January 9, 2015 10:57 am
What not to do in a crisis
Ferdinando Giugliano
How we avoided Depression-era errors — and then relaxed too soon
Hall of Mirrors: The Great Depression, the Great Recession, and the Uses — and Misuses — of History, by Barry Eichengreen, OUP, RRP£20/ $29.95, 520 pages
Ever since the business cycle replaced the seasons as the prime driver of economic life, mankind has learnt to adapt to the inevitability of booms and busts. Yet, just as our farming ancestors struggled to cope with extreme weather, large-scale financial crises have repeatedly caught industrial and postindustrial societies off guard. Policy makers have had to dig deep into the past for lessons as they sought to contain bank runs and fight soaring unemployment.
The Great Recession has been no exception. After the largely benign economic fluctuations of the 1990s and early 2000s, central bankers were stunned by the financial crisis that struck in 2007-08.
Their immediate instinct was to look back 80 years, to the upheavals of the Great Depression.
In Hall of Mirrors, Barry Eichengreen, a professor of economics at the University of California, Berkeley, argues that knowledge of what happened in the 1930s has been a mixed blessing for today’s policy makers. Hindsight allowed politicians and central bankers to avoid many of the errors made by their predecessors, sparing the world a more dramatic crisis. But Eichengreen also believes that the success of the initial response meant the reform effort stopped halfway. This has left the west vulnerable to a new financial shock.
As a leading scholar of the Great Depression and one of the deftest commentators on the current crisis, Eichengreen is perfectly placed to compare the two slumps. The book is rich with anecdotes — including portraits of the financiers who twice helped to bring the US banking system to its knees — that make it highly readable.
Yet the author’s main interest is policy, which, as he rightly argues, is what transformed the crunch of the 1930s into a catastrophe. Central bankers across the world fetishised the gold standard, the system of fixed convertibility between currencies and gold that had for decades dominated the international monetary system. To preserve what was widely seen as an anchor of stability, most monetary authorities chose to raise interest rates during the crisis, worsening the slump.
It did not have to be that way. By abandoning its peg to gold early, in 1931, the UK suffered a milder crisis than many other countries. Japan’s decision to follow suit under finance minister Korekiyo Takahashi prompted a turbocharged recovery.
Hall of Mirrors has few kind words for Herbert Hoover, the US president at the time. “Hoover . . . may have understood what needed to be done, but this didn’t mean he wanted government to do it,” Eichengreen writes. Facing a banking crisis, the US president was deeply reluctant to involve the Federal Reserve. Instead, he sought to address the panic asking lenders to contribute to a voluntary pool of money that would be used to give breathing space to banks in trouble. But since the problem was one of insolvency as much as liquidity, several bankers were reluctant to intervene. Hoover’s National Credit Corporation made only $10m of loans between its creation in October 1931 and the end of the year.
Output only contracted for a year before rebounding sharply. Financial markets suffered but the cumulative percentage losses to US stockholders were significantly smaller than in the 1930s. The difference between the two crises, Eichengreen contends, had little to do with international co-ordination. He is rather sceptical about the then much-trumpeted London summit of the Group of 20 leading nations in 2009, when Gordon Brown, host and UK prime minister, announced a $1tn stimulus to reflate the global economy. As Hall of Mirrors convincingly argues, the increase in spending was poorly structured, with countries that had the ability to spend more, such as Germany, contributing less than they should have done. The real explanation lay in the behaviour of central bankers. In particular, the US Federal Reserve, under the stewardship of Ben Bernanke, a scholar of the Great Depression, stood ready to provide ample liquidity to the US and global financial systems. Eichengreen is right in arguing that the Fed could have scaled up its quantitative easing programme more quickly, which would have helped the US secure a faster recovery.
But the Fed did in the end commit to buy securities on an unlimited scale — via its third round of QE. The timidity of the European Central Bank, which has only recently launched an asset-purchase programme in spite of sharply declining inflation, casts the actions of the modern-day Fed in a much more favourable light. The prompt policy reaction of the 2000s, however, has had its drawbacks. This is, perhaps, the most important lesson Hall of Mirrors has to offer. The more painful plunge of the 1930s produced radical reforms, for example in the banking system, including the 1933 Glass-Steagall Act in the US, forcing the separation of commercial banking from the more hazardous investment banking. As the book correctly argues, the reform legacy of the current crisis is significantly weaker: megabanks continue to dominate the financial landscape, and neither the 2010 Dodd-Frank Act in the US nor the recommendations included in the EU’s Liikanen report of 2012 have enough teeth to ensure that the financial system is safe.
Hall of Mirrors has its shortcomings. While it includes three chapters near the end on the eurozone debt crisis, its focus remains largely on the US. This is a shame, as policy blunders in Europe were significantly worse than those on the other side of the Atlantic. The author is adamant that introducing the euro was a step too far and that the structural changes introduced since the crises, including a banking union, are insufficient. “The task of completing Europe’s monetary house continued to resemble the home renovation project that never ends,” he writes. But Eichengreen shies away from the important question of whether it would be best for Europe to bring its single currency dream to an end in the absence of deeper reforms.
Nor are the long-term consequences of the eurozone’s — and to some extent US’s — inadequate response to the crisis spelt out in sufficient detail. As Alexander Field, an economic historian at Santa Clara University, California, has shown, one of the main boons of Roosevelt’s programme of public investment was boosting productivity growth in the US. The failure by the eurozone’s lawmakers to match this effort means the currency union is giving up a unique opportunity to make its economy more efficient in the long run.
However, these faults are minor when set against the ambition and thoroughness of this impressive work. Hall of Mirrors is destined to change the way we think about both the Great Depression and the Great Recession. Commentators and scholars will debate its thesis for many years to come.
Ferdinando Giugliano is the FT’s economics correspondent Photograph: Getty Images
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