Montagu Norman and the Bulwarks of Civilization: Today's Economic History
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The Great Depression and the Great Recession in the North Atlantic

2015 McKenna Lecture :: Claremont McKenna College

Over at Equitable Growth: Back in 1959 Arthur Burns, lifelong senior Republican policymaker, Chair of the Council of Economic Advisers under President Eisenhower, good friend of and White House Counselor to President Nixon, and Chair of the Federal Reserve from 1970 to 1978 gave the presidential address to the American Economic Association. In it, he concluded that the United States and a lot of choices to make as far as its future economic institutions and economic policies were concerned. And, he said:

These... choices will have to be made by the people of the United States; and economists--far more than any other group--will in the end help to make them...

That's you. "Economists", that is. And I am glad to be here, because I am glad that you are joining us. For we--all of us in America--need you. Arthur Burns was right: you are better-positioned than any other group to help us make the right choices, at the level of the world and of the country as a whole, but also at the level of the state, the city, the business, the school district, the NGO seeking to figure out how to spend its limited resources--whatever. READ MOAR

So why did Arthur Burns say this? And why was he right? Two blocks away over at Harvey Mudd college, people will say that they understand technologies--and that you, we, like Jon Snow of "Game of Thrones" (who I strongly believe is really Jon Targaryen-Stark, but let that pass), know nothing.

I would say:

  • While the engineering principles they know over at Harvey Mudd will endure, the knowledge of actual technologies they have will be largely obsolete in one decade and completely obsolete in two.
  • Economists know about systems, and how systems work:
    • Supply and demand
    • Opportunity cost
    • General equilibrium
    • Incentives and behavior
  • Get how the system works wrong, and your technological knowledge points in the wrong direction--is worse than useless.
  • Get how the system works right, and there will be many opportunities to figure out how to use and apply the technologies--not least because people will learn that they can make money by offering to teach you.

But while your heads should swell, I don't want your heads to swell too much. So let me tell you a story of today--and of how economists as a group, definitely including me, got it very wrong.

Let us return to Arthur Burns and his presidential address. In it, his first and his main point was that a business-cycle episode like the one we have just been through was not a realistic possibility. I quote, at extended length:

More than twenty-five years have elapsed since we last experienced a financial panic or a deep depression of production and employment. Over twenty years have elapsed since we last had a severe business recession.... There is no parallel for such a sequence of mild... [cycles] at least during the past hundred years.... The character of the business cycle itself appears to have changed....

The evolution of corporate practice, as well as the growth of corporate enterprise itself, has served to reduce the influence of a cyclical decline... on the flow of income.... The expansion and the means of financing of governmental enterprise... have had a similar effect.... In the classical business cycle... once business investment began declining... a reduction of consumer spending soon followed....

The specific measures adopted by the government in dealing with the recessions of the postwar period have varied.... In all of them, monetary, fiscal, and housekeeping policies played some part... [with] the most nearly consistent part of contracyclical policy... in the monetary sphere... influence... exerted only in part through lower interest rates. Of greater consequence... credit becomes more readily available... the money supply is increased... [and] the liquidity of financial assets is improved....

The net result has been that the intensity of cyclical swings of production has become smaller.... It seems reasonable to expect that the structural changes... which have served to moderate and humanize the business cycle will continue to do so.... Of late, many economists have been speaking... persuasively,though not always as grimly, of a future of secular inflation. The warning is timely...

That is the end of the quote.

Between 1959 and 2007--for nearly half a century--the overwhelming majority of economists would have endorsed Arthur Burns's conclusions. In fact, things got better from the perspective of unemployment. After two moderate recessions in the middle and just after the end of the 1970s, the size of the business cycle in employment and production shrunk again, giving rise to what was called the "Great Moderation". Arthur Burns's warning that the big economic threat had become inflation was nearly a decade too soon to be properly timely, but it was correct. And as of 2007 the overwhelming bulk of economists were still keeping their weather eye on inflationary problems of too-much money chasing too-few goods: exchange-rate depreciation provoked by shifts in desired capital flows, legislatures that could not muster the nerve either to cut programs and benefits to what could be properly-funded by taxes or raise taxes to what was needed to properly-fund programs and benefits, or simply central banks that fell victim to growth optimism and so failed to properly raise interest rates in a boom.

Thus what happened after 2007 in the North Atlantic came to nearly all economists as an astonishing surprise. Economists like Nouriel Roubini, my co-author Paul Krugman, and me would have said "we told you so" if a drying-up of the flow of finance from China led to a crash of investment spending in the U.S., a steep fall in the dollar, the bankruptcy of underregulated large New York banks that had bet their futures on a stable dollar, and an outbreak of inflation that caused a painful stagflation episode of high unemployment, high interest rates, and a rise in inflation that left the government with only painful policy options. Economists like my teacher Marty Feldstein and Michael Boskin would have said "we told you so" if failures to either raise taxes or enact entitlement reform had given the Federal Reserve an unpleasant choice between raising interest rates to prevent inflation and accepting higher unemployment or lowering interest rates to preserve employent at the price of higher inflation. Only a very few--like my co-author Dean Baker--saw the housing sector as a potential source of serious danger. And what has happened since 2007 has been an order of magnitude worse than even Dean envisioned in his worst nightmares.

Even today, 8% of the wealth that back in 2007 we confidently expected the North Atlantic to have has simply vanished. Our workers have fewer jobs, and are less productive. Our businesses have idle capacity. Productive links in the global division of labor that would in the normal course of events have been made since 2007 have not been. Productive links in the global division of labor that existed back in 2007 have been broken. This year I can still say that those of you graduating who are male still face the worst job market for newly-minted male college graduates in American history--albeit slightly better than 2012-2014, and somewhat better than 2009-2011, but worse than in any other year or years.

The total properly-discounted losses from the Great Depression cumulated to 1.4 times the initial year's GDP in the United States and half that in Western Europe--and perhaps that total is a mammoth underestimate, if one believes that in the absence of the Great Depression Europe's downfall into Naziism and World War II would have been avoided. 40 million people were killed or left to starve during World War II in Europe--six million of them Jews. 10 million people were killed or left to starve during World War II in Asia--seven million of them Chinese. Restrict ourselves to the narrower totals, however. Assume that in the absence of the financial crisis of 2007-8 and what followed production in the entire North Atlantic would have followed its pre-2007 trend. Then sometime next year the total losses from the current unpleasantness in Europe will pass the Great Depression as a share of GDP. And if we stay on our current trajectory in the United States rather than finding some way to restore pre-2007 trends of growth, come 2026 the Great Depression will no longer be America's greatest depression.

Diagnoses of how we got into this mess and why we are still mired in it--albeit to a substantially less degree than in 2009, and to a much less degree than in 2009 we feared we would be in 2010--vary. Let me give you my take--which is disputable, and indeed often disputed. I follow my next-door office neighbor at Berkeley, Barry Eichengreen, and find that one of the many important factors that has led to our current situation was the intellectual success of a book: Milton Friedman and Anna Jacobsen Schwartz's A Monetary History of the United States. You can read Barry's version of the argument in his excellent and brand-new book, Hall of Mirrors. Here is mine:

In the 1960s and 1970s monetarist economists drawing their analysis from Friedman and Schwartz's Monetary History of the United States advanced their particular economic-historical interpretation of the causes of the 1930s Great Depression as due to an improper and not-neutral--a contractionary--monetary policy. They were opposed by others. Some others, call them Keynesians, focused on fluctuations in the irrational "animal spirits" of businesses and thus of business willingness to engage in investment spending, on the limited power of monetary policy to counter coordinated shifts in psychology, and thus saw the Great Depression as originating in an unstable private sector and an unwillingness or inability of the government to directly direct and command the flow of spending through the economy. Still other others--call them Minskyites, but they were always a small sect--saw the private-sector instability as a financial-sector instability driven by a failure to properly regulate, control, and limit credit: as my Minskyite friend Bill Janeway of Warburg-incus says: give the banking system too much unregulated credit and you know what they will eventually do--you just do not know against which wall they will do it.

The Great Depression, Friedman and his co-author Anna Jacobson Schwartz had argued, was at its root a failure of government. It was due solely and completely to the failure of the 1929-1933 Federal Reserve to properly and aggressively expand the monetary base in order to keep the economy’s money stock stable. Seeing the money stock stable is a neutral monetary policy. And no decline in the money stock, no Great Depression. It was the government's failure to follow a "neutral" monetary policy--the active disturbance by government incompetence of what was by nature a stable full-employment market economy--that was the only reason the 1930s downturn became the Great Depression.

This interpretation was coherent sense. However, it rested on a particular premise: that the so-called velocity of money, the speed with which people spent the cash in their pockets and the demand deposits in their banking accounts, would vary little with changes in interest rates. And this interpretation involved some fast talk and fast dancing as to what a "neutral" monetary policy was. What Friedman and Schwartz called a "neutral" monetary policy in the Great Depression would have required that the Federal Reserve flood the zone with liquidity and buy bonds and print cash at a rate never before imagined, and that in fact the Federal Reserve in the Great Depression did not imagine.

But would a "neutral" monetary policy be enough? Suppose the velocity of money was interest-elastic. Then the open-market operations undertaken to expand the money supply would have pushed down interest rates. They would so cause a further fall in monetary velocity. And so that would have made Freedman and Schwartz’s cure impotent. And if Keynesian psychological shifts in the animal spirits of businessmen or fears provoked by a Minskyite financial crisis were to push interest rates down far enough and if the elasticity of money demand was high enough, the Great Depression would have come even had the money supply remained stable--even had monetary policy been "neutral" on Friedman and Schwartz's definition. Then to have successfully stopped the Great Depression in its tracks would have required Keynesian expansionary fiscal and Minskyite supportive credit-market policies.

The monetarists won the economic-historical and macroeconomic debate in the 1960s and 1970s. My teacher Peter Temin's Did Monetary Forces Cause the Great Depression did point out convincingly that there was no great contractionary surprise in anything the Federal Reserve did--no place where interest rates jumped up as it deviated from what people were expecting--and at most minor and irregular downward pressure on liquidity. Others picked away at the Friedman-Schwartz thesis on other details. But that didn't matter.

Why not? I think it did not matter because the debate wa really two debates:

At one level, the debate between monetarists, Keynesians, and Minskyites was a simple empirical matter of reading the evidence: Was the interest-elasticity of money demand in a serious downturn low, as Milton Friedman claimed, or high, as in John Maynard Keynes’s and John Hicks’s liquidity trap? Were financial markets a near-veil because the money stock was a near-sufficient statistic for predicting total spending, as Milton Friedman claimed, or was the credit channel and its functioning of decisive importance, as Minsky warned?

At the second level, however, the debate was over whether market failure or government failure was the bigger threat.

The Great Depression had, before Friedman and Schwartz's Monetary History, been seen as an unanswerable argument that market failure was potentially so dire as to require the government to take over direction of the whole economy. And that created a presumption that there might be other, smaller market failure might require a government to be interventionist indeed not just in macro but in micro as well. But if the Great Depression could be understood as a failure of government, then the cognitive dissonance between its reality and right-of-center economists' presumption that government failure was always the bigger threat could be erased.

And of course, the textbook Friedmanite cure was tried á outrance over 2008-2010 and proved insufficient. The monetary policy that Ben Bernanke pursued was Friedman-Schwartz to the max. It cushioned the downturn--the U.S. has done better than western Europe about to the degree that Bernanke was more aggressive in lowering interest rates and buying bonds for cash than his European counterpart Trichet. That is evidence that Friedman and his monetarists were wrong about the Great Depression as well. There are thus few people today who have properly done their homework who would say, as Ben Bernanke said to Milton Friedman and Anna Schwartz in 2002:

You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

And right now Ben Bernanke, now at the Brookings Institution, has changed his mind. He is now calling for Keynesian cures--expansionary fiscal policy, especially infrastructure spending, as the bet road forward.

But, even in the 1970s, the empirical evidence did not weigh strongly enough on the monetarist side to account for its decisive victory. The completeness of the victory must, I think be attributed to the fact that economics is never technocratic economics, it is always political economy, which is always politics. And that means, as British economist and moral philosopher John Stuart Mill lamented back in the 1800s, that there is no position so absurd that it has not been advanced by some political economist of note and reputation.

To admit that the monetarist cure was inadequate would be to admit that the Great Depression had deeper roots then a failure of technocratic management on the part of central banks charged with maintaining a neutral monetary policy.

Such deeper roots in severe market failures would not be fully consistent with a belief back in the 1970s and 1980s that social democracy had been oversold, and that government failure was almost invariably a worse danger than market failure. There was thus an extremely strong elective affinity between a mainstream economics profession caught up in the gathering neoliberal currents of the age and the Friedmanite interpretation of the Great Depression.

And because the intellectual victory in the 1970s and 1980s was complete, policymakers in 2008-2010 were hesitant and unwilling to apply the Keynesian and Minskyite cures to severe downturns enthusiastically enough and on a large enough scale to adequately deal with the problems that emerged. When the collapse came, the economists advising the North Atlantic’s governments and central banks were not ready.

Why did the collapse come? Start with the huge rise in wealth among the world’s richest 0.1% and 0.01% from the 1970s into the 200s, and the consequent pressure for people, governments, and companies to take on increasingly unsustainable levels of debt. Continue with policymakers lulled into complacency by the widespread acceptance of the “efficient-market hypothesis”--believing that investors in deregulated financial markets were relatively good judges of risk. CEnd with hubris: the confidence in the Federal Reserve and elsewhere that grew because the Penn Central collapse of 1970, the Latin American financial crisis of 1982, the stock market crash of 1987, the S&L crisis of 1991, the Mexican crisis of 1995, the East Asian crisis of 1997, the Russian/LTCM crisis of 1998, and the dot-com crash of 2000 had not caused the Federal Reserve problems that it could not handle well enough to keep the unemployment rate from going up by more than two percentage points.

Thus in 2008 the North Atlantic had a trend rate of inflation at 2%/year too low to make people feel they had to spend their cash even in a time of great uncertainty. It had a great deal of subprime debt, and an even greater degree of debt that might be subprime--because your supposedly investment-grade counterparty's ability to pay you depended on its subprime creditors paying it. Add in the peculiar problems of Europe, which is now a single currency but not a single government, a single financial system, or a single people. These were not problems that could be solved by the simple Friedmanite cure.

So when the 2008 financial crisis erupted, and policymakers tried to apply the solutions Friedman had proposed for the Great Depression to the present day, those solutions were not sufficient. It is not that they were counterproductive. The policies were enough to prevent the post-2008 recession from developing into a full-blown depression.

But from our standpoint today, we have reason to fear that partial success may turn out to be Pyrrhic victory. Politicians--Obama, Cameron, Merkel, and others--declare that the crisis had been overcome and the economy is strong. Yet by the standard of the pre-2007 period we have a depressed level and anemic growth, combined with acceptance of these as the new normal. Thus the North Atlantic is on track to have thrown away 10% of their potential wealth. And there have been insufficient changes in financial-sector regulation or in automatic stabilizers or in other institutions to keep the North Atlantic from once again developing the vulnerabilities it turned out to have in 2007.

That is the end of my story.

The little lesson from this story? We should not be satisfied with the current state of the economy. We should be pressing for policies to not just stabilize the situation but reverse the damage, and pick the fruit that back in 2007 we thought we would have today but that is still hanging.

The big lesson from this story? That your ideology, like fire and (we hope) fusion, turns out to be a good servant but a terrible master. Ideologies make sense of the entire world. We need them--our brains cannot handle too much complexity, for we have barely evolved barely enough smarts to have made it this far. But they break in our hands precisely because they force the world to make sense, and make a single kind of sense, and the world may not--or may not make that particular kind of sense.

Thus we can accept the conclusion that decentralized market economies and private property as societal institutions are among our greatest blessings. This is what John Maynard Keynes called "individualism". And he wrote:

the traditional advantages of individualism will still hold good. Let us stop for a moment to remind ourselves what [its] advantages are.... The advantage to efficiency of the decentralisation of decisions and of individual responsibility is even greater, perhaps, than the nineteenth century supposed.... Individualism... is the best safeguard of personal liberty in the sense that, compared with any other system, it greatly widens the field for the exercise of personal choice. It is also the best safeguard of the variety of life, which emerges precisely from this extended field of personal choice, and the loss of which is the greatest of all the losses of the homogeneous or totalitarian state. For this variety preserves the traditions which embody the most secure and successful choices of former generations; it colours the present with the diversification of its fancy; and, being the handmaid of experiment as well as of tradition and of fancy, it is the most powerful instrument to better the future...

But Friedman started there and built a bridge to the conclusion that therefore episodes like the Great Depression were impossible if only the central bank maintained a constant money stock and thus a neutral monetary policy, and that that neutral monetary policy would all by itself be sufficient to guard against big depressions.

And that bridge was a bridge too far.