How US political cycle (elections) prevented another depression?

Peter Temin a noted economic historian from MIT writes a paper comparing this recession with great depression. Though many such papers have been written, we are going to get a lot more in future. I have pointed to a few as well.

The paper is NBER version. I couldn’t find the free version.

Temin (alongwith Barry Eichengreen) brought the role of gold standard in creating great depression. So, in this paper he uses the same analogies.

This paper discusses parallels between our current recession and the Great Depression for the intelligent general public. It stresses the role of economic models and ideas in public policy and argues that gold-standard mentality still holds sway today. The parallels are greatest in the generation of the crises, and they also illuminate the policy choices being made today. We have escaped a repeat of the Depression, but we appear to have lost the opportunity for significant financial reform.

He says if it was gold standard in 1930s which led policymakers to believe all is well, it was Washington Consensus of 1990s which led to the same belief in 1990s.

First some good quotes:

John Maynard Keynes wrote in the depths of the Great Depression that, “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”  This acute observation is applicable to our current Great Recession as well.   In fact, the newly discredited ideas are not too different from the old, suggesting that Keynes may have overestimated the ability of people to learn from their mistakes.

I discuss the parallels between these two watersheds in recent economic history in three steps. The first and most important step is the causes of the crises and their relation to economic theory. The second step is the spread of the crises as they affected the whole world. I close with the final step, recovery—at least as far as we can see it at this point. Marx said famously that history repeats itself, “the first time as tragedy, the second as farce.”   I argue that this observation also fits our current condition.

He then explains how the imbalances shaped up in both events. Early US was the net lender and Germany the net borrower fuelling imbalances and now it is China the net lender and US the borrower (see this Frieden paper for more insights on global imbalances in the two eras). What led imbalances to continue?

The housing boom flourished in recent years, nourished by the availability of  Chinese capital and the ruling economic theory of the Washington Consensus. This term indicated a set of economic policies that ranged from stable exchange rates and responsible fiscal policies to deregulation and privatization. It was an adaptation of the Gold Standard to current conditions, stipulating stable instead of fixed exchange rates to avoid the rigidities of the Gold Standard that were so harmful in the 1930s.

Other requirements spelled out the conditions assumed under the Gold Standard in the era of large governments that followed the Great Depression and the Second World War. The government should stay out of the way so that private finance and industry could prosper in this theory; competition would ensure continued growth and prosperity. Like the Gold Standard, the Washington Consensus was based on the enlightenment ideas of Hume and Smith and promulgated as a way to organize the postwar world. It was the economic component of the New World Order that the first President Bush was looking for.

Excellent stuff.

He also points to other similarities. Read the paper..

Let me come to the what was really different from other papers. What caught my eye was this interesting explanation for different policies followed in both events. There is a hypothesis the crisis was prevented from  becoming a Depression-II because of huge policy stimulus followed by the countries esp US. What changed?

Fortunately, we are now in a great recession, not a repeat of the Great Depression. We have 10 percent unemployment and unemployment insurance instead of 20 percent without a safety net. The primary reason for this divergence is the vagary of the American political cycle. Voters had to wait three years after the Great Depression began and a full year after the Fed turned a recession into a depression to vote on public policy, but voters in 2008 had this opportunity just months after the financial crisis began. The similarity between now and then is that it took a new group of leaders to change policy.

I have not read this explanation anywhere. It is so true and fascinating. Imagine if Geroge Bush had another 2 years of term left!!

However, this political cycle has its limitations as well which are quite big:

The Obama administration has many holdovers, and Obama has reappointed Bernanke as Fed Chairman, but there is no doubt that the theories underlying the policy are now different than they were in the last administration. One difference between now and then that—since this is only a recession—Obama does not have the opportunity for reform that Roosevelt did.

Roosevelt opened most banks quickly after their holiday, and he took the United States off gold a month later. He introduced the National Industrial Recovery Act (NILR) and the Agricultural Adjustment Act (AAA), pillars of the New Deal, shortly thereafter. This complex of actions signaled a clear new direction in government policy, what economists call a new policy regime. Investment rose and consumption began to recover; the long economic decline had ended.

Another excellent thought. The way current events go it would take a depression to do any meaningful financial sector reform. As crisis is nearing an end, wall street is opposing every reform under the sun. 

Reforms FDR could do:

The growth of unions was only one of the results of the New Deal, Roosevelt’s blizzard of reforms to the prostate economy. Not all of these reforms were consistent with each other, and not all of them lasted more than a few years. The enduring parts of the New Deal however changed the economy in many ways. Labor and tax reforms preserved a stable income distribution in the economic expansion that followed the Second World War. Creation of the FDA led to the expansion of the pharmaceutical industry that extended life for many people, and Social Security made the lives of older people vastly more pleasant.

Reforms to the financial system led to a half-century free of financial crises. The Federal Deposit Insurance Corporation (FDIC) freed most people from worry about the safety of their bank accounts. This insurance was complemented by bank regulation to substitute for critical investors and depositors. Commercial and investment banks were separated from each other in the Glass-Steagall Act. The Federal Reserve System was restructured to make its central office more powerful, and the Security Exchange Commission (SEC) was created to regulate financial investments. Banking became a boring industry, and more people invested safely in the stock market. There  not a lot of excitement in the financial markets, and the economy grew rapidly and consistently after the war.

He adds all this was forgotten as Americans became wealthy and financial sector just grew after dergulation. There were crisis but there were no worries as they were in developing countries.

Economists and politicians alike pushed for less regulation at home and deregulation abroad. They particularly sought to deregulate the international flow of capital and hailed the Washington Consensus as the way forward for all countries, developing and developed. They were like Irving Fisher, a great economist of the early 20th century who believed his models too much and predicted continued prosperity just before the Great Depression.

He says there are 2 lessons from all this:

The first is that the open American economy is prone to collapse every once and a while. Favorable conditions— the New Deal and a vigorous post-war expansion—can eliminate “great” economic contractions for a generation or so, but American exuberance appears to chafe under these conditions. As the memory of past economic difficulties fades, economic and political pressure for change rises to the fore. International economic imbalances are condoned until they have to be corrected, often painfully.

 The second lesson is that there are strong pressures for unregulated capitalism that only abate in the face of sharp economic downturns like the Great Depression. We avoided another Great Depression by luck—the election cycle—and skill. Marx was  correct when he argued that tragic history repeats itself as farce: we now have the oxymoronic Great Recession after all the fears of Great Depression II. Keynes was  right too; discredited economic theories—and the Gold Standard mentality—will continue to dominate the actions of even “practical” men and women. Recent policy initiativesappear to have done little to reduce the underlying risk of another financial crisis.

What a paper by Prof.  Temin. Full of insights and rich history. Economic history always has something extra to tell you.

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