understood and warned about the downsides, but largely its flaws were realised in retrospect. The gold standard is a bit like the euro today. It worked quite well during the good times of the late 1800s and early 1900s, just as the euro worked quite well before the financial crisis. Policymakers tended to think it would always work well.
Eichengreen argues that the gold standard worked well in its heyday because countries played by the rules and the Bank of England was an effective worldwide manager of the system. But after the gold standard broke down during the First World War, economists and policymakers were slow to realise when they tried to restore it that it might not work as well, especially in the face of enormous shocks in the US.
Do you think there is anything like the gold standard today? By which I mean bad ideas about economic policy that history will judge as causing or exacerbating our economic problems?
Absolutely. The most important one is the notion that fiscal contractions – reducing the budget deficit immediately – can be expansionary. Some policymakers have become convinced that cutting spending and raising taxes will be so good for confidence that it will increase rather than decrease employment and growth. This is a very bad idea that is contradicted by strong empirical evidence.
This mistaken belief in expansionary fiscal contractions has caught hold especially in Europe. It’s a big part of why Europe is in the mess that it’s in. Deeply troubled countries, such as Greece and Spain, have been forced to adopt severe fiscal austerity in order to receive aid from other European countries and the IMF. And other countries, such as the UK and Germany, have moved to austerity because they bought into the idea that it would be good for their growth. But the outcome has not been good. Growth has slowed throughout Europe, and the eurozone has almost certainly entered another recession. Countries such as Spain and Greece that have adopted extreme austerity measures have seen unemployment rise dramatically. This rise in unemployment makes it all the harder for them to actually get their budget deficits under control.
There are much wiser policies for Europe and for the US. The fiscal problems are very real but they should be dealt with gradually. It would be far better to pass plans now, but not make the actual spending cuts and tax increases until the economies are healthier. Policies aimed at stimulating growth would be far more humane, and ultimately better for the fiscal situation. Without growth and full employment, it is very hard to ever get the budget deficit truly under control.
The gold standard is back in the news as the tent pole policy of one of the Republicans running for president, Ron Paul. What do you say to people calling for a return to the gold standard today?
Read Barry Eichengreen’s book. Not only is the gold standard not a cure for our current ills, it could make things much worse.
Your next book is a collection of essays by the current chairman of the Federal Reserve, Ben Bernanke, who was previously a professor of economics at Princeton University. Please explain how this book, and in particular the paper “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”, has added to our understanding of financial downturns.
Chairman Bernanke has written a number of important papers about the Great Depression. The one that really stands out is the paper you mentioned. Friedman and Schwartz showed that banking panics caused a decline in the money supply, which likely depressed output by raising real interest rates. Bernanke argued that a financial crisis also has negative effects working directly through the decline in credit availability. When a financial panic causes banks to go out of business or makes them unwilling to lend, that can have an impact on the economy above and beyond any effects on the money supply. He found evidence from the Great Depression that such non-monetary effects of a banking crisis could be very large.
Bernanke’s focus on the non-monetary effects of financial crises turned out to be incredibly important. It started a whole literature on how credit matters, above and beyond what’s reflected in interest rates. He changed our view of how monetary policy affects the economy.
How did Bernanke’s theories impact the understanding and handling of the 2008 crisis?
His work and the subsequent research it inspired made us realise how important it is in a financial crisis not to just prevent the money supply from falling, but also to make sure that credit keeps flowing. We learned from the Great Depression that when credit dries up it has devastating consequences.
That idea had a huge impact on the Federal Reserve’s behaviour in the most recent crisis. In response to the financial crisis in the fall of 2008, the Fed not only followed the conventional central bank remedy – flood the system with liquidity and make sure there’s plenty of cash out there – but they also took extraordinary actions to keep credit flowing. When they saw credit markets were not functioning, the Fed was incredibly creative in finding ways to make sure that firms could get credit. For example, many businesses issue commercial paper to cover payroll and finance day-to-day operations. When that market stopped functioning and no one was willing to buy commercial paper, the Fed said, we’ll buy it.
These aren’t the type of actions that the public has historically associated with central banks. Has monetary policy evolved a lot? What is it?
Conventionally, monetary policy refers to Federal Reserve decisions about setting interest rates. We’re used to the Fed saying they’re going to push the federal funds rate up or down. But this crisis was so extreme that the Fed had to be much more aggressive and creative. In addition to reducing the funds rate to zero, the Fed has taken a number of actions to keep credit flowing and to reduce interest rates other than the funds rate. Whether you call that monetary policy or credit policy or quantitative easing is somewhat arbitrary. Since all the policies are being conducted by the central bank, I tend to lump them under the broad term of monetary policy.
A lot of people have second-guessed the Obama administration’s fiscal policy response to the “Great Recession”. Would you care to second-guess the monetary policy response?
We often think of the financial crisis as beginning with the collapse of Lehman Brothers, but there was real strain in financial markets starting from late 2007, with the meltdown in subprime mortgages. The Fed worked very hard throughout 2008 to mitigate the consequences of falling house prices and credit contraction. They were very proactive. Then when the crisis hit in the fall of 2008, the Fed was essential in helping to prevent a much more catastrophic meltdown. They kept the financial crisis from being much worse than it otherwise would have been. It’s hard to second-guess them on that part of their response.
Where I think you can second-guess them is once we got through the immediate crisis. By the fall of 2009, the financial system had stabilised but the rest of the economy was still reeling from the fallout and unemployment was heading up to 10%. Instead of further aggressive moves to encourage faster recovery, such as more quantitative easing or a bold communications policy, the Fed essentially took a breather. That was a mistake.