Lessons from the Great Depression

I re-read this week Peter Temin's book Lessons from the Great Depression (MIT Press: 1989), which is of extraordinary relevance to our current situation. The book is a set of lectures (the Lionel Robbins Lectures) that Temin delievered in the UK in 1989, in which he lays out his views about the causes of the worldwide economic collapse of the 1930s and about the sources of the eventual recovery.

He sees the collapse stemming from continued adherence to a theory of the way in which national economies interact with each other, with an initial deflationary impulse then transmitted both internationally and amplified domestically. He argues that tentative policy steps to arrest the decline, or to spur recovery, were ineffective because these steps were seen as a part of a policy regime that was inadequate to the real conditions of the global economy. Ultimately, he argues, the recovery could not occur until, in two countries (the US and Germany, in both cases following the coming to power of "outsider" governments), the old orthodoxy was decisively replaced by what was immediately seen as a new policy regime aimed at reversing the deflationay impulses of the late 1920s and early 1930s and focused on a return to full employment.

While the particular policy regime that led, according to Temin, to the Great Depression is no longer much with us (he blames adherence to, and an attempt to restore behavior consistent with, the gold standard), this general story seems extremely plausible in our current situation. We developed, through the 1980s and 1990s (but beginning earlier) a policy regime based on a theory of financial markets emplasizing (a) rational expectations and (b) a fairly strong form of the efficient markets hypothesis. In this world, deregulation of financial markets, according to the theory, would generate increased efficiency in financial activity and would thus support expanded real economic activity. The policy regime was thus one that stressed deregulation, financial innovation without much restriction, reduced concern for lending and underwriting standards, increased financial leverage, and the use of new (and fairly opaque) instruments to manage risk.

The results have not been pretty. Taking Temin's analysis as a template, one would suggest that we need a new policy regime, one that constitutes as much of a break from the recent orthodoxy as breaking with the gold standard did in the 1930s. Temin's story [and Barry Eichengreen's exhaustive analysis of the gold standard (Golden Fetters: The Gold Standard and the Great Depression 1919 - 1939 (Oxford University Press: 1992)] makes it clear that such a break is difficult even to think of, much less to act upon.

I think we need to take the necessity of developing a new policy regime seriously. And, while there are financial regulation proposals in Congress, it may be that none of them actually constitutes a clear enough break with the "old" regime as we need. Times like this, I could wish I'd decided to specialize in financial economics all those years ago...