It Can Be Worse than the Great Depression
Post on the Financial Times' Economists' Forum
© Financial Times
This is the worst global asset bubble and financial panic since the Great Depression of 1929-33. Still, almost all argue that it cannot become equally bad, because we have learned those lessons.
Analytically, that statement does not hold. True, our policymakers are not likely to repeat the same mistakes of the Great Depression, but they may commit other mistakes. Bank deposit insurance has come to stay for good, but not all advances represent progress, and many create new vulnerabilities.
One 1930s mistake was to defend exchange rates by all means. Today, most exchange rates float freely. Right now, we are seeing an unprecedented US dollar surge, which is not warranted by fundamentals but reflects a desperate search for a safe haven. The new hazard might be excessive and destabilizing exchange rate fluctuations caused by financial panic. If so, the major financial powers need to intervene to stabilize exchange rates.
Milton Friedman attacked the Fed for allowing the nominal monetary supply to contract sharply during the Depression, and John Maynard Keynes argued for more public expenditures through budget deficits, while the prevailing policy was budget surplus. The monetary expansion and budget deficits may become excessive this time.
Deficit spending and monetary expansion are supposed to boost demand, but people spend less in a financial panic, rendering increased public expenditures rather ineffective. We learned the limitation of Keynesianism in the 1970s. In recent decades, some former communist and Latin American countries have shown how the expansion of public expenditure beyond the permissible can lead to state default.
In the 1930s, states did not go bankrupt, fearful of the consequences of those who had done so in the wake of the First World War.
Now, major states, such as Italy, have public debt of more than 100 percent of GDP even before the crisis, rendering major state bankruptcies a real danger. Fiscal and monetary stimulation are needed and deflation must be avoided, but currently fiscal considerations are disregarded altogether, which is a recipe for disaster. State default can easily lead to hyperinflation, which is far worse than deflation.
The global financial system is so much deeper and more sophisticated than in the 1920s, but that is a problem. The 1920s had its version of subprime loans, but it did not have nontransparent collateralized debt obligations. The many derivatives have created the mother of all bubbles. The deeper the financial system, the harder we may fall.
Although the Great Depression had worldwide reach, it largely emanated from two countries, the United States and Germany. Never before has the world seen such a monstrous and truly global bubble. The real estate bubble is probably worst in the Persian Gulf and Moscow, while also extreme in Britain, Spain, and Ireland.
Never have big financial institutions been as overleveraged as Fannie Mae and Freddie Mac or the former US investment banks, not to mention the hedge funds. The excessive leverage is now being unwound by financial panic, apart from what is countered with recapitalization.
The 1930s protectionism must not be repeated, but frozen finances have already left countries such as Iceland and Ukraine temporarily outside of the world financial system. Such exclusion must not be allowed to become permanent.
In the 1920s, both the US dollar and gold were unchallenged sources of value. Today, the US dollar is neither stable nor an uncontested world currency. At 10, the euro is too young to be a debutant, and the biggest question is will it hold together in this rough financial weather, especially if one or several euro countries default.
Everybody from Milton Friedman to John Kenneth Galbraith has criticized the Federal Reserve and US President Herbert Hoover for their policies during the Depression, but at least they were policymakers and stood for principles. As if to illustrate their impotence, President George W. Bush is assembling the political leaders of the group of 20 large countries for a photo opportunity in Washington on November 15.
Their failure to come up with anything but vanity could unleash untold financial panic. This crisis envelops the whole world, but global financial governance is missing.
Finally, the 1920s had neither television nor the internet. Information, decisions, and implementation can now be carried out in seconds, which harms the quality of decisions and nerves. Transparency is usually preferable, but unmitigated speed might be harmful. CNBC and Bloomberg can spread worldwide panic instantly.
We must not repeat the mistakes of the Great Depression, but we need to ascertain that new policies are not even worse.