AMERICAN FUTURE

Almost a year ago — on July 11, 2011 — I put up a post titled “Is Another 1931 in the Offing?“  The probability of the answer to this question being “yes” is unfortunately higher — much higher — now than it was then. Martin Wolf’s column in today’s Financial Times is a sign of the times. The first part of his column –  “Panic has become all too rational” — deals with the present; the second with the past.

Part 1 — Today’s crisis

Suppose that in June 2007 you had been told that the UK 10-year bond would be yielding 1.54 per cent, the US Treasury 10-year 1.47 per cent and the German 10-year 1.17 per cent on June 1 2012. Suppose, too, you had been told that official short rates varied from zero in the US and Japan to 1 per cent in the eurozone. What would you think? You would think the world economy was in a depression. You would have been wrong if you had meant something like the 1930s. But you would have been right about the forces at work: the west is in a contained depression; worse, forces for another downswing are building, above all in the eurozone. Meanwhile, policy makers are making huge errors.

The most powerful indicator – and proximate cause – of economic weakness is the shift in the private sector financial balance (the difference between income and spending by households and businesses) towards surplus. Retrenchment by indebted and frightened people has caused the weakness of western economies. Even countries that are not directly affected, such as Germany, are indirectly affected by the massive retrenchment in their partners.

According to the International Monetary Fund, between 2007 and 2012 the financial balance of the US private sector will shift towards surplus by 7.1 per cent of gross domestic product. The shift will be 6.0 per cent in the UK, 5.2 per cent in Japan and just 2.9 per cent in the eurozone. But the latter contains countries with persistent private surpluses, notably Germany, ones with private sectors in rough balance (such as France and Italy) and ones that had huge swings towards surplus: in Spain, the forecast shift is 15.8 per cent of GDP. Meanwhile, emerging countries will also have a surplus of $450bn this year, according to the IMF.

One would expect feeble demand in such a world. The willingness to implement expansionary monetary policies and tolerate huge fiscal deficits has contained depression and even induced weak recoveries. Yet the fact that unprecedented monetary policies and huge fiscal deficits have not induced strong recoveries shows how powerful the forces depressing economies have been. This is the legacy of a huge financial crisis preceded by large asset price bubbles and huge expansions in debt.

Finance plays a central role in crises, generating euphoria, over-spending and excessive leverage on the way up and panic, retrenchment and deleveraging on the way down. Doubts about the stability of finance depend on the perceived solvency of debtors. Such doubts reached a peak in late 2008, when loans secured against housing were the focus of concern. What is happening inside the eurozone is now the big worry, with the twist that sovereigns, the actors upon whom investors depend for rescue during systemic crises, are among the troubled debtors. Such doubts are generating a flight to safety towards Germany and, outside the eurozone, towards countries that retain monetary sovereignty, such as the US and even the UK.

Part 2. Yesterday’s crisis

It is often forgotten that the failure of Austria’s Kreditanstalt in 1931 led to a wave of bank failures across the continent. That turned out to be the beginning of the end of the gold standard and caused a second downward leg of the Great Depression itself. The fear must now be that a wave of banking and sovereign failures might cause a similar meltdown inside the eurozone, the closest thing the world now has to the old gold standard. The failure of the eurozone would, in turn, generate further massive disruption in the European and even global financial systems, possibly even knocking over the walls now containing the depression.

How realistic is this fear? Quite realistic. One reason for this is that so many fear it. In a panic, fear has its own power. To assuage it one needs a lender of last resort willing and able to act on an unlimited scale. It is unclear whether the eurozone has such a lender. The agreed funds that might support countries in difficulty are limited in a number of ways. The European Central Bank, though able to act on an unlimited scale in theory, might be unable to do so in practice, if the runs it had to deal with were large enough. What, people must wonder, is the limit on the credit that the Bundesbank would be willing (or allowed) to offer other central banks in a massive run? In a severe crisis, could even the ECB, let alone the governments, act effectively?

Furthermore, people know that both banks and sovereigns are under severe stress in important countries that seem to lack any prospect of an early return to growth and so suffer the costs of high and rising unemployment. No better indication of this can be imagined than Spain’s final cry for help with its banks. Political systems are under stress: in Greece, a fragile democracy has imploded. Meanwhile, the German government seems to have reiterated opposition to more support.

How much pain can the countries under stress endure? Nobody knows. What would happen if a country left the eurozone? Nobody knows. Might even Germany consider exit? Nobody knows. What is the long-run strategy for exit from the crises? Nobody knows. Given such uncertainty, panic is, alas, rational. A fiat currency backed by heterogeneous sovereigns is irremediably fragile.

Before now, I had never really understood how the 1930s could happen. Now I do. All one needs are fragile economies, a rigid monetary regime, intense debate over what must be done, widespread belief that suffering is good, myopic politicians, an inability to co-operate and failure to stay ahead of events. Perhaps the panic will vanish. But investors who are buying bonds at current rates are indicating a deep aversion to the downside risks. Policy makers must eliminate this panic, not stoke it.

In the eurozone, they are failing to do so. If those with good credit refuse to support those under pressure, when the latter cannot save themselves, the system will surely perish. Nobody knows what damage this would do to the world economy. But who wants to find out?

As a long-time student of the Great Depression, I’ve often asked myself the same question that Wolf raises in his penultimate paragraph. Like him, I know now the answer.

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Being human, I take some pride in being occasionally prescient — even if, as in this instance, I wish I had not been. That’s my excuse for subjecting you to the entirety of my July 11, 2011 post:

As financial contagion spreads across Europe to include Italy, it brings to my mind 1931, when the mother of all such contagions took place. It began in Austria with the failure of the Kreditanstalt Bank. In only four months, the contagion spread to Germany, followed by England and, finally, the United States.

History need not repeat itself. However, as I argued in an earlier post, I’m concerned that the forthcoming budget deal will derail the anemic American economic recovery. Should this occur, it could have unforeseen — or, at least, unmentioned consequences — not the least of which could be an erosion of the values of the assets held by our major financial institutions. With the growing uncertainty regarding the creditworthiness of the sovereign debt of several European countries — and, hence, of the financial intermediaries holding that debt — the possibility of a financial perfect storm can’t be ruled out. Adding to that risk, in my view, is the position of the Bank for International Settlements (BIS), which in its recently-issued annual report, concluded that

Many of the challenges facing us today are a direct consequence of a third consecutive year of extremely accommodative financial conditions. Near zero interest rates in the core advanced economies increasingly risk a reprise of the distortions they were originally designed to combat. Surging growth made emerging market economies the initial focus of concern as inflation began rising nearly two years ago. But now, with the arrival of sharper price increases for food, energy and other commodities, inflation has become a global concern. The logical conclusion is that, at the global level, current monetary policy settings are inconsistent with price stability.

Even more worrisome to me is the position of the European Central Bank (ECB). While the BIS is an advisory institution, the ECB controls the monetary policy of the euro-zone, which includes all major European countries (and many minor ones, including Greece) with the exception of the United Kingdom. On July 7, the ECB raised interest rates for the second time this year.

While the U.S. Federal Reserve has a dual mandate — to keep the lids on both inflation and unemployment, the ECB’s sole objective is to contain inflation. Like the ECB, the BIS’ concern is solely with inflation; judged by the contents of its annual report, unemployment is beyond its ken. Unfortunately, in my view, the BIS’ and the ECB’s policy prescriptions — that interest rates should rise — mirror those of the many central bankers in the early 1930s who, in the midst of falling output and deflation, believed that monetary stringency was the cure for the ailing world economy. If the current slowdown in the world economy should worsen, as may happen in the aftermath of ECB’s rate hikes and the U.S. budget cuts, will these powerful institutions reverse course, or will they stay the course? I have no way of knowing. All  I can say is that, if they don’t implement policy changes under such a circumstance, the possibility of something resembling the financial crisis of 1931 unfolding within the next year or two will increase.

At the beginning of each year in the 1920s and 1930s, the New York Times published a chronological record of the financial events of the past year.  Below the fold are excerpts pertaining to the five months — from May to September of 1931 — of financial contagion that broadened, deepened and lengthened the Great Depression. For those who aren’t familiar with what transpired during those historic months, which witnessed the collapse of an international monetary system based on the gold standard, the investment of a few minutes of your time may be worthwhile.

MAY

Heavy Decline in Stocks; Bank Rates At Very Low Level

The principal event abroad, whose importance was not realized in America at the time, was the virtual failure of the great Kreditanstalt Bank in Austria, a Rothschild enterprise. Although the institution was saved by the Austrian Government, its collapse, under what proved to be discreditable circumstances, turned out later to have had an immense effect in producing the chain of circumstances which subsequently demoralized German and English finance.

JUNE

Run on Foreign Creditors on Reichsbank; Home Trade Unfavorable

The outstanding event of June was the sudden beginning of a run of foreign creditors on Germany’s gold reserve. In a very short time the recall of foreign balances and short loans from Berlin became panicky and reached almost unprecedented volume . . . The existence of a grave crisis was openly recognized by the German Government; it resulted in a precipitous fall of Germans foreign securities and in the efforts at foreign assistance to the country’s finances. The crisis was met in the middle of the month by President Hoover’s proposal of a one-year moratorium on both intergovernmental debts and German reparations [both stemming from World War I].

JULY

Critical German Situation; Run on Bank of England’s Gold

Very great uneasiness over the German situation continued during July, and in the latter part of the month financial attention was suddenly and unexpectedly converged on a run of foreign depositors on the London market and the Bank of England, similar to the “raid” on Germany and resulting in the swift development of crisis, with two advances of the Bank of England rate . . . Conferences of governments and bankers regarding the German situation were held during July at London and Paris . . .

Advances were made to the Reichsbank by foreign central banks, and emergency measures taken by the German Government regarding the situation, limiting the withdrawal of deposits and requiring that gold proceeds of foreign sales should be turned into the treasury. Early in the month the German bank and government authorities visited all important European centres in search of relief expedients . . .

In the middle of the month the strain shifted to England, in a run on the Bank of England’s gold by foreign depositors and lenders who were calling home their capital. Along with this, panic spread through European high finance . . .

Great demoralization occurred in foreign bonds on the New York market, as a result of the European troubles. At the same time domestic bonds, especially the second grade, fell to extremely low levels under forced selling of their holdings by banks which believed themselves to be in danger . . .

AUGUST

London Crisis Acute, Labor Ministry Resigns; Markets Here Uncertain

Although the German crisis was partly mitigated in August by the emergency measures taken by the government, by the assistance of other central banks, and by foreign bankers’ pledges to leave their German credits “frozen” at Berlin for six months, the strain on London increased. At the beginning of the month the Bank of England obtained a $250,000,000 foreign credit from the central banks of France and America for the support of sterling; this was virtually exhausted in three weeks . . . Pressure on the Bank of England relaxed at the end of the month, when the British government obtained a second emergency credit of $400,000,000 from French and American banks.

SEPTEMBER

England Suspends Gold Payments; Run on Our Reserves

In September the crisis in Europe’s credit situation reached a climax, and with it came outright panic in European high finance and a sudden and large-scale raid by European institutions on the American gold reserve. Simultaneously, the talk in American banking circles of impending bankruptcies of the economic world and of “breakdown of the capitalistic system” pervaded even experienced Wall Street circles.

The event which brought this mental unsettlement to a head was the suspension of gold payments by Great Britain, announced on the morning Of Sept. 21. It was followed first by similar suspension of gold payments by Norway, Sweden, Denmark, Finland and Egypt. It immediately occasioned renewed outpour of the American market of investment bonds both from home and foreign holders, along with large-scale hoarding of money on the European Continent and greatly accentuated American hoarding of cash.

“Those who don’t know history are destined to repeat it.”

– Edmund Burke (1729-1797)

“Those who cannot remember the past are condemned to repeat it.”

–George Santayana (1863-1952)

In addition to illustrating the financial version of the Golden Rule — that those with the gold make the rules — the German government’s insistence that austerity is the only way that the health of the Eurozone’s economically-troubled members can be restored shows that knowledge of the past doesn’t prevent it from being repeated.

When World War I ended, the victorious Allies imposed a Carthaginian peace on Germany. The Versailles Treaty milked Germany dry. Unable to make its reparation payments, the government of the Weimar Republic resorted to the printing press. The hyperinflation of 1923 destroyed the savings of the middle class. Loans from American banks — a stop-gap measure analogous to credits now being issued through the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) — restored economic and political stability for five years. In 1928, the Germany economy started to contract. Soon after the 1929 Wall Street crash, risk-averse American bankers stopped bankrolling Germany. The German economy crumbled, accelerating the worldwide economic crisis. And setting the stage for Hitler.

The lesson from this admittedly sketchy depiction of a tragic episode in world history is that victors (militarily or economically) that impose harsh austerity on losers ultimately pay a heavy price. Unfortunately, this isn’t the lesson that the Merkel Government and the majority of the German people have taken to heart. Instead, fear of inflation has been embedded in the German DNA. They know their history, but they’ve drawn the wrong lesson from it.

The export-heavy German economy is outperforming other mature economies, but for how long? If the German belief in and enforcement of austerity persists, the economies of its Eurozone trading partners — led by Greece — will fall deeper and deeper into an economic quagmire. As this happens — and whether or not the currency union survives — exports will plunge, resulting in a German economic contraction. Carthaginian austerity will undermine its author.

“Those who do not remember the past are condemned to repeat it.”

– George Santayana

Few quotes are more frequently mentioned than this one. Keep it in mind while taking a few minutes to read (and ponder) this article from the Economist’s December 10th issue.

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In 2008 the world dodged a second Depression by avoiding the mistakes that led to the first. But there are further lessons to be learned for both Europe and America

“YOU’RE right, we did it,” Ben Bernanke told Milton Friedman in a speech celebrating the Nobel laureate’s 90th birthday in 2002. He was referring to Mr Friedman’s conclusion that central bankers were responsible for much of the suffering in the Depression. “But thanks to you,” the future chairman of the Federal Reserve continued, “we won’t do it again.” Nine years later Mr Bernanke’s peers are congratulating themselves for delivering on that promise. “We prevented a Great Depression,” the Bank of England’s governor, Mervyn King, told the Daily Telegraph in March this year.

The shock that hit the world economy in 2008 was on a par with that which launched the Depression. In the 12 months following the economic peak in 2008, industrial production fell by as much as it did in the first year of the Depression. Equity prices and global trade fell more. Yet this time no depression followed. Although world industrial output dropped by 13% from peak to trough in what was definitely a deep recession, it fell by nearly 40% in the 1930s. American and European unemployment rates rose to barely more than 10% in the recent crisis; they are estimated to have topped 25% in the 1930s. This remarkable difference in outcomes owes a lot to lessons learned from the Depression.

Debate continues as to what made the Depression so long and deep. Some economists emphasise structural factors such as labour costs. Amity Shlaes, an economic historian, argues that “government intervention helped make the Depression Great.” She notes that President Franklin Roosevelt criminalised farmers who sold chickens too cheaply and “generated more paper than the entire legislative output of the federal government since 1789”. Her book, “The Forgotten Man”, is hugely influential among America’s Republicans. Newt Gingrich loves it.

A more common view among economists, however, is that the simultaneous tightening of fiscal and monetary policy turned a tough situation into an awful one. Governments made no such mistake this time round. Where leaders slashed budgets and central banks raised rates in the 1930s, policy was almost uniformly expansionary after the crash of 2008. Where international co-operation fell apart during the Depression, leading to currency wars and protectionism, leaders hung together in 2008 and 2009. Sir Mervyn has a point.

Look closer, however, and the picture is less comforting. For in two important—and related—areas, the rich world could still make mistakes that were also made in the 1930s. It risks repeating the fiscal tightening that produced America’s “recession within a depression” of 1937-38. And the crisis in Europe looks eerily similar to the financial turmoil of the late 1920s and early 1930s, in which economies fell like dominoes under pressure from austerity, tight money and the lack of a lender of last resort. There are, in short, further lessons to be learned.

Riding for a fall

It was far easier to stimulate the economy in the 2000s than in the 1930s. Social safety nets—introduced in the aftermath of the Depression—mean that today’s unemployed have money to spend, providing a cushion against recession without any active intervention. States are more relaxed about running deficits, and control much larger shares of national economies. The package of public works, spending and tax cuts that President Herbert Hoover introduced after the crash of 1929 amounted to less than 0.5% of GDP. President Barack Obama’s stimulus plan, by contrast, was equivalent to 2-3% of GDP in both 2009 and 2010. Hoover’s entire budget covered only about 2.5% of GDP; Mr Obama’s takes 25% of GDP and runs a deficit of 10%.

Roosevelt raised spending to 10.7% of output in 1934, by which point the American economy was growing strongly. By 1936 inflation-adjusted GDP was back to 1929 levels. Just how much the New Deal spending helped the recovery is still debated. Some economists, such as John Cochrane of the University of Chicago and Robert Barro of Harvard, say not at all. Fiscal measures never work, they say.

Those who think that fiscal measures do work nonetheless tend to believe that, in the 1930s, spending was less important than monetary policy, which they see as the prime cause of suffering. In a paper in 1989 Mr Bernanke and Martin Parkinson, now the top civil servant in Australia’s finance ministry, wrote that rather than providing recovery itself “the New Deal is better characterised as having ‘cleared the way’ for a natural recovery.” Others, such as Paul Krugman, would ascribe a more positive role to stimulus spending.

Whatever relative importance is assigned to monetary and fiscal policy, though, there is little doubt that their simultaneous tightening five years into the Depression led to a vicious relapse. Spurred by his treasury secretary, Henry Morgenthau—who worried in 1935 that “we cannot help but be riding for a fall unless we continue to decrease our deficit each year and the budget is balanced”—Roosevelt urged fiscal restraint on Congress in 1937.

By that point the national debt had reached an unheard of 40% of GDP (huge by the standards of the day, but half what Germany’s debt is now). Congress cut spending, increased taxes and wiped out a deficit of 5.5% of GDP between 1936 and 1938. That was a larger consolidation than Greece now faces over two years (see chart 1), but is much smaller than what is planned for it in the longer term. At the same time the Federal Reserve doubled reserve requirements between mid-1936 and mid-1937, encouraging banks to pull money out of the economy. The Treasury began to restrict the money supply in step with the level of gold imports. In 1937 and 1938, the recession within a depression brought a drop in real GDP of 11% and an additional four percentage points of unemployment, which peaked at 13% or 19%, depending on how you count it.

The Snowdens of yesteryear

Today’s monetary policy hasn’t turned contractionary, as America’s did in the 1930s. As The Economist went to press, the European Central Bank (ECB) was expected to announce a further reduction in interest rates. But in many places fiscal policy is moving rapidly in that direction. Mr Obama’s stimulus is winding down; state- and local-government cuts continue. Republican candidates for the presidency echo the arguments of Mr Morgenthau, claiming that deficit-financed stimulus spending has done little but add to the obligations of future taxpayers. Mr Obama, like Roosevelt, has started to stress the need for budget-cutting. If the current payroll-tax cut and emergency unemployment benefits were to lapse, growth over the next year would be reduced by around one percentage point of GDP.

America is not alone. Under David Cameron, Britain’s hugely indebted government introduced a harsh programme of fiscal consolidation in 2010 to avert a loss of confidence in its creditworthiness. The rationale was similar to that for chancellor Philip Snowden’s emergency austerity budget of 1931, with its tax rises and spending cuts. On that occasion confidence was not restored, and Britain was forced to devalue the pound and abandon the gold standard. On this occasion the measures have indeed boosted investor confidence, and thus bond yields; that the country still faces a second recession is in large part due to the euro zone’s woes. That said, the possibility of such shocks should always be a counsel for caution when a government embarks on fiscal tightening.

Some say tightening need not hurt. In 2009 Alberto Alesina and Silvia Ardagna of Harvard published a paper claiming that austerity could be expansionary, particularly if focused on spending cuts, not tax increases. Budget cuts that reduce interest rates stimulate private borrowing and investment, and by changing expectations about future tax burdens governments can also boost growth. Others doubt it. An International Monetary Fund (IMF) study in July this year found that Mr Alesina and Ms Ardagna misidentified episodes of austerity and thus overstated the benefits of budget cuts, which typically bring contraction not expansion.

Roberto Perotti of Bocconi University has studied examples of expansion at times of austerity and showed that it is almost always attributable to rising exports associated with currency depreciation. In the 1930s the contractionary impact of America’s fiscal cuts was mitigated to some extent by an improvement in net exports; America’s trade balance swung from a deficit of 0.2% of GDP to a surplus of 1.1% of GDP between 1936 and 1938. Now, most of the world is cutting budgets and not every economy can reduce the pain by boosting exports.

The importance of monetary policy in the 1930s might suggest that central banks could offset the effects of fiscal cuts. In 2010 the IMF wrote that Britain’s expansionary monetary policy should mitigate the contractionary impact of big budget cuts and “establish the basis for sustainable recovery”. Yet Britain is now close to recession and unemployment is rising, suggesting limits to what a central bank can do.

The move to austerity is most dramatic within the euro zone—which can least afford it. Operating without floating currencies or a lender of last resort, its present predicament carries painful echoes of the gold-standard world of the early 1930s.

In the mid-1920s, after an initially untenable schedule of war reparations payments was revised, French and American creditors struck by the possibility of rapid growth in the battered German economy began to pile in. The massive flow of capital helped fund Germany’s sovereign obligations and led to soaring wages. Germany underwent a credit-driven boom like those seen on the European periphery in the mid-2000s.

In 1928 and 1929 the party ended and the flow of capital reversed. First, investors sent their money to America to bet on its soaring market. Then they yanked it out of Germany in response to financial panic. To defend its gold reserves, Germany’s Reichsbank was forced to raise interest rates. Suddenly deprived of foreign money, and unable to rely on exports for growth as the earlier boom generated an unsustainable rise in wages, Germany turned to austerity to meet its obligations, as Ireland, Portugal, Greece and Spain have done. A country with a floating currency could expect a silver lining to capital outflows: the exchange rate would fall, boosting exports. But Germany’s exchange rate was fixed by the gold standard. Competitiveness could only be restored through a slow decline in wages, which occurred even as unemployment rose.

As the screws tightened, banks came under pressure. The Austrian economy faced troubles like those in Germany, and in 1931 the failure of Austria’s largest bank, Credit Anstalt, triggered a loss of confidence in the banks that quickly spread. As pressure built in Germany, the leaders of the largest economies repeatedly met to discuss the possibility of assistance for the flailing economy. But the French, in particular, would brook no reduction in Germany’s debt and reparations payments.

Recognising that the absence of a lender of last resort was fuelling panic, the governor of the Bank of England, Montagu Norman, proposed the creation of an international lender. He recommended a fund be set up and capitalised with $250m, to be leveraged up by an additional $750m and empowered to lend to governments and banks in need of capital. The plan, probably too modest, went nowhere because France and America, owners of the gold needed for the leveraging, didn’t like it.

So the dominoes fell. Just two months after the Credit Anstalt bankruptcy a big German bank, Danatbank, failed. The government was forced to introduce capital controls and suspend gold payments, in effect unpegging its currency. Germany’s economy collapsed, and the horrors of the 1930s began.

It is all dreadfully familiar (though no European country is about to elect another Hitler). Membership in the euro zone, like adherence to the gold standard, means that uncompetitive countries can’t devalue their currencies to reduce trade deficits. Austerity brings with it a vicious circle of decline, squeezing domestic demand and raising unemployment, thereby hurting revenues, sustaining big deficits and draining away confidence in banks and sovereign debt. As residents of the periphery move their money to safer banks in the core, the money supply declines, just as it did in the 1930s (see chart 2). High-level meetings with creditor nations bring no surcease. There is no lender of last resort. Though the European Financial Stability Facility (EFSF) has got further off the ground than Norman’s scheme, which it chillingly resembles, euro-zone leaders have yet to find a way to leverage its €440 billion up to €2 trillion.

Even if they succeed, that may be too little to end the panic. Investors driven by turmoil in Italian markets are pre-emptively reducing their exposure to banks and sovereign bonds elsewhere in the euro zone. Even countries with relatively robust economies such as France and the Netherlands have not been spared. No matter how secure an economy’s fiscal position, a short-term liquidity crunch driven by panic can drive it into insolvency.

History need not repeat itself. Norman’s Bank of England was created in the 17th century to lend to the government when necessary; central banks have always been obliged to lend to governments when others will not. The ECB could take on this role. It is prohibited by its charter from buying debt directly from governments, but it can purchase debt securities on the secondary market. It has been doing so piecemeal and could declare its intention to do so systematically. Its power to create an unlimited amount of money would allow it credibly to announce its willingness to buy any bonds markets want to sell, thus removing the main cause of panic and contagion.

This week France and Germany proposed the adoption of legally binding budgetary “golden rules” by euro-zone members, ahead of a summit of European leaders in Brussels on December 8th-9th. Mario Draghi, the ECB’s new president, has hinted that were a fiscal pact to be agreed, the ECB might buy bonds on a larger scale. What scale he has in mind, though, is unclear. Jens Weidmann, president of Germany’s Bundesbank and an influential member of the ECB’s governing council, has clearly stated that the ECB “must not be” the euro zone’s lender of last resort.

Where this path leads

On the present course, conditions in developed economies look like getting worse before they get better. Growth in America and Britain will probably be less than 2% in 2012 on current policy, and in both recession is quite possible. A euro-zone recession is likely. The ECB could improve the euro zone’s economic outlook by loosening its monetary policy, but widespread austerity and uncertainty will be difficult to overcome. As in 1931 and 2008, a grave financial crisis may cause a large drop in output. That, in turn, would place more pressure on euro-zone economies struggling to avoid default.

As panic built in 1931, country after country faced capital flight. The effort to defend against bank and currency runs prompted rounds of austerity and plummeting money supplies in pressured economies, helping generate the collapse in output and employment that turned a nasty downturn into a Depression. It took the end of the gold standard, which freed central banks to expand the money supply and reflate their economies, to spark recovery. Today the ECB has the tools needed to salvage the situation without breaking up the euro. But the fact that the ECB and euro-zone governments have options does not mean that they will take them.

The collapse of the gold standard led to recovery, but caused terrible economic damage as countries erected trade barriers to stem the flood of imports from those that had devalued their currencies. Governments elected to fight unemployment experimented with wage and price controls, cartelisation of industry and other interventions that often impeded the recovery enabled by expansionary monetary and fiscal policies. In the worst-hit countries long-suffering citizens turned to fascism in the false hope of relief.

The world today is better placed to cope with disaster than it was in the 1930s. Then, most large economies were on the gold standard. Today, the euro zone represents less than 15% of world output. In developed countries unemployment, scourge though it is, does not lead to utter destitution as it did in the 1930s. Then, the world lacked a global leader; today, America is probably still up to the job of co-ordinating disaster response in troubled times. International institutions are much stronger, and democracy is more firmly entrenched.

Even so, prolonged economic weakness is contributing to a broad rethinking of the value of liberal capitalism. Countries scrapping for scarce demand are now intervening in currency markets—the Swiss are fed up with their franc appreciating against the euro. America’s Senate has sought to punish China for currency manipulation with tariffs. Within Europe the turmoil of the euro crisis is encouraging ugly nationalists, some of them racist. Their extremism is mild when compared with the continent-wrecking horrors of Nazism, but that hardly makes it welcome.

The situation is not yet beyond repair. But the task of repairing it grows harder the longer it is delayed. The lessons of the 1930s spared the world a lot of economic pain after the shock of the 2008 financial crisis. It is not too late to recall other critical lessons of the Depression. Ignore them, and history may well repeat itself.

Marc Schulman, “A Golden Future?,” (August 2011)

The eurozone standard is the modern day equivalent of the gold standard. Countries that are in economic trouble are forced to implement austerity measures that have ramifications outside their borders. In the 1930s, a crisis in little Austria spread like wildfire to Germany, Great Britain and, finally, to the United States. In our time, a crisis that began in little Greece has spread like wildfire to Portugal, Spain, Italy, and, perhaps France.

Deutsche Bank, “Is the Euro today the Gold Standard of the 1930s for European Economies?,” (December 2011):

The 1930s in Europe was a slow moving game of falling dominoes with countries one by one leaving the narrow confines of the Gold Standard after chronic growth problems that a fixed currency system intensified. There was a definite trend in the 1930s that saw those countries that left the Gold Standard seeing a much quicker recovery from the Depression than those that stayed on for a number of years into the latter half of the decade. Figure 12 shows a case study of six countries currencies relative to Gold in the 1930s. We’ve rebased them to 100 at the start of the series. In order of leaving the Gold Standard, we had the UK (left September 1931), Sweden (also left September 1931), US (April 1933), Belgium (March 1935), France (September 1936) and Italy (October 1936).

Interestingly, by the middle of 1937 all had devalued by at least 40% to Gold except Belgium who had devalued by around 30% in 1935. France, which held on until September 1936, then saw its currency collapse by nearly 70% in the three years up to WWII. Figure 13 then shows the same six countries nominal (left) and real (right) GDP performance over the same period.

The UK and Sweden, which left the Gold Standard earliest (September 1931) in this sample, saw a ‘relatively’ mild negative growth shock compared to the other four. In contrast, France which stuck to Gold until late 1936 saw growth notably under-perform until they left the standard. Interestingly as discussed above, France later saw a dramatic 3 year 70% devaluation to Gold which helped restore nominal GDP close to that of the UK and Sweden by the end of the 1930s. However, in real terms they were still the laggard at this point. The worst slump of all was that seen in the US between 1929 and 1932 where they lost nearly half the value of their economy in nominal terms and nearly 30% in real terms. However, the bottom pretty much corresponded to the end of the Dollar’s gold convertibility and subsequent devaluation. From this point on, the recovery was fairly dramatic until the 1937 recession we’ll discuss below. Overall, Figure 13 does indicate some fairly strong evidence that growth did seem to respond to currency debasement and that countries which left this later ended up with weaker economies for longer and also, in France’s case, a more dramatic end devaluation.

“. . . in two important—and related—areas, the rich world could still make mistakes that were also made in the 1930s. It risks repeating the fiscal tightening that produced America’s “recession within a depression” of 1937-38. And the crisis in Europe looks eerily similar to the financial turmoil of the late 1920s and early 1930s, in which economies fell like dominoes under pressure from austerity, tight money and the lack of a lender of last resort.”

– The Economist

This quote is from the December 10th issue, which is now available online.

During the summer, I published three posts that made the same points the Economist is now making:

• On financial turmoil: Is Another 1931 in the Offing? (July 11)
• On premature financial tightening: Is Another 1937 in the Offing (July 12)
• On their simultaneous occurrence: 1931 and 1937, At the Same Time (August 4)

Please excuse me for patting myself on the back. I promise it won’t happen very often.

“Those who cannot remember the past are condemned to repeat it”

– George Santayana (1905)

On several occasions since starting this blog in June, I’ve complained that policymakers are repeating the mistakes of the 1930s. In particular, I’ve argued that the nearly simultaneous implementation of fiscal austerity programs by the world’s major economic powers in their efforts to improve their debt-to-GDP ratios is woefully misguided and self-defeating, and that “the eurozone standard is the modern day equivalent of the gold standard.“

Obviously, I’m not alone in having this view.  Among the many others who share this opinion is Paul De Grauwe, a well-known economist associated with the Centre for European Policy Studies (CEPS), a major European think tank.

In January 2010, CEPS published a De Grauwe brief commentary titled “Lessons for Europe from the 1930s.” With my emphases, here’s a large part of it:

The Great Depression taught us a number of lessons. The first is that central banks must be readyto provide ample liquidity to save the banking system. Present-day central banks did just that. They did not repeat the mistakes of the 1930s, when their predecessors tightened money in theface of a banking crisis. The second lesson is that governments should not try to balance the budget when economic activity collapses. Similarly, the governments of today did not repeat the mistakes of many governments in the 1930s, which desperately tried to balance their books when the economy crashed. [This was written before "austerity" became the cause célèbre]

Yet there is one area of policy-making where authorities may not have learned the lessons of history, and are in the process of repeating the same mistakes. During much of the 1930s, a number of continental European countries, the so-called ‘gold bloc’ countries (France, Italy, Belgium, the Netherlands and Switzerland) kept their currencies pegged to gold. When in the early 1930s the UK and the US went off gold and devalued their currencies, the gold bloc found their currencies to be massively overvalued. This had the effect of depressing exports and prolonging the economic depression in these countries.

Incredibly, the same mistakes are being made today involving some of the same countries as during the Great Depression. This time it is the continental west European countries tied together in the eurozone that have seen their currency, the euro, become strongly overvalued. The two countries that in the 1930s responded to the crisis by devaluing their currencies, the US and the UK, have today also allowed their currencies to depreciate significantly. Since the start of the financial crisis, pound sterling has depreciated against the euro by about 30%. After having strengthened vis-à-vis the euro prior to the banking crisis of October 2008, the dollar depreciated against the euro by close to 20%. Thus, as in the 1930s, the dividing line is the same. The US and the UK have allowed their currencies to depreciate; the continental European countries tied into the euro area have allowed their currency to become significantly overvalued. Even the numbers are of the same order of magnitude. During the1930s, the overvaluation of the gold bloc currencies amounted to 20-30%. Today, the euro is overvalued by similar percentages against the dollar and the pound.

So why are the euro area countries employing the same policies as the gold bloc countries did nearly eighty years ago? The answer is economic orthodoxy. In the 1930s it was the orthodoxy inspired by the last vestiges of the gold standard. Today the economic orthodoxy that inspires the ECB is very different, but no less constraining. It is the view that the foreign exchange market is better placed than the central bank to decide the appropriate level of the exchange rate. A central bank should be concerned with keeping inflation low and not with meddling in the foreign exchange market. As a result the ECB has not been willing to gear its monetary policy towards some exchange rate objective.

As in the 1930s, the euro area countries will pay a heavy price for this orthodoxy. The price will be a slower and more protracted recovery from the recession. This will also make it more difficult to deal with the internal disequilibria within the eurozone between the deficit and the surplus countries.

In view of events since this was written, the last sentence is particularly prescient.

This paper, published by the New America Foundation and authored by Daniel Alpert, Robert Hockett and Nouriel Roubini, is the best analysis of the economic crisis than I’ve read. Policymakers here and abroad should study it carefully. I hope that readers of this blog will do the same.

An American financial innovation — the securitized subprime mortgage — was a potent poison that proved deadly to the entire world when it was discovered that housing prices would not always rise. A similar circumstance arose in October, 1929, when it was discovered that the toxic asset of that era — American equities — would not always rise. In both cases, the expectation of extraordinary returns led foreign investors to bet heavily on dollar-denominated assets.

A month after the 1929 crash, the Economist pondered what the aftereffects would be, saying that

. . . it is natural that people should be asking themselves how widespread and of what character will be the economic reactions of this slump. The question acquires added importance from the fact that in its later stages the Wall Street movement pervaded the whole world by drawing money, not merely from all corners of America, but from every continent.

This, of course, is exactly what happened with subprime mortgages.

The same Economist article summarized the views of those who were most concerned about the future:

A more serious view is taken by others, who point not only to the heavy “break” in commodity prices which has accompanied the slump, but to the danger that Wall Street losses may have gravely shaken the psychological confidence of America in the prospect of unlimited expansion. These observers think that the orgy of speculation in the United States has been so widespread that persons of all classes deceived by, in some cases, real, but in many more cases, purely paper profits from their investments, having been living beyond their means, or, at all events, mortgaging their future by buying luxury goods up to, or even beyond, the full limits of their incomes.

If “housing” is substituted for “Wall Street,” this paragraph could have been written today, rather than 82 years ago.

Somewhat modified, history repeats itself.

Washington Post

• Robert Samuelson, “Repeating mistakes of the 1930s“

Europe is caught in an economic pincer: slow-growth assaults from one side; fickle financial markets from the other. One obvious way out — the China option — seems barred by geopolitics. There is precedent. Historians blame the Great Depression’s severity in part on poor international cooperation. Economist Charles Kindleberger found a vacuum of power: Great Britain, the old economic leader, could no longer lead alone; and the United States — a replacement — wasn’t ready to help. Is there a parallel today between the United States and China? Are we repeating the mistakes of the 1930s? Unsettling questions.

Bloomberg

• Christine Harper, “Banks splinter on Europe debt crisis“

The Institute of International Finance, an organization of more than 400 financial companies worldwide, holds its annual meetings in parallel with the IMF’s . . . in private discussions, bankers said the environment was exceptional. A senior European banker said he sees policy makers’ decisions as being as momentous as those in the 1930s. A senior U.S. bank executive said he’s more worried than he was at any point during the financial crisis of 2008 and 2009.

Financial Times

• Gavyn Davies, “Europe teeters on the brink of recession“

Significantly, J.P. Morgan has broken ranks with those forecasters who merely warn of “increased downside risks”, and they now show a European recession as their main case forecast for the next 12 months. This also breaks with long-standing economic tradition. Cyclical downturns in Europe normally follow several quarters behind those in the US, but this time it is the other way around.

New York Times

• Nelson D. Schwartz, “Europe stews on Greece, and markets sweat out the wait“

On both sides of the Atlantic, there is a feeling that policy makers have few arrows left in their quiver. A Federal Reserve announcement on Wednesday that it would buy $400 billion in long-term Treasury securities left the stock market unimpressed.

“It gets worse before it gets better,” said Adam Parker, Morgan Stanley’s chief United States equity strategist. “If you’re banking on a policy to bail you out, you will be disappointed.”

TODAY’S RECESSION does not merely resemble the Great Depression; it is, to a real extent, a recurrence of it. It has the same unique causes and the same initial trajectory. Both downturns were triggered by a financial crisis coming on top of, and then deepening, a slowdown in industrial production and employment that had begun earlier and that was caused in part by rapid technological innovation. The 1920s saw the spread of electrification in industry; the 1990s saw the triumph of computerization in manufacturing and services. The recessions in 1926 and 2001 were both followed by “jobless recoveries.”

The above quotation is from an essay in the current issue of The New Republic. Written by John B. Judis, titled “Doom!” and subtitled “Our economic nightmare is just beginning,” it synthesizes the economic and political angst currently being experienced here and in Europe, as well as the disturbing parallels between the Great Depression of the 1930s and what could easily become the Great Depression of the 2010s. It’s an essay I would be proud to have written. I encourage you to read every word, and would appreciate your comments.