October 25, 2008

Learning from the Great Depression

N. Gregory Mankiw, the economics professor from Harvard, writes in the New York Times about the lessons learned by economists since the Great Depression. He takes issue with overconfident rhetoric from IMF's chief economist, Olivier Blanchard.

Like most economists, those at the International Monetary Fund are lowering their growth forecasts. The financial turmoil gripping Wall Street will probably spill over onto every other street in America. Most likely, current job losses are only the tip of an ugly iceberg.

But when Olivier Blanchard, the I.M.F.’s chief economist, was asked about the possibility of the world sinking into another Great Depression, he reassuringly replied that the chance was “nearly nil.” He added, “We’ve learned a few things in 80 years.

Yes, we have. But have we learned what caused the Depression of the 1930s? Most important, have we learned enough to avoid doing the same thing again?

The Depression began, to a large extent, as a garden-variety downturn. The 1920s were a boom decade, and as it came to a close the Federal Reserve tried to rein in what might have been called the irrational exuberance of the era.

So professor Mankiw clearly recognizes the significance of the prior excess. He then goes on to discuss the effects of the stock market crash.

But things took a bad turn after the crash of October 1929. Lower stock prices made households poorer and discouraged consumer spending, which then made up three-quarters of the economy. (Today it’s about two-thirds.)

Here Professor Mankiw is putting the carriage way ahead of the horse. The fact that the economy was almost completely built on consumption is clearly the primary cause of the depression, just as it is now. Such "hollowness" of the economy was the reason for the market implosion, not vice versa.

Is Professor Mankiw really trying to say that if only consumption could have been kept going, a downturn would have never come? Have we really learned so very little in those 80 years?

But such an assumption is partially correct. The consumption could have continued in a less diminished form, only not without a massive recognition of losses for those that had amassed huge savings in the form of debt receivables during the previous decade or two. Those savings were mostly imaginary. The "wealth" that was supposed to be so great in the roaring twenties was mainly a mirage. It was not backed up by actual assets, just a whole lot of credit.

But there was actual wealth, even though it was not up to the level of credit in the banking system. People can't eat credit. There was real production. Real buildings were built.

What resulted in losses to the real economy was the panicky scramble by the owners of the financial system to realize as much as possible of their inherently imaginary wealth. This resulted in factory closures, cuts to production and overall liquidations of everything in sight.

But preserving the imaginary value of the financial system in general was impossible. The value just wasn't there. Even if a few early birds might have salvaged an out-sized piece of the pie, liquidations of productive assets made the overall situation catastrophic, and actually reduced the pool of real wealth in existence.

The only way to prevent such a panic of liquidations is an abrupt and early recognition of the true base of value in the economy, combined with equitable distribution of losses to holders of imaginary wealth. This much is clearly understood by professor Mankiw.

Probably the most important source of recovery after 1933 was monetary expansion, eased by President Franklin D. Roosevelt’s decision to abandon the gold standard and devalue the dollar. From 1933 to 1937, the money supply rose, stopping the deflation. Production in the economy grew about 10 percent a year, three times its normal rate.

It is nice to see that Professor Mankiw recognizes the value of giving up on the gold standard. After all, the standard was effectively given up much earlier by letting the financial system grow so far ahead of its reserves.

Monetary stimulus can not be trusted to perform the delivery of losses in an equitable way. It hurts savers in actual assets and favours the owners of imaginary wealth in the financial system. Monetary stimulus must be accompanied by distribution of losses to all levels of the financial system, including depositors and other creditors. Professor Mankiw kind of admits this in a later paragraph.

The Fed and the Treasury Department, intent on avoiding the early policy inaction that let the Depression unfold, have been working hard to keep credit flowing. But the financial situation they face is, arguably, more difficult than that of the 1930s. 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.

The comment about 1930's not being mostly about shortage of solvency is quite frankly puzzling.

It must be recognized that the free market does not much help us here. In a free market of rational people, there will be a completely rational panic in a widespread insolvency situation. This puts us in a prisoner's dilemma situation where the common good is seriously neglected by individuals acting out of rational self-preservation. If we are additionally ready to accept, as the economic theory of late has been very loath to do, that people in general are not very rational, or have no access to the necessary information for rational decision-making, we can assume that there will be complete carnage.

An equitable distribution of losses, as a necessary but inherently repulsive proposition, requires some kind of coordination. This includes taking bad banks out of business as early as possible, instead of letting them pile on the losses.

But human nature is not very well suited for early recognition of losses, even if that would be rational. Overall deposit guarantees has been the unfortunate (and very late) first reaction from governments in Europe. It just makes the situation worse and further delays the recognition of the differences in the values of the financial system and the real economy.

Instead of guaranteeing all deposits, there should be a way to rearrange all bank liabilities, including deposits, into new equity, while the old equity would be wiped out.

Deposits above a suitable threshold, which could be quite high, should be converted to new equity in a bank failure. This would directly address the solvency issues without causing a need for fire-sale disposition of the assets of the failed bank. This would also be useful for keeping bank management in a healthy state of fear: "Do your job properly, or face a mob of angry ex-depositors in the next general meeting of shareholders."

A solution to too much credit is not more credit. It is conversion of credit to equity and realizing losses from imaginary wealth.

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