This theoretical standoff has crippled our ability to provide a comprehensive explanation for the Great Depression and thus to offer a convincing comparison between it and the current crisis. So let’s start over—let’s ask the kind of questions that are already foreclosed by the competing models. Was the Great Depression just another business cycle that the Fed screwed up because it didn’t understand the money supply? Or was it a watershed event that registered and caused momentous structural changes in the sources of economic growth? Or would more astute crisis management have saved the day?
Does the current crisis bear any resemblance to the Great Depression? Or is it just another generic business cycle that requires an unprecedented level of government intervention because the staggering amount of bad debt has compromised the entire financial system?
The short answers, in order, are No, Yes, No, Yes, No.
Here are the long answers. The underlying cause of the Great Depression was not a short-term credit contraction engineered by central bankers who, unlike Ferguson and Bernanke, had not yet had the privilege of reading Milton Friedman’s big book. The underlying cause of that economic disaster was a fundamental shift of income shares away from wages/consumption to corporate profits that produced a tidal wave of surplus capital that could not be profitably invested in goods production—and, in fact, was not invested in good production. In terms of classical, neoclassical, and supply-side theory, this shift of income shares should have produced more investment and more jobs, but it didn’t. Why not?
Look first at the new trends of the 1920s. This was the first decade in which the new consumer durables—autos, radios, refrigerators, and the like—became the driving force of economic growth as such. This was the first decade in which a measurable decline of net investment coincided with spectacular increases in nonfarm labor productivity and industrial output (roughly 60 percent for both). This was the first decade in which a relative decline of trade unions gave capital the leverage it needed to enlarge its share of revenue and national income at the expense of labor.
These three trends were the key ingredients in a recipe for disaster. At the very moment that higher private-sector wages and thus increased consumer expenditure, became the only available means to enforce the new pattern of economic growth, income shares shifted decisively away from wages toward profits. For example, 90 percent of taxpayers had less disposable income in 1929 than in 1922; meanwhile corporate profits rose 62 percent, dividends doubled, and the top 1 percent of taxpayers increased their disposable income by 63 percent. At the very moment that net investment became unnecessary to enforce increased productivity and output, income shares shifted decisively away from wages toward profits. For example, the value of fixed capital declined at the cutting edge of manufacturing—in steel and automobiles—even as productivity and output soared because capital-saving innovations reduced both capital/output ratios and the industrial labor force.
What could be done with the resulting surpluses piling up in corporate coffers? If you can increase labor productivity and industrial output without making net additions to the capital stock, what do you do with your rising profits? In other words, if you cannot invest those profits in goods production, where do you place them in the hope of a reasonable return?
The answer is simple—you place your growing surpluses in the most promising markets, in securities listed on the stock exchange, say, or in the Florida real estate boom, particularly in view of receding returns elsewhere. You also establish time deposits in commercial banks and start issuing paper in the call loan market that feeds speculative trading in securities.
At any rate that is what corporate CEOs outside the financial sector did between 1926 and 1929, to the tune of $6.6 billion. They had no place else to put their increased profits—they could not, and they did not, invest these profits in expanded productive capacity because merely maintaining and replacing the existing capital stock was enough to enlarge capacity, productivity, and output.
No wonder the stock market boomed, or rather no wonder a speculative bubble developed there. It was the single most important receptacle of the surplus capital generated by a decisive shift of income shares away from wages toward profits—and that surplus enforced rising demand for new issues of securities even after 1926. By 1929 about 70 percent of the proceeds from such IPOs were spent unproductively (that is, they were not used to invest in plant and equipment or to hire labor), according to Moody’s Investors Service.
The stock market crashed in October 1929 because the nonfinancial firms abruptly pulled their $6.6 billion out of the call loan market. They had experienced the relative decline in demand for consumer durables, particularly autos, since 1926 and knew better than the banks that the outer limit of consumer demand had already been reached. Demand for stocks, whether new issues or old, disappeared accordingly, and the banks were left holding the proverbial bag—the bag full of “distressed assets” called securities listed on the stock exchange. That is why they failed so spectacularly in the early 1930s—again, not because of a “credit contraction” engineered by a clueless Fed but because the assets they were banking on and loaning against were suddenly worthless.
The financial shock of the Crash froze credit, including the novel instrument of installment credit for consumers, and thus amplified the income effects of the shift to profits that dominated the 1920s. Consumer durables, the new driving force of economic growth as such, suffered most in the first four years after the Crash. By 19341, demand for and output of automobiles was half of the levels of 1929; industrial output and national income were similarly halved, while unemployment reached almost 20 percent.
And yet recovery was on the way, even though increased capital investment was not—even though by 1934 nonfinancial corporations could borrow from Herbert Hoover’s Reconstruction Finance Corporation at almost
interest-free rates. By 1937, industrial output and national income had regained the levels of 1929, and the volume of new auto sales exceeded that of 1929. Meanwhile, however, net investment out of profits continued to decline so that by 1939 the capital stock per worker was lower than in 1929.
How did this unprecedented recovery happen? In terms of classical, neoclassical, and supply-side theory, it couldn’t have happened—in these terms, investment out of profits must lead the way to growth by creating new jobs, thus increasing consumer expenditures and causing their feedback effects on profits and future investment. But as H. W. Arndt explained long ago in The Economic Lessons of the Nineteen-Thirties (1944), “Whereas in the past cyclical recoveries had generally been initiated by a rising demand for capital goods in response to renewed business confidence and new investment opportunities, and had only consequentially led to increased consumers’ income and demand for consumption goods, the recovery of 1933–1937 seems to have been based and fed on rising demand for consumers’ goods.”
That rising demand was a result of net contributions to consumers’ expenditures out of federal deficits and of new collective bargaining agreements, not the eradication of unemployment. In this sense, the shift of income shares away from profits toward wages, which permitted recovery was determined by government spending and enforced by labor movements.
So the underlying cause of the Great Depression was a distribution of income that, on the one hand, choked off growth in consumer durables—the industries that were the new sources of economic growth as such—and that, on the other hand, produced the tidal wave of surplus capital which produced the stock market bubble of the late 1920s. By the same token, recovery from this economic disaster registered—and caused—a momentous structural change by making demand for consumer durables the leading edge of growth.
II
So far I have asked five questions that would allow us to answer this one: Does the recent and recurring economic turmoil bear the comparisons to the Great Depression we hear every day, every hour? On my way to these questions, I noticed that mainstream economists’ explanations of the Gr
eat Depression converge on the idea that a credit contraction engineered by the hapless Fed was the underlying cause of that debacle. They converge, that is, on the explanation offered by Milton Friedman and Anna Jacobson Schwartz in 1963 in A Monetary History of the United States, 1867–1960. In this sense, the presiding spirit of contemporary thinking about our current economic plight—from Niall Ferguson to Henry Paulson and Ben Bernanke—is Friedman’s passionate faith in free markets.
I am not suggesting that there is some great irony or paradox lurking in the simple fact that a new regulatory regime resides in the programs proposed by Paulson and Bernanke. Saving the financial system is a complicated business that will produce innumerable unintended consequences. Instead, my point is that rigorous regulation, even government ownership of the commanding heights, is perfectly consistent with the development of capitalism.
Here, then, are the remainder of those five questions—the questions that are foreclosed by the theoretical consensus gathered around Friedman’s assumptions about business cycles and crisis management.
Would more astute crisis management have prevented the economic disaster of the 1930s? Does the current crisis bear any resemblance to the Great Depression? Or is it just another generic business cycle that requires an unprecedented level of government intervention because the staggering amount of bad debt has compromised the entire financial system?
The short answers to these questions are No, Yes, and No. The long answers to the first two questions appeared in Part 1. Let’s take up the last three here, always with the policy-relevant implications in view.
More astute crisis management could not have saved the day in the early 1930s, no matter how well-schooled the Fed’s governors might have been. The economic crisis was caused by long-term structural trends that, in turn, devastated financial markets (particularly the stock market) and created a credit freeze—that is, a situation in which banks were refusing to lend and businesses were afraid to borrow. The financial meltdown was, to this extent, a function of a larger economic debacle caused by a significant shift of income shares toward profits, away from wages and consumption, at the very moment that increased consumer expenditures had become the fulcrum of economic growth as such (see Part 1).
So, even when the federal government offered all manner of unprecedented assistance to the banking system, including the Reconstruction Finance Corporation of 1932, nothing moved. It took a bank holiday and the Glass-Steagall Act—which barred commercial banks from loaning against collateral whose value was determined by the stock market—to resuscitate the banks, but by then they were mere spectators on the economic recovery created by net contributions to consumer expenditures out of federal deficits.
So the current crisis does bear a strong resemblance to the Great Depression, if only because its underlying cause is a recent redistribution of income toward profits, away from wages and consumption (of which more in a moment), and because all the unprecedented assistance offered to the banking system since the sale of Bear Stearns and the bankruptcy of Lehman Brothers in September—AIG, Washington Mutual, Fannie Mae, Freddie Mac, the bailout package, the equity stake initiative, and so on—has not thawed the credit freeze. The markets, here and elsewhere, have responded accordingly, with extraordinary volatility.
The liquidation of distressed assets after the Crash of 1929 was registered in the massive deflation that halved wholesale and retail prices by 1932. This outcome is precisely what Ben Bernanke and Henry Paulson have been trying desperately to prevent since August 2007—and before them, it is precisely what Alan Greenspan was trying to prevent by skirting the issue of the “housing bubble” and placing his faith in the new credit instruments fashioned out of securitized assets derived from home mortgages. Their great fear, at the outset of the crisis, was not another Great Depression but the deflationary spiral of Japan in the 1990s, after its central bank pricked a similar housing bubble by raising interest rates and disciplining the mortgage dealers.
On the one hand, these men feared deflation because they knew it would cramp the equity loan market, drive down housing prices, slow residential construction, erode consumer confidence, disrupt consumer borrowing, and reduce consumer demand across the board. Meanwhile, the market value of the assets undergirding the new credit instruments—securitized mortgages—would have to fall, and the larger edifice of the financial system would have to shrink as the banks recalculated the “normal” ratio between assets and liabilities. In sum, Greenspan, Bernanke, and Paulson understood that economic growth driven by increasing consumer expenditures—in this instance, increasing consumer debt “secured” by home mortgages—would grind to a halt if they didn’t reinflate the bubble.
On the other hand, they feared deflation because they knew its effects on the world economy could prove disastrous. With deflation would come a dollar with greater purchasing power, to be sure, and thus lower trade and current account deficits, perhaps even a more manageable national debt. But so, too, would come lower U.S. demand for exports from China, India, and developing nations, and thus the real prospect of “decoupling”—that is, a world economy no longer held together by American demand for commodities, capital, and credit. The centrifugal forces unleashed by globalization would then have free rein; American economic leverage against the rising powers of the East would be accordingly diminished.
So Greenspan is not to be blamed for our current conditions, as every congressman and all the CNBC talking heads seem to think. Under the circumstances, which included the available intellectual—that is, theoretical—alternatives, he did pretty much what he had to, hoping all the while that the inevitable market correction would not be too severe. So have Bernanke and Paulson done their duty. There may well be corruption, fraud, stupidity, and chicanery at work in this mess, but they are much less important than the systemic forces that have brought us to the brink of another Great Depression.
The real difficulty in measuring the odds of another such disaster, and thus averting it, is that those available intellectual alternatives are now bunched on an extremely narrow spectrum of opinion—a spectrum that lights up a lot of trees but can’t see the surrounding forest. Again, everyone, including Bernanke, now seems to think, along with Milton Friedman, that the underlying cause of the Great Depression was a credit contraction that froze the financial system between 1930 and 1932. Here is how Niall Ferguson put it in Time magazine for the week of October 13, 2008: “Yet the underlying cause of the Great Depression—as Milton Friedman and Anna Jacobson Schwartz argued in their seminal book A Monetary History of the United States, 1867–1960, published in 1963—was not the stock market crash but a ‘great contraction’ of credit due to an epidemic of bank failures.”
M. Gregory Mankiw more recently joined this monetarist chorus in the New York Times, similarly suggesting that a credit contraction was the cause of that epic debacle: “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. In 1928, the Fed maneuvered to drive up interest rates. So interest-sensitive sectors like construction slowed.” Then the crash came, and “banking panics” followed—the “money supply collapsed” and credit froze as fear gripped the “hearts of depositors.” So the recovery after 1933 was a function of “monetary expansion” eased by the end of the gold standard; the “various market interventions” we know as the New Deal “weakened the recovery by impeding market forces” (New York Times 10/26/08).
By this accounting, pouring more money into the financial system (“monetary expansion”) will fix it, and when it is fixed, the larger economy will find a new equilibrium at a reflated price level. The goal is to “recapitalize” the banks so that they can resume lending to businesses at a volume that sustains demand for labor and to consumers at a volume that sustains demand for finished goods. By the terms of the $700 billion bailout package and according to new (and unprecedented) initiatives by the Fed, this recapitalization will
take three forms.
First, the Treasury will buy equity stakes in banks deemed crucial to reanimating the lifeless body of the financial system—to make this move is not to nationalize these banks by installing government as their owner but rather to provide “start-up” capital free and clear, as if Paulson were backing an IPO. Second, the Fed can buy short-term commercial paper from firms who need money to maintain inventory, pay vendors, and hire labor. This move opens the central bank’s discount window to mutual funds as well as nonfinancial firms, presumably small businesses that have neither cash reserves nor credibility with local bankers.
Third, and most importantly, the Treasury will conduct an auction through which the mortgage-related distressed assets now held by lenders are liquidated—that is, are bought by the government for more than their market value but less than their nominal value. Once those assets are “off the books,” banks will have sufficient unencumbered capital to resume loaning at volumes and rates conducive to renewed growth and equilibrium. Investor confidence will return as investment opportunities appear, so the logic runs, and new borrowing will soon follow. But because this auction can’t take place until the Treasury sorts through the books of the firms holding distressed
assets—a matter of months—the equity stake approach has become, at least for the time being, the government’s most promising means of restoring investor confidence in the integrity of the financial system.
Let us suppose, then, that Ferguson, Paulson, and Bernanke are right to assume that monetary policy is both the necessary and the sufficient condition of crisis management under present circumstances. (Bernanke now says he’s in favor of a “stimulus package,” but this is like saying he’s in favor of the sun rising tomorrow—the real question is what version of fiscal stimulus will take effect, not whether stimulus will be proposed by Congress and the president.) Let us suppose, in other words, that the recapitalization of the banks proceeds exactly according to plan and that interest rates keep falling because the Fed wants to encourage borrowing. Does the reflation and recovery of the larger economy naturally follow?
The World Turned Inside Out Page 22