This is Bruce Bartlett’s take on the Great Depression and Today’s Great Recession. For a comprehensive comparison go to my blog Ten Differences between the Great Recession and Today’s Great Recession.
Eighty years ago this week, the stock market crashed. Although it was more a symptom of the economy’s underlying problems than a cause of the Great Depression, it is still considered the day the worst economic crisis in American history began.
I’ve always been curious about the Great Depression. In fact, I think I decided to study economics because of it. As a child, I remember asking my father about its causes, and he told me that there wasn’t enough money for people to spend. I asked where the money went, thinking that vast amounts of currency and coin couldn’t have just disappeared. My father explained that most money is in the form of checking accounts, so when the banks failed, a lot of money did just vanish.
My father was not an economist, but somehow he had figured out an essential truth about the cause of the Great Depression that most economists didn’t know at the time. I remember my high school history teacher saying that it happened because people suddenly stopped buying cars because the market was saturated; everybody who wanted one owned one.
My college professors weren’t much more sophisticated. They talked about a lot of different things–the Smoot-Hawley tariff, the gold standard, international debts et al.–but beneath these specifics was an undercurrent of blame for capitalism itself. It was in its nature, they said, that it generated bubbles that created great hardship when they burst, as the stock market bubble of the 1920s had done in late October 1929.
The idea that capitalism caused the Great Depression was widely held among intellectuals and the general public for many decades. Indeed, there was widespread belief that capitalism bred secular stagnation; consequently, there was enormous fear that the Great Depression would simply start up again where it left off after the temporary prosperity of World War II ended with the war.
Policymakers were united in their desire to make sure this didn’t happen if humanly possible. Many postwar institutions such as the World Bank, General Agreement on Tariffs and Trade and International Monetary Fund were created to fix various problems thought to be responsible for the Great Depression. Congress even passed a law, the Employment Act of 1946, that requires the president to do everything in his power to prevent another depression.
To everyone’s great relief, the doomsayers were wrong and secular stagnation did not resume after the war. But as long as there was no satisfactory explanation for the Great Depression, the default position was to blame the private sector, which greatly handicapped conservatives in economic debates about the role of government. Those favoring a free market were at a severe disadvantage against those who said government spending and regulation were the only things standing between prosperity and another Great Depression.
Fortunately for conservatives, the greatest free market economist of all time, Milton Friedman, found an explanation for the Great Depression that let capitalism off the hook. The fundamental problem, he said, was that the Federal Reserve foolishly allowed the money supply to shrink by a third between 1929 and 1933. Since my father had already told me that the problem in the 1930s was a lack of money, Friedman’s explanation made perfect sense to me.
A sharp decline in the money supply sets in motion forces that inevitably cause an economic crisis. Because the gross domestic product (GDP)–goods and services sold times their prices–equals the money supply times its rate of turnover, which economists call velocity, then a fall in the money supply of a third is going to necessarily cause nominal GDP to fall by about a third. This will lead to both deflation–falling prices–and falling output.
The faster prices adjust, the faster the economy will turn around and resume growth. The problem is that prices are sticky–they don’t adjust quickly to changes in monetary conditions–and wages are even stickier. Getting workers to accept large pay cuts is extremely difficult, especially in heavily unionized industries.
An even bigger problem is that the Fed can’t expand the money supply by cutting interest rates because a large deflation would require a negative nominal interest rate. But no bank is ever going to lend at a negative nominal rate, so the zero-bound problem, as economists call it, is a serious barrier to reversing a deflation through monetary policy alone. Also, a deflation magnifies the real burden of debts.
By fingering the Fed’s mistakes as the root cause of the Great Depression, Friedman rescued capitalism from blame. Today, I think most economists accept this explanation, although they differ on the appropriate response to the decline in the money supply. Many conservatives still believe the government should have done nothing, or at least different things than it did, because it just made things worse. In particular, conservatives are highly critical of deficit spending during the Roosevelt administration.
Most economists do not accept the do-nothing theory. They believe that government must play an active role in stimulating growth when the economy is suffering from a large, sustained deflation. Government spending must compensate for the fall in private spending that results from a deflation–people and businesses will put off buying when they think prices will be lower in the future. Only when spending is again rising will monetary policy become effective; until then it is like pushing on a string to get money circulating and prices rising again.
In the 1930s, there were a number of economists who argued strenuously for a do-nothing policy. But as the Great Depression dragged on and collapsed in 1937–when conservatives were successful in having the federal government slash the budget deficit (it fell from 5.5% of GDP in 1936 to 0% in 1938)–they lost credibility. Economists today generally believe that it was the unprecedented deficits resulting from World War II that actually ended the Great Depression.
Fortunately for policymakers, every postwar recession until this one occurred under inflationary conditions. This made the readjustment vastly easier because real wages could be cut just by reducing their growth rate to less than the inflation rate; real interest rates could easily be pushed to a negative level if necessary; and Fed policy was always effective.
Unfortunately, the current crisis is caused by the same deflationary forces that caused the Great Depression. Monetarists dismiss this argument on the grounds that the money supply has not only not fallen, but in fact has risen sharply. At the end of September, the money supply (M2) was up by $523 billion over a year earlier–a substantial increase. For this reason, they dismiss the idea that government stimulus was necessary to get the economy moving again.
What my monetarist friends forget is that that the money supply impacts GDP through the velocity multiplier. Normally, it is around 1.9. But it fell to 1.86 in the third quarter of 2008, 1.76 in the fourth quarter, 1.7 in the first quarter of 2009 and 1.69 in the second quarter before rising a bit to 1.72 in the third quarter.
This may not sound like much, but a decline of 10% in the velocity ratio has exactly the same macroeconomic effect as a 10% decline in the money supply. If velocity were still at 1.9, third-quarter GDP would have been $15.8 trillion instead of $14.3 trillion. In other words, there would be no recession.
Getting velocity to rise presents policymakers with the same problem they had in the 1930s and requires the same solution: Government spending has to compensate for the falloff in private spending, which should be $1.5 trillion higher based on M2 of $8.3 trillion at the end of September.
The main differences between today’s crisis and the Great Depression is that the deflationary pressure is less than a third of what it was in the 1930s and policymakers today reacted much more swiftly and more appropriately than they did after 1929. Those who think the government should have done nothing risked turning the current downturn into another Great Depression. Thankfully, their advice was ignored.
Bruce Bartlett is a former Treasury Department economist and the author of Reaganomics: Supply-Side Economics in Actionand Impostor: How George W. Bush Bankrupted America and Betrayed the Reagan Legacy. Bruce Bartlett’s new book is:The New American Economy: The Failure of Reaganomics and a New Way Forward. He writes a weekly column for Forbes.com.