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By Robert J. Samuelson
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It may be a sign of the times that a 10th-grade history teacher recently assigned the following essay topic: What caused the Great Depression, and how do economic conditions then (the 1920s) and now compare? I know because a desperate mother--a friend--called seeking some useful references for her daughter. My first reaction was: good luck. For decades, the causes of the Great Depression baffled economists. My second reaction was: lots of people may be quietly asking similar questions. So I'll attempt some answers.
The parallels between the 1920s and today are intriguing and (of course) unnerving, because the Depression was--after the Civil War--America's greatest social calamity. In 1933 joblessness hit a record 25 percent of the labor force. Indeed, unemployment remained in double digits from 1931 until 1940, when it was cured by World War II defense spending. The Great Depression was terrifying because it was so resilient.
Hardly anyone thinks it could happen again. Memory matters. Governments now respond quickly to economic weakness. Just last week the Federal Reserve lowered its key interest rate (the Fed Funds rate) by 50 basis points to 5.5 percent. That makes a full percentage point cut in the past month. Most economists think the Fed will cut more, probably to below 5 percent. Similarly, the odds that Congress will pass a major tax cut increase daily. Lower interest rates and taxes would aid a faltering economy.
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Still, the slowdown--or recession--could prove unexpectedly long or nasty. Cuts in interest rates and taxes are crude weapons. People may trim spending if they fear losing their jobs. Businesses curb investment if profits fall and idle capacity rises. Booms often end badly because people and firms--foolish or too optimistic--become overextended. They have spent or borrowed too much.
Here, parallels with the 1920s become troubling. Consider some obvious similarities:
"Then, as now, Federal Reserve policy and productivity growth [from technology] worked together to heighten optimism," writes economist Allan Meltzer of Carnegie Mellon University. The 1920s' optimism boomeranged. Stocks got overpriced. After the 1929 crash, consumer spending dropped almost 7 percent in 1930. Debt played a role, Olney says. Consumers with installment loans feared that if they defaulted, their car or refrigerator would be repossessed. So they cut other spending to maintain monthly payments.
Fortunately, some major differences also separate then from now. For one, government is bigger. This makes more room for tax cuts or spending increases. As important, the world is no longer on the gold standard. Back then, paper currencies were backed by gold reserves. As Meltzer shows in a recent paper, this gold standard was unstable. The United States and France accumulated much of the world's gold (55 percent by 1929), because exchange rates were unrealistic and trade flows were lopsided. Without ample gold, other countries couldn't easily expand their economies.
Once the Depression started, fears that countries would "go off gold" made matters worse. Countries tried to protect their gold stocks. They kept interest rates too high so that speculators wouldn't convert investments into gold. And they issued too little paper money to defeat bank runs by panicky depositors. Bank failures spiraled up; spending and global trade spiraled down. The Depression went global and fed on itself through less trade and more pessimism. Only when countries left gold (Britain in 1931, the United States in 1933 and France in 1936) did the Depression begin to abate.
Highly simplified, this is the scholarly explanation of the Depression. It emerged only after years of grinding research. The consensus seems good news. Gone is the mechanism (the gold standard) that spread the Depression around the globe. If there's not a modern counterpart, then the U.S. slump shouldn't drag down most other countries and trigger a destructive chain reaction of weaker trade, investment and confidence. Unfortunately, that's still a big "if."
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