Thursday, February 25, 2016

Economy: Even Economic Crises Are *Getting Better* Over The Time

(Drivebycuriosity) - Many commentators compare the current soft spot of the US economy with the  crisis of 2008 or even with the Great Depression of the 1930s. Bloomberg commentator Justin Fox even sees a similarity with the 15th century - the bullion famine (bloomberg).

What can we learn from these comparisons?  I notice that these crises were worse the earlier they happened in history. 2008 was bad, but the depression of the 1930 was much worse. And the crises in the 19th century were even worse than the 1930 depression.

The historican John Steele Gordon describes in his economic history of America ("An Empire Of Wealth - Rise Of The American Economy" amazon) the frequent and severe crises of the 19th century. They were started by recurrent crashes of banks, railroads and other companies which caused a panic leading to a depression: "Seller´s panic produce, by their nature, a sudden surge in demand for money as investors and depositors seek liquidity, and money, of course, is the ultimate liquid asset. Because there was no central bank empowered to regulate the money supply and to provide the liquidity needed to protect the banking system in times of stress, however, these sellers`panics greatly exacerbated the downward swings of the business cycle. Basically sound institutions collapsed by the hundreds when they were unable to meet the sudden demand for money. Often they took the life savings of families and the liquid assets of businesses with them".

One of these frequent depressions began in early 1893: "By the end of the year some fifteen thousand companies had failed, along with 491 banks. The gross national product fell by 12%, and unemployment rose rapidly from a mere 3% in 1892 to 18.4% two years later", reports Gordon. The recession 2008, as bad as it was, was not comparable with this event or the 1930s depression.

The observation that crises got worse the farther you go into the past implies reversely (e contrario) that crises are getting less severe the later in history they occur. The 19th century crises were less apocalyptic then the famine of the 15th century. The Great Depression, as bad as it was, was not as catastrophic as the 1893 crisis. And the 2008 recession was by far not as desastrious as the Great Depression of the 1930s and the crisis of the 19th century.

                                                          Rookie Mistakes

I think this is a result of a general learning process. People are able to learn from their mistakes and they try to get better, that includes politicians, public institutions, banks and other corporations. In 1913 the US government finally had learned from the 19th century crisis and created the Federal Reserve System, the central bank. This institution was founded to stabilize the money supply and to supply liquidity in a bank panic. But the Fed was young, inexperienced and made rookie mistakes. 

In the year 1931 the Federal Reserve moved aggressively to defend the dollar and maintain the gold standard as foreign banks and investors moved to repatriate gold, writes Gordon: "It was an utterly disastrous decision, perhaps the greatest of all mistakes made in these years..Maintaining the gold standard required raising interest rates and cutting the money supply, causing an already severe deflation to become much more severe." Banks called loans to stay liquid, while customers postponed purchases in expectation of lower prices.

Milton Friedman and his colleague Anna Schwartz described in their book "A Monetary History of the United States, 1867–1960" , that The Great Depression could have been avoided if the Fed had not so badly botched its monetary policy (  "Fed’s failure to carry out its assigned role as the lender of last resort. Rather than providing liquidity through loans, the Fed just watched as banks dropped like flies, seemingly oblivious to the effect this would have on the money supply. The Fed could have offset the decrease created by bank failures by engaging in bond purchases, but it did not".

As a result "from 1929 to 1933 the money supply fell by 27 percent—for every $3 in circulation in 1929 (whether in currency or deposits), only $2 was left in 1933. Such a drastic fall in the money supply inevitably led to a massive decrease in aggregate demand. People’s savings were wiped out so their natural response was to save more to compensate, leading to plummeting consumption spending" (

And the US government made more fatal mistakes too (

1) In response to a sharp decrease in tax revenues in 1930 and 1931 (caused by a slowdown of economic activities), the US government passed the largest peacetime tax increase in the history of the United States, which clearly applied the brakes on any recovery that could have taken place;

2) the US government also passed the Smoot-Hawley Tariff Act in 1930, substantially increasing tariffs and leading to retaliatory restrictions by trading partners, which resulted in a considerable decrease in demand for U.S. exports and a further slowdown in production (not to mention a loss of mutually advantageous division of labor).

                                                           Learning Process

The time since World War II shows that the Fed and other institutions had learned from the Great Depression. For instance the stock market crash from 1987 (Black Monday) - a drop of 22% over night - didn´t start a recession, because the Fed responded swiftly and "encouraged banks to continue to lend to one another on their usual terms" (federalreserve). The US economy grew 3.6% in 1987 and advanced 4.2% in 1988 in spite of the stock market turmoils. The 2008 crisis didn´t turn into a fully fledged depression in the 1930s style thanks to the Federal Reserve and other central banks who cut interest rates close to zero and flooded the markets with money (QE).

I expect that we will have another recession some day. But I believe that the next downturn will be less severe than the recession from 2008 because the Fed and other central banks have already learned from the 2008 crises. They have been refining and advancing their instruments (like negative interest rates, assets purchases) further and are better suited to response to a banking crises. The regulators are learning too. New laws (in the US the Dodd-Frank Act wikipedia) require the banks to hold more capital to collateralize their loans and they have to pass stress tests. Recessions are possible, they belong to a business cycle, depressions are highly unlikely. Everything is getting better over time - even the crises.

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