What can we learn from the Depression?

By C.R. | LONDON

SINCE the start of what some now call the “Great Recession” in 2007, economists have been unable to avoid comparing it with the Depression of the early 1930s. For some, the comparisons are explicit. Economists like Paul Krugman and Barry Eichengreen have drawn parallels between the two slumps. Olivier Blanchard, chief economist of the International Monetary Fund (IMF), warned several times over the last few years that the world risked falling into a new “Great Depression”. Economic historians themselves have had an unprecedented role in policy making during the recent crisis. Ben Bernanke at the Federal Reserve and Obama-administration advisors like Christina Romer all have academic backgrounds in the discipline.

Can economic historians give policy-makers advice on the basis of what they believed caused the Great Depression? A discussion of this topic by Britain’s top economic historians in a lecture at Cambridge University on November 4th suggested the question is more complex than it first appears. Although there are similarities between this crisis and that of the 1930s, much else—including technology, geopolitics, and the role of the state—has changed dramatically in the intervening period. Financial markets and credit systems now work in different ways than back then. Exotic derivatives like CDOs and CDSs only became widely used in the 1990s. Global economic institutions like the IMF and the World Bank did not exist, and Europe was dominated by the Treaty of Versailles rather than the European Union.

But what has made producing lessons more difficult is that many traditional views about the causes of the Depression have been overturned by academics in recent decades.

Take, for example, the view that the rise of protectionism, such as the Smoot-Hawley Tariffs of 1930, “caused” the Depression. According to research by Paul Bairoch, tariff rates in fact fell in the period immediately before the calamity. He found that average annual customs rates of countries in continental Europe remained broadly flat between 1913 and 1927—only rising from 24.6% to 24.9% in those fourteen years. European tariff rates continued to hold flat until 1930, well after the Depression had begun. Outside Europe, average tariff rates actually fell in the 1927-29 period as the result of the success of the International Economic Conference in 1927, at which countries around the world agreed to reduce barriers to trade.

Although the rise of protectionism increased the velocity and depth of the depression when tariffs started rising in 1930, they were still only responsible for part of the fall in world GDP during the Depression. Since American exports only accounted for 7% of GDP in 1929, falling trade volumes can only explain part of the 29.5% reduction in real GDP it experienced between 1929 and 1933.

The idea that the Wall Street crash caused the depression has also gone out of favour in recent years. This perception was popularised by the Harvard economist J. K. Galbraith, who in the 1950s emphasised the importance of the stock-market crash in sparking off the Great Depression.

However, historians in other parts of the world have pointed out that the global economy was already on a downward path before stock prices in New York started falling. American house prices peaked by the mid-1920s and the construction industry had gone into a tailspin by 1929. Industrial production in Germany and Britain, Europe’s largest economies, was already falling by mid-1928. The redirection of capital towards the overheating stock market in America exacerbated credit shortages elsewhere in the world before the crash. Businesses in Europe and Latin America were already facing a credit crunch by the start of 1929. As with the rise of protectionism, it seems that the Wall Street crash was a symptom of problems in the global economy, rather than the underlying cause of them.

Economic historians now focus on a different candidate to take the blame for the sudden economic collapse of the 1930s: the structure of the world financial system before 1929. In particular, the work of the economic historians such as Mr Eichengreen and Peter Temin has recently stressed the importance of the malfunctioning of the gold standard currency system as the cause of the Depression, as well as its severity.

From the mid-19th century most countries pegged their currencies to a fixed value of gold, an arrangement that became known as the “gold standard”. This system worked whilst countries helped each other with loans to solve periodic balance-of-payments crises (and while gold discoveries made for gentle price-level trends) but World War One disrupted this system. The result was that many countries found themselves with currencies fixed at an inappropriate rate of exchange to those of other countries. While France and America initially gained in the 1920s from holding their currencies at too low a value, countries like Britain and Germany suffered from recurrent balance-of-payments problems as the result their overvalued currencies.

This system came to a head when the global economy started what, at first, seemed to be a very ordinary business cycle downturn in the late-1920s. When the drop in global demand caused balance-of-payments crises in countries around the world due to gold outflows, they were forced to use fiscal and monetary means to deflate their economies to protect the fixed value of their currencies (they also resorted to tariffs).

This amplified the recession into a depression. According to some monetarist historians, the four waves of banking crises in the 1930-33 period that bankrupted half of America’s banks were caused by the Federal Reserve tightening monetary policy in response to gold outflows. Similar effects were seen in Europe too. Austerity in Germany and Austria lead to a wave of bank failures in 1931, plunging the central European economy into its most severe period of contraction. According to research by Mr Eichengreen, countries that escaped the gold standard and changed to floating exchange rates first, such as Britain in 1931 and America in 1933, tended to recover earlier and far faster. The critique of monetary policy as a conduit of Depression dates back to Milton Friedman and Anna Schwartz's "Monetary History of the United States", first published in 1963.

Policy-makers have drawn some lessons from the 1930s. Unlike in the Depression, central banks in Britain and America avoided unnecessary monetary tightening. Instead, they slashed interest rates and used unconventional monetary stimulus such as quantitative easing in an effort to fend off deflation (a scourge of the Depression). The role of banking crises in turning a normal recession into a deep depression has also been recognised. Governments pulled out the stops to prevent the Lehman failure from generating a global financial meltdown, keenly aware of the role of financial contagion in the 1930s.

However, lessons from the Great Depression for Europe's current problems may be more difficult to discern than one might assume. The euro zone is a fixed-exchange-rate system, with elements similar to those of the gold standard. But the political and economic constraints holding back policy-makers are different from those that prevailed in the 1930s. Economists now say that the higher level of financial integration in Europe today makes leaving the euro-zone a much riskier prospect than was leaving the gold standard was back in the 1930s. And the euro zone has a central bank that can print euros—something the gold-standard system lacked.

Perhaps economic historians can make a better contribution by ensuring the past is not abused in debates about modern-day crises. For instance, putting all the blame on Wall Street for the Great Depression—or on bankers in the current crisis—does not stand up to historical scrutiny. The responsibility may more properly lie in a complex combination of factors, like how global financial systems are structured. But this still needs be interpreted from modern day evidence rather than in over-simplistic “lessons” from the past. As the Irish economic historian Cormac Ó Gráda once wrote, “shattering dangerous myths about the past is the historian’s social responsibility”. Such sentiments should apply to the Great Depression as much as they do any other episode in history.

Suggested reading:

Bairoch, P., (1993). Economics & World History: Myths and Paradoxes. Chicago: University of Chicago Press.

Bernanke, B. S., (2000). Essays on the Great Depression. Princeton: Princeton University Press.

Crafts, N.,and Fearon, P. (eds.), (2013). The Great Depression of the 1930s: Lessons for Today. Oxford: Oxford University Press.

Eichengreen, B., (1992). Golden Fetters: The Gold Standard and the Great Depression, 1919-1939. Oxford: Oxford University Press.

Eichengreen, B., and Temin, P., (1997). “The Gold Standard and the Great Depression”. NBER Working Paper 6060.

Friedman, M., and Schwartz, A. J., (1963). A Monetary History of the United States 1867-1960. Princeton: Princeton University Press.

Galbraith, J. K., (1954). The Great Crash, 1929. New York: Time Incorporated.

Kindleberger, C. P., (1973). The World in Depression, 1929-39. Berkeley: University of California Press.