Revisiting the Great Depression: The role of the welfare state in today’s economic crisis recalls the part played by the gold standard in the calamitous 1930s

February 5, 2012

Wilson Quarterly:

The Great Depression cast a dark shadow over the 20th century. It arguably led to World War II, because without the Depression, Adolf Hitler might never have come to power. It discredited unfettered capitalism—which was blamed for the collapse—and inspired the expansion of government as the essential overseer of markets. This economic catastrophe has long fascinated historians and economists, but for decades serious reflection on the Depression didn’t extend much beyond the scholarly world. It couldn’t happen again. We knew too much. There were too many economic and regulatory controls. But the Great Recession has made us wonder. Can we learn from the Depression? Are there parallels between then and now? Most ominously, could we suffer another depression? The conventional wisdom still says no. Unfortunately, the conventional wisdom might be wrong.

There is no precise definition of a depression; it’s a term of art. Generally speaking, it’s a broad economic collapse that produces high unemployment from which there is no easy and obvious escape. The crucial difference between recession and depression is that recoveries from run-of-the-mill recessions occur fairly rapidly in response to automatic market correctives and standard government policies. Businesses work off surplus inventories or repay excessive debt. Governments reduce interest rates and allow budgets to swing into deficit. A depression occurs when these mechanisms don’t work, or don’t work quickly. The pivotal question becomes: Why?

One answer is that powerful historical, social, and political changes overwhelm the normal market and policy responses. Modern depressions are not ordinary business cycles susceptible to routine remedies, because their origins lie in institutions and ideas that have been overtaken by events. But letting go of or modifying these powerful attachments is a painfully slow process, precisely because the belief in them is so strong and the alternatives are often unclear. Hence, adjustment occurs slowly, if at all. Change is resisted or delayed, or wanders down dead ends. Economies languish or decline. The Great Depression was one of those moments. We may now be in another.

There are parallels between then and now, largely unrecognized. Then, the forces suffocating economies stemmed from a jarring historical rupture: the end of the gold standard. In the late 1920s and early ’30s, countries clung to the gold standard—backing paper currencies with gold reserves—as a defense against hyperinflation. Gold was thought to be the foundation of sound money, which was deemed necessary for prosperity. Most simply, gold regulated economic activity. When gold drained out of a country, supplies of money and credit tended to shrink; when a country accumulated gold, they tended to expand. But defending the gold standard caused country after country to suffer banking runs and currency crises. These fed each other and deepened the economic collapse. By 1936, more than two dozen countries had reluctantly jettisoned gold. Once this happened, expansion generally resumed.

Something similar is happening today, with the welfare state—the social safety net of wealthy democracies—playing gold’s destructive role. In Europe, government spending is routinely 40 percent or more of national income. In the United States, it exceeds a third. Like the gold standard 80 years ago, these protections command broad support. They mediate between impersonal market forces and widely shared norms of fairness. The trouble is that many countries can no longer afford their costly welfare states. Some nations have already overborrowed; others wish to avoid that fate. Their common antidote is austerity: spending cuts, tax increases, or both. The more austerity spreads, the greater the danger it will feed on itself. What may make sense for one country is disastrous for many—just as in the 1930s.

The exhaustion of economics is another parallel between our time and the Depression. Then, as now, economists didn’t predict the crisis and weren’t able to engineer recovery. “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate,” said President Herbert Hoover’s Treasury secretary, Andrew Mellon. In the 1930s, this “liquidationist” view dominated. Let wages, stocks, and land values fall until prices are attractive, it said; recovery will occur spontaneously as businesses hire and investors invest. It didn’t work. Today’s orthodoxy is Keynesianism (after John Maynard Keynes), and governments responded to the 2007–09 financial crisis with its textbook remedies. The Federal Reserve and other central banks cut interest rates; governments ran huge budget deficits. Arguably, these measures did prevent a depression. But, contrary to expectations, they did not promote a vigorous recovery. As in the 1930s, economics has disappointed.

Of course, analogies shouldn’t be overdrawn. We’re still a long way from a second Great Depression, even if such an economic disaster is conceivable. Compared to what happened in the 1930s, the present distress—here and abroad—is tame. From 1929 to 1933, the output of the U.S. economy (gross domestic product) dropped almost 27 percent. The recent peak-to-trough GDP decline, from the fourth quarter of 2007 to the second quarter of 2009, was 5.1 percent. From 1930 to 1939, the U.S. unemployment rate averaged 14 percent; the peak rate, in 1932, was 23 percent. Rates elsewhere in the world were as bad or worse. Unemployment among industrial workers had reached 21 percent in the United Kingdom a year earlier; it hit 44 percent in Germany in 1932. The social protections we take for granted barely existed. Congress didn’t enact federal unemployment insurance until 1935.

Still, the economy’s present turmoil resembles the Great Depression more than anything since. As this is written, Europe is sinking into recession. In the United States, unemployment stayed above nine percent for 21 consecutive months, and then another seven after a short period slightly below that level. The longest previous stretch was 19 months, in the early 1980s. Against this backdrop, it’s natural to reexamine the Depression and search for parallels.

The Depression is usually dated from late 1929 to the eve of World War II. But people didn’t immediately recognize that they had entered uncharted economic waters. “Down to the last weeks of 1930, Americans could still plausibly assume that they were caught up in yet another of the routine business-cycle downswings that periodically afflicted their boom-and-bust economy,” David Kennedy writes in his 2001 Pulitzer Prize– winning history Freedom From Fear: The American People in Depression and War, 1929–1945. Unemployment, for example, reached nearly 12 percent in the recession year of 1921 and was 8.9 percent in 1930. The riddle is: What caused the Depression to defy history? Over the years, many theories have been floated and discredited.

Chief among the fallen is the stock market crash of 1929. True, it was terrifying. From October 23 to November 13, the Dow Jones Industrial Average dropped almost 40 percent, from 327 to 199. Fortunes were lost; Americans were fearful. But steep market declines, before and since, have occurred without causing a depression. The most obvious connection would be the “wealth effect.” Shareholders, being poorer, would spend less. However, very few Americans (about 2.5 percent in 1928) owned stocks. Moreover, stocks rebounded, as historian Maury Klein has noted. By March 1930, the Dow had recovered 74 percent from their December level. Stocks later fell, but that was a consequence of the Depression, not the cause…

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