Arnold Kling  

Lessons of the Great Depression

Kotlikoff on Social Security... Comment of the Week, 10-15-03...

In this essay, I summarize what I have been reading about the Great Depression and its implications for today.

The Depression certainly was an era of displacement. In fact I have borrowed the very term "displacement" from the late economic historian Charles Kindleberger, author of Manias, Panics, and Crashes and one of the eminent economists interviewed by Parker. Kindleberger's theory of manias, such as the Tulip Mania, the South Sea Bubble, or the Internet craze, is that they are triggered by a major change in the economic or geopolitical environment. The change creates new opportunities and sudden wealth, leading to greed and overspeculation. Kindleberger views the 1929 stock market boom and subsequent crash as a classic example of this theory. The geopolitical realignment following World War I, and the rapid growth of industries in automobiles and electronic communications, created displacement.

For Discussion. The essay argues that there are parallels between the 1930's and today, except that contemporary economic policy is better. Are there other important differences?

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Eric Krieg writes:

Oh yeah! Come on, the electorate today is A LITTLE more sophisticated than it was in 1930.

There is no Communist contingent in today's electorate. No is going to vote to nationalize industry. Unions are near collapse, whereas in 1930 they were just hitting their stride. People are much more entreprenurial oriented now that then.

Unfortunately, there are some similarities. Protectionism is still out there, especially among people who shoulc know better, like COMPUTER PROGRAMERS!

triticale writes:

The economy is more complex, so that problems in one sector have less impact on others. We also do not have an environmental disruption of the scale of the Dust Bowl multiplying the impact of changes in the agricultural economy.

Jim Glass writes:

"Are there other important differences?"

For sure. Today there's no gold standard that is being mismanaged around the world in a deflationary mannwer as nations try to re-impose and hold it at pre-WWI parities that don't fit -- in the US in particular, causing the Fed to raise interest rates in the midst of deflation and recession in a manner that seems insane by our standards. That's a huge difference.

The gold standard was a necessary if not sufficient condition for the Depression. IIRC, the only significant country to escape the plunge -- Stage I of the Depression -- was also the only one not on the gold standard: Spain.

And as every country left the gold standard, the domestic contraction in it stopped. (Stage II of the Depression, the more or less protracted recovery, more in the US because of New Deal policies, was another story.)

Without the gold standard back then first setting the stage by weaking several major economies (e.g. Britain's with its too-high parity), and later transmiting the fincancial crisis from nation to nation (just as fixed exchange rates did in the Russian/Asian ciris of the late '90s) there would have been no Depression as we know it.

E.g., see economic histories of the Depression such as Eichengreen's _Golden Fetters_ or Temin's Robbins Lectures published as _Lessons From the Great Depression_

Kyle Markley writes:


"No is going to vote to nationalize industry."

Except health care.


"Today there's no gold standard that is being mismanaged..."

Was the problem the gold standard, or the fact that it was being mismanaged?

Tom Grey writes:

The huge employment transfer out of farms into cities over the 26-32 years is under reported (or not robust in Grapes of Wrath). Employment diversity reduces the problem.

Similarly, over-production misallocation of capital caused asset price/value decreases in 29. In 2000, the bubble burst mostly financial paper wealth w/o huge capital misallocations, except telecom overbuilding bandwidth. Knowledge worker temporary misallocation errors are far cheaper to correct than capital factory building misallocations.

Tom Grey writes:

Also (first time here) Great comments! Plus permalink at the bottom so I can easily copy my comment to my own blog, etc.

(I've like your TCS articles every time I read them. Keep watching Paul Krugman, please.)

Jim Glass writes:

"Was the problem the gold standard, or the fact that it was being mismanaged?"

The problem was that WWI changed the world, and the gold standard no longer fit it. As a few examples...

* The old money parities to gold didn't fit, but the governments tried to reinstate them. So, e.g., there wasn't enough gold in Britain which went into a prolonged tight-money slump, while in countries like the US and France there was too much gold, which was inflationary.

Then the latter countries to control their inflation "sterilized" their excess gold and gold inflows through open market operations. But you weren't supposed to do that under the old pre-war gold standard, because while it was OK for the countries that did it other countries with too little gold couldn't "un-sterilize" ("infect"?) money, so there was a net deflationary effect world-wide.

* A gold standard really is a single currency regime. These require free and open flows of goods, money and people across borders to absorb economic shocks, since central banks can't absorb them by changing interest rates and varying exchange rates. And just prior to WWI the gold standard international economy was the most open ever -- more so than today for all of our "globalization".

But after WWI that was all gone. Every nation was out for itself, dealing with domestic interest groups like trade unions and industrial groups and more, tariffs were up, immigration was blocked, and nobody was going to willingly absorb a "shock" coming from another country for the common good. Everybody tried to fix the game in their own favor.

* Fixed exchange rate regimes are always subject to periodic crises (like in Asia in '97). Before WWI there were plenty of them but, with open economies and small governments that were sympathetic to the gold standard, central bankers and big private bankers had a free hand to intervene to manage them.

After WWI that wasn't so. The big governments and interest groups had to politically vet what the central bankers did. And of course post-WWI international finances were horribly worse than before. So the world was crisis prone. In the end the crash of the Great Depression was the mother crisis of them all, transmitted internationally through the fixed exchange rate (gold standard).

So really, after all the changes that WWI wrought, I don't think it's so much that the gold standard was mismanged via mistakes A,B & C so much as it was impossible not to mismanage it because it just didn't fit the new world.

And I'm not saying the gold standard "caused" the Depression, only that it was necessary for the Depression to occur as we know it.

One of the interesting things about reading economic histories of the Depression is that the central bankers of back then weren't stupid -- they well knew everything that I listed above. But they made the judgment that bringing back the gold standard for all its problems was better than the risk of staying with the fiat currencies that they came out of the war with.

Who knows? Maybe they were right and if they hadn't brought back the gold standard we'd have had some calamity in a different way as we haven't known it.

Kyle Markley writes:


It sounds like the inflation (money supply growth) caused by and subsequent to WWI is the real culprit here. The gold standard became a political obstacle to be overcome. If there hadn't been a war, or if it hadn't been funded by inflation (which produced the parity problems), the Depression would have been avoided.

dsquared writes:

Keynes proved that the gold standard is inherently deflationary as it puts all the burden of adjustment on a country with a current account deficit ...

JT writes:

In response to Arnold's question, another important difference is the presence of federal bank deposit insurance. Bank runs were a big problem in the 1930s and, though our confidence in the investment system has been shaken somewhat, there is nowhere near the incipient panic that existed prior to the establishment of the FDIC.

Lawrance George Lux writes:

Some interesting speculations can be made about the Great Depression. Previous comment mentioned the rise of the Auto industry of the 1920s, and it's similiarity to the Tech boom of the 1990s. Both were an instance where excessive Investment assets and extreme Consumption dollars were devoted to a new, rapidly expanding industry. One can assert both over-Produced to eventual Consumer Demand--part of the problem. It could be other economic sectors were under-capitalized by these developments, and fell behind in technological development; a case of technological loss of advancement in these sectors. The 1930s witnessed extreme under-production due to lack of Consumption dollars. We are now seeing huge foreign outsourcing of production, due to Monetary policy extension of Consumer Credit; making many kinds of production unprofitable under old technological methods, which lacked the capitalization upgrades equal to concurrent development comparative to, and because of, the Tech boom. Both Eras can be viewed as caused by a mis-venting of of Capital distribution in the prior decade.

The economic theory of the 1930s insisted Government deficit spending could provide the economic push for performance. Current economic theory suggests easy Credit extension and Tax credits for Business will bring Us out of the slump. The suggestion that contemporary Economic thought is better Today, may be equally wrong. Economic recontruction may call for restricted Government spending, high Tax rates, Tax credits extended only for hard Capital construction (specifically not Paper), and a round of Deflation. lgl

Ray Gardner writes:

Looking at the basic cause & effect routine, recessions are not avoidable in a dynamic (i.e. healthy) economy. Depressions on the other hand are avoidable. Without getting into the various definitions of both, suffice it to say that the milder of the two is just part of the business cycle while the more severe of the two is not inherently natural to a free market.

In other words, recessions are merely the trough in a natural business cycle while a depression requires unnatural additions or interventions into the market.

So we’ve learned over the years how to avoid many of the conditions that bring about deep recessions and we’ve learned (‘we’ not constituting all) not to exasperate the situation when we find ourselves in a trough.

Of course there are still those in power or wanting to be in power that think plowing the crops under is good economic policy but society as a whole seems to have learned the lessons well enough.

David Thomson writes:

I’ve long laughed at the radical right wingers advocating a return to the gold standard. This may have made some sense a few hundred years ago. During that era, it was admittedly very difficult to figure out if a particular nation’s currency was truly of any value. We no longer have that problem. Immediate and accurate information is relatively easy to find.

Eric Krieg writes:

I haven't heard anyone suggest the gold standard, but guys like Steve Forbes advocate a "modern gold standard", where you guide monetary policy based on a standard basket of commodities.

Gautam writes:

Many of the comments seem to let government interventions into the market process off, as some sort of a cosmic inevitability, this is not a unique phenomenon but some sort of a spillover into our thinking arising from the fiction that we perpetrate in economic model building to externalise 'G'.

I think the role of the Government and its expansionary policies should be more critically considered, when examining the events leading up to depressions. Though Kindleberger maybe right about historical situations that cause the boom-busts, the 'G' does play an active often negative role in these.

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