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 This was the question posed by N. Gregory Mankiw in Sunday's New York Times. The former chairman of President George W. Bush's Council of Economic Advisors was asking if we had learned enough about causes of the Great Depression to avoid another one. It's a compelling question, but largely a nonstarter. The world is completely different today than it was in the 1930s. We need to cast our net a lot wider.
To be sure, some lessons do apply, and Mankiw provides a very brief but succinct summary of U.S. policy decisions of the late 1920s and early 1930s and their impact on the broader economy. (Interestingly enough, he leaves out the Smoot-Hawley Tariff Act of 1930, which to many was one of the chief culprits. Or maybe that's just The Economist and Forbes. Another topic for another day) He deems monetary expansion, specifically President Franklin D. Roosevelt's decision to abandon the gold standard and devalue the dollar as "probably the most important source of recovery after 1933."
This lesson has obviously not been lost on central banks, who (with a few exceptions, most notably the European Central Bank, though even they have started to come around) have been working independently and in concert to flood the system with liquidity and face off deflation. By doing so they are "intent on avoiding the early policy inaction that let the Depression unfold," Mankiw writes. So far, so good. But that was then, this is now. We aren't out of the woods yet, and Mankiw admits as much. "Then the problem was largely a crisis of confidence and a shortage of liquidity. Today, the problem may be more a shortage of solvency, which is harder to solve," he writes. Besides not being a cure-all, cheaper money carries its own perils as the more recent past demonstrates. Let's take a step back and look at what got us into this predicament in the first place. Cheap credit begat a housing bubble, which begat subprime mortgages, which begat collateralized debt obligations, which begat credit default swaps (or what were supposed to be credit default swaps but turned into worthless pieces of paper because the CDS market is essentially unregulated and has no settlement mechanism as do options contracts and other derivatives), which eventually took down the investment banking world as we know it. Cheap credit. Aye, there's the rub. For in that injection of liquidity what dreams may come. Still we have to shuffle off this deflationary spiral. It was Alan Greenspan who raised the spectre of deflation earlier this decade, in an attempt to justify keeping the main Fed rate at 1% far longer than he had any right to. This caused a flight to hard assets, such as commodities and housing, and we were off to the races. The former chairman of the federal reserve now admits he was wrong. Well, not quite. He admits he made mistakes and is even contrite about them, but much like a certain member of the New York Yankees on a different issue is unwilling to identify these mistakes by name. Greenspan's deflation turned out to be a boogeyman. Today's is not. "Deflation in the housing market is a source of many of our present difficulties," Mankiw writes. A source that was ultimately created by the very measures now being (re)instituted to fix it. Mankiw leaves out this more recent economic history. In doing so, he perhaps answered his own question. The one about whether we have learned enough. To be sure, few economists are arguing that monetary expansion is anything other than a necessary course at this point. The dangers of the alternative are well-documented (not just with the Great Depression, either. The Japanese economy last decade provides a more recent example). But it is equally short-sighted to avoid looking at the longer term consequences of this action. Printing money is a great short-term solution, but it can be extremely dangerous, especially for governments with large current account deficits. For this reason, once the desired measures begin to take hold, the world's central banks should move to tighten monetary policy as quickly as they did to loosen it. Failure to do so could eventually lead to inflation and worse. A nightmare scenario, for sure, not one without historical precedent either. - Nathaniel Baker Categories Deal Video
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