Lessons from Great Depressions of 20th Century and Keynes dictum turned on its head

We usually associate Great Depression with the huge recession in 1930s. The initial research focused on GD in US which was then expanded to other economies as well (See Bernanke’s paper for a review).

I just found that there were GDs in other economies and Tim Kehoe and Ed Prescott have done a project on the same. All the experiences have been complied in this book which should be a superb read.

Kehoe and Gonzalo Fernández de Córdoba have put up a small paper on lessons learnt. Findings:

In the book  Federeal Reserve Bank of Minneapolis, Kehoe and Prescott, together with a team of 24 economists from all over the world, have studied the great depressions that occurred in North America and Western Europe in the 1930s, those that occurred in Latin America in the 1980s, and isolated Great Depressions of the Twentieth Century, published in 2007 by the Federal experiences in other places and times. What lessons can be learned from comparing and contrasting these historical experiences?

They find that a large drop in productivity always plays a large role in accounting for the depression. In some depressions, such as the U.S. depression of the 1930s, large drops in labor inputs also play important roles. In others, such as the Mexican depression of the 1980s, the drop in productivity accounts for almost the entire drop in output.

Looking at the historical evidence, Kehoeand Prescott conclude that bad government policies are responsible for causing great depressions. In particular, they hypothesize that, while different sorts of shocks can lead to ordinary business cycle downturns, overreaction by the government can prolong and deepen the downturn, turning it into a depression.

Prescott co-wrote the paper on Japan which I covered here which helped me understand the depth of the crisis in Japan. The main reason for Japan’s slump was not the fin system, monetary system etc but decline in productivity.

As far as govt policies are concerned the authors cite experiences of 4 economies in 2 time periods. Mexico and Chile in 1980s and Finland and Japan in 1990s. Mexico and Japan messed up with their interventions but Finland and Chile got their acts together and in a better fashion.

So what are the lessons for this crisis:

Now it is the countries of North America and Western Europe that find themselves in a financial crisis. To emerge from the crisis as did Chile and Finland, and not become trapped in stagnation as did Mexico and Japan, we need to avoid implementing policies that stifle productivity by providing bad incentives to the private sector. With banks and other financial institutions in crisis, the government needs to focus on providing liquidity so that banks can provide credit at market interest rates, and using the market mechanism, to productive firms. Unproductive firms need to die. This is as true for the automobile industry as it is for the banking system. Bailouts and other financial efforts to keep unproductive firms in operation depress productivity. These firms absorb labor and capital that are better used by productive firms. The market makes better decisions than does the government on which firms should survive and which should die.

Read the examples the authors cite. Superb.

Finally, the authors say:

Those who try to justify the sorts of Keynesian policies implemented by the Mexican government in the 1980s and the Japanese government in the 1990s often quote Keynes’s dictum from  A Tract on Monetary Reform : “The long run is a misleading guide to current affairs. In the long run we are all dead.” Studying past great depressions turns this dictum on its head: “If we do not consider the consequences of policy for productivity, in the long run we could all be in a great depression.”

 

 

 

Governemnts please note. Unfortunately, these lessons are best being ignored. The policymakers themseleves have been asseting that same firms that got us into trouble are getting taxpayers’ monies. Again ignorance of economic history has serious consequences.  

One Response to “Lessons from Great Depressions of 20th Century and Keynes dictum turned on its head”

  1. Lessons from New Deal « Mostly Economics Says:

    […] supposed to ease recession should not distort market incentives. This was a lesson from works of Prescott et al as […]

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