The Great Depression from the Perspective of Today, and Today from the Perspective of the Great Depression

The past six years have seen an interesting dual shift in economics and economic history. Six years ago economists were a highly confident, aggressive, and arrogant bunch. We believed that we understood how modern market economies worked. We believed that we knew how to keep them running with both low and stable inflation and at fairly high levels of prosperity, relative to their technological productive potential.

It happened--as it had always happened whenever economics had thought that they had it figured out--we were wrong.

We were wrong, as we have discovered over the past six years as people attempted to do economic policy, that we had misjudged how to reliably keep economies running at a high level of prosperity. And we had misjudged how to reliably keep economies running at a high level of prosperity because we had misjudged what the Great Depression was. The fact that we had a faulty vision of the Great Depression was a cause of the policy errors and macroeconomic disaster of our day, and the fact that following the policy course that we did did not cure the problems of today has led us to revise our view of the Great Depression. Thus we were doubly wrong, but now--we hope--we have it right.

Our demonstrated wrongness means that a substantial amount of what economists like me were teaching, both about the structure of the economy today and about the Great Depression, was wrong. A consequence of the past six years is that we economists need to rip up a substantial part of our lecture notes--both the modern macro lectures on proper policy during business cycles, and also our economic history lectures about the Great Depression.

Six years ago we economists saw the Great Depression as something the Federal Reserve system could, should, and ought to have stopped dead in its tracks at its beginning. But, we would have said six years ago, the Federal Reserve did not understand the situation, and so it did not act properly. But, we would have said years ago, we today know better. Thus, we would have said six years ago, if anything even remotely Great Depression-like comes down the tracks, we can stop it did. You do not need to worry that we will once again, as in The Great Depression, find ourselves in an economy that is not just depressed but profoundly depressed, and depressed not for a year or two but for more than five--and perhaps more than ten.

That was the subtext of one of the large discussions carried on at the Federal Reserve Bank of Kansas City's August 2005 Jackson Hole Conference. Raghuram Rajan--who has just been named the governor of The Bank of India, India’s central bank--argued that recent changes in financial deregulation had created a situation in which there were too many many cowboys on Wall Street doing too many things and creating too many risks. The general response--from Ben Bernanke and Alan Greenspan, from Arminio Fraga and Larry Summers, and from many many others, from practically everyone speaking to the group in the room save Alan Blinder--was: yes, there are cowboys, and the cowboys will lose money, but their actions will not cause any large-scale damage to the economy. Why not? Because we know well how to build firewalls between financial crises on Wall Street and the real economy of spending on currently-produced goods and services, production, and employment.

Because we know well how to build such firewalls, the near-consensus was, even if the systemically-important financial institutions have lost all control over their derivatives books and taken on immense risks they do not understand, there is no danger to the economy as a whole. Moreover, the argument was, there is value in letting the cowboys continue to do their thing. They might find some interesting business models. They will bear risk--and the world economy as a whole is short of risk-bearing capacity in normal times. Their willingness to bear risk might help accelerate technological progress: the dot-com bubble was a disaster for late-stage investors in venture capital and dot-com equities, but a boon for the rest of us as ten years' of experimentation and investment in high-tech was compressed into three.

Big mistake. Big misjudgment.

by Brad DeLong, Longform |  Read more:

Image: Wikipedia