Lessons for the Current Depression

Here is an interesting blog entry by Jeff Frankel who teaches at Harvard. It talks about the "lessons" of the Great Depression and how they apply to today. First he gives four reasons why the current depression won't turn into a Great Depression (but he carefully "circumscribes" these with warnings that these reasons may not hold). Then he identifies four policies that we have learned from the 1930s which should help contain this depression:

The usual reason that is given not to fear a repeat of the Great Depression is that we have learned from the mistakes of that era, and won’t repeat them this time. What exactly is it that we learned? How can we be sure of doing it right this time? There are four big lessons for economic policy from the 1930s:

(Lesson I) Monetary policy — The Fed should respond to a severe loss of demand by aggressive monetary expansion, not by allowing the money supply to contract as happened in the 1930s (most famously pointed out by Milton Friedman and Anna Schwartz, in the Great Contraction chapter of a Monetary History of the United States). It happens that the Chairman of the Federal Reserve, Ben Bernanke, and the Chair of the President’s Council of Economic Advisers, Christie Romer, are two of the very top experts in the monetary history of the 1930s. The lessons of this period have been well absorbed, and the Fed has already given us an appropriately aggressive response. But that can only take us so far.

(Lesson II) Regulation of the financial sector — In times of financial crisis, many banks and especially their depositors will have to be bailed out; this recognition in turn requires a corresponding degree of regulation in normal times. The 1930s left us with institutions such as deposit insurance and minimum requirements for banks’ reserves and capital. The existence of these safeguards is another reason why it is indeed unlikely that we will experience anything as bad as the Great Depression. The origins of the financial crisis of 2007 was not that de-regulation fervor had led to a dismantling of the important safeguards from the 1930s. (It’s true that Glass Steagall and prohibitions on inter-state banking were dismantled in the 1990s. But that did not cause the crisis.) The problem was rather that regulation did not keep up with new innovations in non-bank financial institutions. Reform in this area is more easily said than done, and more easily done wrong than done right; but will nevertheless have to be attempted as soon as we get past the current crisis.

(Lesson III) Fiscal policy — When a deficiency of aggregate demand leads to a serious and prolonged recession, the government should respond with intelligently designed fiscal easing, in the form of both spending increases and tax cuts. To the extent that Franklin Roosevelt tried Keynesian stimulus in 1933, it worked, though only World War II spending years later finished the job. There are several critical qualifiers to note before we generalize to the post-war era. First, the budget process must not be so encumbered by political machinations or corruption as to delay disbursements until it is too late, on the one hand, or to divert them to projects with miserable cost/benefit ratios, on the other hand. Second, the budget plans must also pay due attention to the constraints of long-run fiscal sustainability. Absent these conditions, a fiscal expansion could well make things worse rather than better. The good news is that the fiscal stimulus package that President Obama signed into law last Tuesday was better designed than those enacted in many past American recessions, let alone those enacted in other countries. The efforts to block it, by those in the Congress who do not understand the lessons of the past, were unsuccessful (though they did succeed in slightly reducing bang for the buck). The bad news is that Obama has taken office with a handicap that Franklin Roosevelt did not have: a trillion-dollar deficit and a $11 trillion national debt, both of which are already guaranteed to reach alarming levels as a share of GDP in the coming year. This negative inheritance constrains the extent of fiscal expansion that is feasible.

(Lesson IV) Trade policy — The lesson that economists have long thought had been most clearly demonstrated by the 1930s is the lesson to which today’s Congress has paid the least heed. Senator Smoot (R) and Congressman Hawley (R) in 1929 proposed legislation to raise US tariffs sharply. Warnings of the damage that such protectionism would cause were ignored, including a petition organized by the leading economists of the day and signed by 1,028 of the profession. President Hoover (R) signed the infamous Smoot-Hawley bill in 1930. The consequences are well-known. Other countries instantly retaliated, and emulated this aggressive act of protectionism. Over the subsequent years world trade collapsed (down 60% by 1932), helping to put the “Great” into Great Depression and facilitating the rise of rabid nationalism in Germany and Japan.

The Buy America provisions in the original House version of the current stimulus bill risked a repetition of the mistake of Smoot-Hawley. These provisions have received far more attention in the media in every foreign country than inside the United States. President Obama insisted that the legislation abide by our international treaty commitments. It would have been better if this statement had come earlier, but it was music to the ears of us free traders. The final stimulus bill that the President signed this week was somewhat better from a trade perspective than the original. In his short time in office, Obama is already doing a better job of respecting international commitments than did his predecessor, who imposed WTO-illegal steel tariffs in 2002.

We are assured that:
(i) the government will apply the remaining Buy America provisions in a judicious manner (we are only talking about government procurement here, not interference with private-sector imports); that
(ii) in particular, the legal commitments to open markets vis-à-vis Canada and Mexico will continue, and that
(iii) the import content to the stimulus package would have been low in any case (just some iron and steel in bridges). I still worry. The part of the Smoot-Hawley lesson that even a mercantilist can appreciate is foreign retaliation: the initial reduction in imports is more than offset by a reduction in exports. If the Buy America provision was heard internationally as the firing of a starting gun in a new race toward protectionism, then the preceding three reassurances are not very reassuring.

The first two lessons seem to be safely "learned" but as you read this you should recognize that the last two lessons do not appear to have been learned and in fact the same mistakes may very will be repeated. So it isn't clear that a severe depression can be averted. Words are reassuring, but actions speak louder. What I see is a country that has responded too little and too late at every step and which a right wing political crew bent on wrecking progress rather than pitching in to help. It does not bode well.