Friday, November 07, 2008

The Relevance of the Great Depression

Quite a lot of people, commenting on the current economic difficulties, have suggested that we are at risk of another Great Depression. So far as the economics of the situation are concerned, I think they are mistaken. There is, however, a different and disturbing sense in which we might be facing a parallel series of events.

According to a version of history that is widely accepted, the Great Depression occurred because of inherent flaws in laissez-faire capitalism and was successfully dealt with by the New Deal. According to a more recent and I think more nearly correct interpretation of the evidence, the Great Depression occurred because the Federal Reserve, the institution created by the government to prevent a banking panic, responded to the initial bank runs by tightening rather than loosening, making the problem worse rather than better.

More relevant to the present situation, the account I think more nearly accurate holds that the continuation of the Depression was more nearly because of the New Deal than in spite of it. A decade earlier, what looked as though it should have been the beginning of a great depression was met with no substantial government intervention and the effects were over in a year or so. This time Roosevelt intervened on a massive scale, following a similar but smaller intervention by his predecessor, and the depression was still going eight years later when the attack on Pearl Harbor pulled the U.S. into the war.

It could happen again. One can imagine a future in which President Obama, supported by Democratic majorities in both houses, engages in massive interventions in the economy following the massive interventions already under way and the result is a serious economic downturn prolonged for years, perhaps for two terms. If that happens many people--most obviously, the same people who insist that the collapse of Fannie Mae and the associated difficulties are the fault of laissez-faire and deregulation--will conclude that only massive intervention preserved us from a still worse outcome.


Jared Saltz said...

Certainly something to think about in the coming months and promised waves of changed policies--probably including larger gov't and gov't payoffs.

Because larger gov't is always the answer, right?

Anonymous said...

You're essentially giving your dad's moneterist interpretation of the proximate cause of the Depression. I think it's fair to say that Bernanke is attempting to use the moneterist playbook to avoid a catastrophe. We'll see whether it works.

I think this particular event is finally going to put to rest the debate between the Moneterist school and the Austrian school, with the result in favor of the later.

Most likely, in my opinion, the moneterist approach is going to lead to a Japanese style depression - severe and prolonged over a long period of time:

See long term nikkei chart

Maurizio said...

The Great Depression occurred because the Federal Reserve, the institution created by the government to prevent a banking panic

Couldn't bank panics also be prevented by forbidding banks from using deposit money to make loans? More in general, what do you think are the pros and cons of fractionary reserve banking?

chofland said...

OK. Now, Professor Friedman, you're just making me cry...

Anonymous said...

Great post. One thing missing in your analysis of how our current crisis is different from 1929 is how we (government) will today do anything - sell any soul and sell our progeny and future down a river of debt - merely to avoid short term economic pain.

One other point to consider that makes this crisis different: wealth is generated by human capital and knowledge (See: Romer). Unfortunately for us, this human capital is best developed within intact, strong families with large parental investment. To see what happens to an economy when families/children are not invested in, examine Africa or even cities like Detroit and New Orleans.

It's a little chilling to consider that over the last 40 years, not much investment in children and/or families has been made like in the past, and we can't kick the can down the road and avoid these consequences forever. Examine the metrics. Heck, just examine the debt the boomers have left behind to see what they think of their offspring...

In summary, the next decade of government trying to deal with this gap in human capital (in all the wrong ways, natch) will be a wild ride.

Anonymous said...

On Roosevelt prolonging the depression. I agree, but is it possible that he had to in order to avoid large scale economic deprivation, i.e. people starving to death.

There's a policy trade off between efficiency and reducing economic deprivation. Its not obvious Roosevelt got the correct (I avoid the word "efficient") trade-off in the New Deal, but we should consider it.

David Friedman said...

In response to Maurizio ... .

My general views on money can be found at:

My preferred system would be private money, probably issued by fractional reserve banks, ideally based on a commodity money.

I don't think the issue of deposit money is central. One could, after all, imagine a fractional reserve bank issuing money but not holding deposits at all, just interest bearing assets of some other sort, preferably ones whose value was closely linked to the value of the monetary commodity.

Will said...

Your last sentence reminds me of something Bryan Caplan said:

"If the bail-out happens, how will we know if it prevented disaster? If unemployment stays under 8%, proponents will say that the bail-out prevented a recession. But if unemployment hits 8% or higher, proponents will say that things would have been even worse without the bail-out. Opponents, of course, will flip things: Good conditions mean the bail-out wasn't necessary, bad conditions mean that the bail-out made things worse.

[...] Tell us how you're going to update in advance. Assume the bail-out happens. If unemployment stays below 8%, does that make you more or less confident that the bail-out prevented disaster? If unemployment rises to 8%+, does that make you more or less confident that the bail-out helped prevented disaster? If you're a good Bayesian, you must give opposite answers to these two questions."

Unfortunately, the opponents of free markets are not good Bayesians. No matter what happens in the coming eight years, free markets will be blamed. You are not the only person seeing parallels between Obama and FDR.

Mike Huben said...

I'm no expert on this subject. But it is obvious that analysis based only on US practices is silly: the rest of the world suffered from the great depression also, and pursued different policies, and recovered at different rates.

And if you want to claim that we can't know if our present interventions actually make things better or worse, then by the same standard you can't claim to know if Roosevelt's interventions made things better or worse.

Rui Yu said...

you can't rely on empirical evidence in many cases like this. this is where theory is very useful.

For FDR, you don't even need theory. Plain common sense shows that the New Deal was anti-recovery.

Bob Murphy said...

Dr. Friedman,

I swear I wrote this Townhall article before reading your blog post...

Do you agree with the Anonymous poster who said this is a good test of the Austrian versus monetarist approaches to the Great Depression? If the monetarists are right, shouldn't the recent injections of tons of base fix things?

montestruc said...

Blogger Maurizio said...
Couldn't bank panics also be prevented by forbidding banks from using deposit money to make loans?
-------end quote--

If this were made the law, for what possible reason would a banker take a deposit in either a checking or savings account? The whole point of a banker taking your money for deposit in his bank is to loan it out at interest, higher than he pays you.

You would destroy banking as an industry if you did that.

David Tomlin said...

One advantage we have over the 1930s is that Keynesianism has been tried and found wanting.

More broadly, we have behind us the entire experience - the New Deal backlash against 'capitalism', and the Reagan-Thatcher counter-backlash against statism (which in the U.S. actually began in the waning days of the Carter administration). And, I almost forgot, we have the widely acknowledged failure of the systems that claimed to offer a fundamental alternative to the market.

There is now a huge body of theory and historical interpretation, including that 'more recent' take on the Great Depression, to support the pro-market side of the debate. This time the market will at least have a trial, and an eloquent defense.

I recently read an article which suggested that economists were more opposed to the Wall Street bailout, at least in its initial form, than the general public.

Public opposition to the bailout is also encouraging. People may be disappointed in the market, but they are also distrustful of the regulators and politicians (of both parties).

On a related note, I've been doing some research on the origins of the crisis, trying to figure out how to apportion blame between state and market. One article claims, IIRC, that there has been no increase in sub-prime mortgage defaults. The rise in defaults is all due to adjustable rate mortgages, many of them on houses bought for speculation rather than residence. If true, this points to speculative excess and (possibly) de-regulation as the culprits.

David, in your price theory text you mention that one justification for assuming rational action is that errors are usually random and mostly cancel out. Speculative bubbles seem to be a case of market failure resulting from rationality breaking down over this point. Psychological factors lead to large numbers of people making errors in the same direction.

Historically bubbles usually occur in times of 'easy credit'. It's easy to see why such bubbles are more likely at such times, but there doesn't seem to be any theoretical reason why they could not occur at any time.

Anonymous said...

pushmedia wrote:
«On Roosevelt prolonging the depression. I agree, but is it possible that he had to in order to avoid large scale economic deprivation, i.e. people starving to death.»

Yeah, policies like slaughtering cattle and destroying crops to keep food prices high did wonders to keep the people fed. But sure, some welfare might have been needed, but the New Deal not only was an extension of those Hoover policies, but added long-term programs and made structural changes to government that sure weren't related to short-term relief.

By the way, not sure in what context you picked up, but usually, in an economics context, it refers to coordination and allocation of resources, not productivity.

John Sullivan said...

The Austrian model is not politically feasable at this time in history where governments have as much power as they do to rule. Why would someone (group) in power not wield what they can of it? Central banking and national currencies are monopolistic devices to be used for political purposes--to inflate as a way to avoid taxation, etc.--like they are doing now, etc.

Monetarism is a method that is more politically realistic. I don't think that Milton Freidman disputed the Austrians as much as wanted to contribute to the scholarship in a more practical manner.

The biggest problem with Monetarism is that even if it were prudently managed, from a libertarian ethical perspective, it is still grossly unliberal because it is constantly distorting what would be the true prices in a free market--which means some people who otherwise be paying higher prices are paying lower prices and vice versa.

This is caused by the pursuit of stable price levels. With free banking and commodity money, as productivity increased due to the intensification of the division of labor, prices would go down. Historically, there would be deflation instead of inflation. So, even monetarism is an inflationary strategy.

Inflation offers an advantage to the first cycles of people receiving the new money and is a tax on the masses who receive none of the money but end up paying more for goods and services later. For example, if the governemnt printed out 1 million dollars of tickets to football games and gave them away 50 people, those people would all buy the tickets before the increased demand drove up the prices for tickets. The masses of fans who received nothing will then have to pay more for tickets.

It is a mistake to think that money creation causes prices to rise evenly. They rise only where the new money is spent initially, but the multiplier effect afterwards tends to allow the money to reach into most markets.

Anonymous said...

«By the way, not sure in what context you picked up, but usually, in an economics context, it refers to coordination and allocation of resources, not productivity.»

I was referring to pushmedia's usage of the word "efficient" here.

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