Great Depression Redux?

New York City--The good news yesterday is that the stockmarket was up by the the fifth largest amount in history. The bad news is that all but one of the other nine largest leaps occurred during the Great Depression. One of the top ten, however, occurred in 1987 after the largely spurious drop that year that did not signal any great financial calamity. This raises the question is the current crisis more like that in 1987 or in the 1930s?

To answer this question, it is important to understand the two stage nature of the Great Depression. Economists (including Ben Bernanke when he was an academic) poring over the years leading up to the 1929 crash have never found a single culprit. True, when shoeshine boys and newsies were trading stock tips, the market was clearly frothy. But froth is not a cause. The most plausible explanation for the 1929 crash seems to be that loans to buy automobiles, the new craze, began to use up all the liquidity in the system. in 1929, if you missed your car payment, not only did the company take back the car, but you still owed the entire original amount of the loan. For this reason, people put off any expense rather than miss a car payment, spending declined and the stock market crashed.

What non economic historians may not know, however, is that by 1931, the economy was showing signs of recovery. There was every indication that the 1929 crash though severe and worse than the one in 1907 or several in the early 1920s was not qualitatively different. What turned the 1929 crash into the Great Depression was actually the less known 1931 crash. And in this case economic historians have pinpointed the culprit: the Fed. Just when the economy was starting to recover, disastrous Fed policy sent the economy reeling and cemented the 1930s place in history as the worst decade in modern economic history.

The contagion began in Europe with a series of runs on currencies. First the German government experienced a financial crisis in July of 1931. In turn, the contagion spread to England as speculators, eying weakness in British accounts began speculative attacks on the pound. At the time, the English pound was backed by gold. To back a currency with gold a country must be willing to buy back its currency with gold at the fixed rate. As the pound's value began to ebb, holders of pounds demanded gold. To stop the outpouring of gold from His Majesty's treasury, Britain took itself off the gold standard in September. As often happens, traders looked around for other countries that might have similar problems and their eyes settled on the United States which also backed the dollar with gold.

In October, 1931, traders began to turn in dollars for gold in a run on the dollar. Faced with an outpouring of gold from Fort Knox, but yoked to the belief that one must maintain a sound currency, the Fed directors, following established central banking theory at the time, and supported by most on Wall Street, dramatically increased US interest rates. In a span of just two weeks--while the US economy was still recovering from the 1929 crash--the Fed more than doubled rates from 1.5% to 3.5%. This caused liquidity to dry up, banks to fail and a huge contraction. The rest is history.

Ben Bernanke surely knows this history and, in any case, understanding of monetary policy has improved to where no one would dramatically increase rates during a recession today. And, of course, we no longer back our currency with gold. Finally, today, the US is the world's reserve currency meaning in moments of panic, our currency tends to strengthen.

There is every reason to think, therefore, that we won't get a Great Depression which was probably an unnecessary mistake avoidable in retrospect. However, it's also unlikely we're experiencing as benign an event as the pseudo crash of 1987. More likely, we are looking at at least a couple years of quite difficult times ahead.