The Depression's history lessons
DEREK DeCLOET
From Saturday's Globe and Mail
October 10, 2008 at 9:41 PM EDT
Move quickly, be decisive
The early response by the politicians to the onset of the Depression was denial. "In the 1930s, there was a reluctance to intervene … the thought that this was a temporary adjustment," said Bill Waiser, a professor of history at the University of Saskatchewan. The two prime ministers who governed during the Depression era, Mackenzie King and R.B. Bennett, at times used the constitution to argue that unemployment and relief were provincial matters — there was no national unemployment insurance scheme — and Ottawa initially threw only meagre, "temporary" support to them, Prof. Waiser said.
In the United States, there was a similar lack of urgency. Far from the hustling fix-it man that is Henry Paulson, the Treasury Secretary at the time, Andre Mellon, was "a passionate advocate of inaction" on most matters of economic policy, John Kenneth Galbraith wrote in The Great Crash, 1929. Meanwhile, President Herbert Hoover was caught between those who wanted action, and those who held tight to the traditional conservative view that the government should always balance its budget (or at least try) and let economic nature take its course.
And where was the U.S. Federal Reserve during this? It "sat on its hands," said David Laidler, an economic historian from the University of Western Ontario. Nominal interest rates dropped as the contraction took hold, but because of massive deflation — prices dropped 24 per cent between 1929 and 1933 — real interest rates were far too high. Unlike today, the Fed of the 1930s wasn't nearly as aggressive in buying securities in order to get cash into bankers' hands — "pushing liquidity into the system," in central bank jargon. Interest rate policy was wobbly. In 1931, with the economy still in a deep funk, the Reserve Bank of New York raised interest rates twice in the space of a week, to stem an outflow of gold and protect the dollar amid fears the U.S. would drop the gold standard (as the U.K. had just done).
A number of academics who've studied the era — including Ben Bernanke, the world's most important central banker — have said the severity of the downturn was made worse by the Fed's foot-dragging and its blunders. Certainly, the lesson has stuck with Mr. Bernanke. In 2002, at economist Milton Friedman's 90th birthday, he gave a speech in which he joked: "I would like to say to Milton … regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."
"The speed of the response today is infinitely faster than it was in the Great Depression," Prof. Laidler said.
Don't demonize government deficits
Jeff Rubin, the chief economist of CIBC World Markets, thinks Canadian politicians have forgotten what governments are meant to do in a recession. The nation was so scarred by the monster deficits of the 1980s and early '90s that neither Liberals nor Conservatives want to add a dime of red ink. "The problem is we've lost sight of the role of fiscal policy over the cycle," Mr. Rubin complained on the same day Finance Minister Jim Flaherty unveiled his budget and pledged, yet again, not to break Ottawa's decade-long streak of surpluses.
Eight months later, the world is in a financial panic and the economic outlook is far worse. Yet Prime Minister Stephen Harper and Liberal leader Stéphane Dion have each stuck to the no-deficit line, with Mr. Dion even saying the Liberals would "never" cause a deficit. As a campaign strategy, it makes sense. No one wants to be attacked as a profligate.
But to stick to that pledge in a deep recession would not only be folly, as Mr. Rubin suggested; it would repeat what was arguably one of the biggest errors of Depression. In both Canada and the U.S., governments were hesitant to try to spend their way out of the problem. It wasn't until 1935 that the Bennett government proposed a Canadian version of the "New Deal" that included unemployment insurance, farm support and a pension scheme.
He was swept aside in the election of that year, but even Mackenzie King took a cautious fiscal approach. The next year, economist John Maynard Keynes published
The General Theory of Employment, Interest and Money — which argued for active government intervention to stimulate investment and jobs — and Keynsian economics was born. Still, Ottawa didn't run a deficit that it planned for until 1938.
Mr. Hoover also could not shake the balanced budget orthodoxy. Remarkably, his administration ran a surplus in fiscal 1930, ran a small deficit in 1931 and raised taxes in 1932. Even Franklin Roosevelt wasn't as big a spender as he's often made out to be. "Roosevelt, unlike Hoover, wasn't absolutely wedded to balanced budgets. But he pretty much was," said Robert McElvaine, author of
The Great Depression: America, 1929-1941 and a historian at Mississippi's Millsaps College. Before the war, he never ran a deficit larger than $5-billion (U.S.). Pearl Harbor, not the Depression, is what caused radical change in fiscal policy. By 1943, the deficit topped $50-billion. The worrying thing is that the U.S. enters this downturn already in poor fiscal shape, unlike in the 1930s. The public debt has increased from $5.7-trillion to $10.2-trillion during George W. Bush's time in the White House.
Bailouts may be only the beginning
This is a lesson that we're learning in real time. Remember how the Paulson plan was supposed to bring some relief? The financial world stayed glued to its screens as it came to a key vote in the U.S. House of Representatives. Once passed, it would give hope — that a $700-billion surgery would cut the cancer of subprime mortgages and toxic debt securities from the banking system, allow credit to flow again, and maybe even put some life into stocks.
President Bush signed the bill into law on Oct. 3. Since then, central banks around the world cut interest rates simultaneously; the Federal Reserve has offered to buy companies' short-term debt; banks have been nationalized, in whole or in part, in the United Kingdom and across Europe and the United States is considering a similar idea; and country after country has moved to stem a run on the banks by guaranteeing deposits or even other bank liabilities. None of it has had much impact so far.
Herbert Hoover, despite his fiscal conservatism, wound up trying all manner of different schemes to revive growth. A federal farm board (established before the market crash, actually) bought up unwanted or surplus production from farmers, in the hope of stabilizing prices, just as Mr. Paulson's new asset management firm seeks to buy unwanted investments from banks.
It didn't work. The National Credit Corp. attempted to bring some large banks together to get them to lend to other banks. It didn't work. The Resolution Finance Corp., created by Mr. Hoover in 1932 and expanded by Mr. Roosevelt, was created to directly lend government money to banks, railways and other businesses, and ultimately ended up as financier to state public works projects. It may have saved the banking system temporarily, Prof. McElvaine believes, but it still didn't prevent the misery of 1933, the Depression's worst year.
In modern-day banking crises, such as those of Finland, Sweden and Norway in the late '80s and early '90s, the experience was much the same. Their governments had to take control of, or inject capital into, large parts of the banking system, but it still took years before the crisis passed and those institutions were healthy enough that blanket government guarantees could be removed.
Don't fall for protectionism
The biggest mistake of Depression-era policy makers wasn't what they did inside their own economies; it was the way they tried to shut other countries out, said Joseph Martin, director of Canadian business history at the Rotman School of Management in Toronto. On this, the politicians acted quickly — and foolishly. The Smoot-Hawley Tariff Act, which raised import tariffs in the U.S. to historically high levels, was passed by the summer of 1930, over the objections of more than 1,000 economists who'd urged Mr. Hoover to veto it. The same summer, Mr. Bennett swept to power in the Canadian election on a now-infamous promise to use tariffs to blast his way into the world's export markets.
The folly of this is now universally acknowledged; world trade declined by two-thirds between 1929 and 1934, and the trade barriers surely made that worse. But will we repeat the mistakes of the past? Recall Senator Barack Obama's earlier rhetoric about the North American free-trade agreement being "a big mistake".
The Democratic candidate has backed down from that remark. But playing to the protectionist crowd is a time-honoured tradition during recessions. And that crowd is growing. Two years ago, 44 per cent of Americans said free-trade agreements were good for their country in a poll by the Pew Research Centre, while 35 per cent said they were bad. Now those numbers have flipped: In a Pew poll taken this spring, 35 per cent said trade deals were a good thing, 48 per cent disagreed. And that was when things were calmer, before the financial crisis got even more serious in September. "From a trade perspective, I'm very nervous," said Prof. Martin. With the strong likelihood of Democratic control of both the White House and Congress, "the House of Representatives will be crying for trade protection. It'll be up to the Senate and the President to stop them. I think it's an issue Canadians seem to be oblivious to — but it's an issue."
Protect the biggest banks
A major New York-based financial institution was on the brink. Regulators scrambled to find a healthy bank — or even a group of banks — to rescue it through an acquisition or merger. At the last hour, a potential deal fell apart, the struggling institution collapsed, and the episode touched off a cascade of bank failures.
It sounds like Lehman Brothers Holdings in 2008. But it also describes the Bank of United States (which, despite its grand name, was not controlled by the government) in December, 1930. At the time, it was the largest commercial bank to go under in American history. Saving it probably wouldn't halted the wave of bank failures that hit the U.S. financial system over the next few years, but because of its size, some historians believe it accelerated the evaporation of confidence. Two thousand U.S. banks failed in 1931.
Lehman's Chapter 11 filing on Sept. 15 marked a similar turning point. You can draw a link between that event and virtually every shock that has happened since. Losses on Lehman debt caused one of the oldest and largest money market funds to "break the buck" (i.e., to cause the fund's value to drop below $1 a share), which caused a run on the money market funds as investors pulled out their money, which made it hard for banks, General Electric Co. and other businesses that rely on a constant infusion of short-term debt to raise the money they need. Result: deep freeze in the credit markets, and investment banks like Morgan Stanley struggling just to survive.
"One of the things I thought we learned from the '30s is, when in doubt, you don't let a financial institution fail if there's a systemic risk," said Prof. Laidler, who believes Mr. Paulson either failed to heed this lesson or made a huge miscalculation. "I just can't comprehend letting Lehman Brothers go broke. I simply don't know how that mistake was made."
Be wary of the rosy scenario
Just before he left office in 1929, U.S. President Calvin Coolidge said things were "absolutely sound" and that stocks were "cheap at current prices." In the spring of 1930, Herbert Hoover said: "We have not passed the worst and with continued unity of effort shall rapidly recover." The "worst" was still three years away.
In August, 2007, at the start of the credit crunch, U.S. President George W. Bush declared: "The fundamentals of our economy are strong." In November, Prime Minister Harper said: "Yes, we have some problems, but as our esteemed finance minister said more than a few times last week … the fundamentals of our economy are as solid as the Canadian Shield."
Hearing this would have amused J.K. Galbraith, the great Canadian-American economist, who died in 2006. In an updated version of
The Great Crash, he wrote: "Always when markets are in trouble, the phrases are the same: 'The economic situation is fundamentally sound' or simply 'The fundamentals are good.'
"All who hear these words should know that something is wrong."
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How this crisis is similar:
Property bubble foreshadows trouble
The Great Depression didn't begin until the autumn of 1929, when chaos erupted in the financial markets. But then, as now, the market crash was preceded by a speculative frenzy in real estate that had burst.
Debt to excess
Brokerages in the late 1920s behaved as the subprime lenders of 2006 did, lending to almost anyone. But the buying of stocks on margin was only a small piece of a much bigger consumer credit boom. Between 1925 and '29, U.S. "instalment debt" more than doubled.
Wall Street was too clever
In the good times, investment bankers are lauded for what's benignly called "financial innovation." Only when those fancy products collapse in ruin are they seen as folly. The late 1920s saw an explosion in the number of investment trusts that made heavy use of leverage and proved to be nearly worthless after the crash. These were analogous to many of the debt-backed financial instruments at the heart of current problem.
A departing President struggles to cope
Though the economic contraction began in 1929-30, the banking crisis didn't really peak until 1933, according to Robert McElvaine, a U.S. Depression historian. President Herbert Hoover was an unpopular, lame-duck Republican who lacked political capital and couldn't contain the slide of confidence in banks.
How it's different:
Social programs help cushion the blow
Unemployment insurance, old age pensions, Social Security in the U.S. — these things either didn't exist in 1929 or existed in only a limited form. They're called "automatic stabilizers" because they put money into the economy as the private sector contracts.
There's still inflation
When the Depression began, Canada's most important export was food, not oil or wood. And the farm sector was already stuck in a deep deflationary funk. By the end of the '20s, the inflation rate in Canada was zero, and the U.S. was already in mild deflation. Today, most producers of commodities — including farmers — have enjoyed years of prosperity before the downturn.
The magnitude of the crisis is different
This may be the biggest financial crisis in 75 years, but let's put it in perspective. The unemployment rate in Canada and the U.S. is still barely 6 per cent. In the U.S., it has been rising quickly, but some key sectors, like health care, are still hiring. That's a long way from the 20-per-cent-plus rates of the 1930s. The latest data do not even show the economy is contracting.
Economic policy is more flexible
The U.S. is no longer on the gold standard, in which all dollars can be converted to a fixed amount of gold. It can let its exchange rate fall to help exporters. Central banks now understand the perils of deflation, and balanced government budgets are no longer a religion.
