Parallels are increasingly being drawn between the Great Depression of the 1930s and the current situation. On Black Thursday, 24 October 1929, the Dow Jones index fell by 12.8%, the largest decline ever until the Black Monday crash of October 1987. By July 1932, the market had lost almost 90% of its value. Umpteen books have been written about the Great Crash, the fall that is generally regarded as having triggered the Depression.
Hopefully, the current situation will not turn out that bad. US Fed chairman Ben Bernanke, whose academic research on commercial paper uncovered credit problems which contributed to the Depression, has aggressively eased to unfreeze the credit markets, unlike the passive policies followed then.
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Also See Leading Up To The Great Crash (Graphic)
Scrutinizing that period, what is striking is the similarity in the policy dilemmas faced by the Federal Reserve System then, and 70 years later, during the dotcom boom. Much of what is known about the economy leading up to the Great Depression is from A Monetary History of the United States, 1867-1960 by Milton Friedman and Anna Jacobson Schwartz. A condensed version of their interpretation of what happened during the Depression is a chapter in the book Free to Choose, by Milton and Rose Friedman. This condensed version deals mostly with the Fed’s inadequate response to bank failures during the 1930s, not so much the period leading up to it—the Roaring Twenties—analysed at great length in their more than 800-page monetary history.
During the 1920s, the US economy grew rapidly. During that decade, the Federal Reserve Bank of New York controlled the reins of power, with the Federal Reserve Board in Washington, DC, playing a minor role. The economic success of the 1920s was generally credited to Benjamin Strong, head of the Federal Reserve Bank of New York from its inception onwards in 1914.
Personality-wise, Strong was a strong man. He began his career as a commercial banker, deeply involved in the 1907 banking crisis that led to the formation of the Federal Reserve six years later. Backed by financial leaders both inside and outside the Federal Reserve System, he had the influence to get his views accepted, and the courage to act upon them.
In failing health for some time, Strong became inactive in August 1928 and died that October. His death set off a power struggle, between the Federal Reserve Bank of New York and the Board in Washington, DC, that left monetary policy paralysed for years. Strong’s successor, then deputy governor in New York, George Harrison, a lawyer, “sought to exercise comparable leadership” (Friedman and Schwartz), but failed to do so. The ensuing inaction and bad decisions, after Strong’s demise, led to the Great Depression, in Friedman and Schwartz’s path-breaking interpretation of the events of that era.
The Federal Reserve Board, which gradually wrested power from New York, was rather removed from the ground realities of the financial markets and banks of New York. It passively stood by during the bank failures and other crises of the 1930s. (Incidentally, is there a lesson here for India’s finance ministry in its handling of capital account policies?for?the last few years?)
The concrete dilemma that the Fed faced in 1927-28 was similar to that faced by it under Alan Greenspan 70 years later, and also by the Bank of Japan in 1987-88. Should it raise rates to try to tackle the stock market bubble, or focus solely on inflation, or some possible early warning indicator of inflation, such as money or credit growth? In the Internet era, dotcom innovations were leading to new ventures and firms with potentially huge earnings, that could perhaps justify the bloated stock valuations. There were similar innovations in the 1920s based on the new automobile industry, the associated spread of instalment credit, and the diffusion of electric power.
Friedman and Schwatrz themselves took the free market purist view that a central bank should not be “an arbiter of security speculation or values” and should not have paid direct attention to the stock market boom. They argued that had the Fed consistently focused on money growth and the real economy throughout, the Depression could have been averted.
Their counterfactual money growth recommendation has been questioned by many who have studied the Depression. But their conclusion that had Benjamin Strong lived longer, he would have handled things differently and quite likely averted the Depression has been more widely accepted. Indeed, Friedman and Schwartz conceded that “a vigorous restrictive policy in early 1928 might well have ended the stock market boom without its having to be kept in effect long enough to constitute a severe drag on business in general”. In a crucial footnote to a chapter in their book, they cite economist Irving Fisher that while Strong was convalescing in 1928, this is what he felt that his colleagues should have been doing “to prevent the crash he saw coming”.
With hindsight, one can always describe a policy as either too little too late, or overkill too late. In real time anything—repeat, anything—can happen. Nevertheless, it is reasonable to infer, as for Japan during 1987-1989 and the Fed under Greenspan during 1997-99 and beyond, that the asset bubble should have been tackled pre-emptively.
Vivek Moorthy is an economics professor at IIM Bangalore. Comment at firstname.lastname@example.org