Policy makers have learned from the mistakes of the 1930s
Nobel Prize winner Paul Krugman will shortly be in town. With Lord Richard Layard, he will be calling for more public spending and borrowing. The two have issued a ‘Manifesto for Economic Sense’. But is it?
The opening sentences make dramatic claims: ‘More than four years after the financial crisis began, the world’s major advanced economies remain deeply depressed, in a scene all too reminiscent of the 1930s. And the reason is simple: we are relying on the same ideas that governed policy in the 1930s.’
This makes for good rhetoric. No doubt the BBC will swallow it whole. Unfortunately, it is simply not true. It would be foolish to say that the world economy is booming, but it is just as wrong to claim that the world’s major advanced economies remain deeply depressed.
Output in both the United States and Germany is above the previous peak levels at the onset of the recession in 2008. Unemployment in America has fallen from a high of 10.0 per cent to 7.8 per cent in September this year. Since the trough of the recession, 4.25 million net jobs have been created. Contrary to widespread perceptions in Britain, the Americans have been shrinking the size of the state. Public sector employment has fallen by half a million. The private sector has more than filled the gap, with employment expanding by 4.75 million.
There is one massive difference in the conduct of economic policy during the 1930s and since the crash of 2008. Milton Friedman and Anna Schwartz wrote a monumental tome entitled ‘A Monetary History of the United States’. It languished unread for a number of years until Friedman sprang to fame 40 years ago. They show that throughout the Great Recession of the 1930s, the American authorities ran a contractionary monetary policy. This only served to intensify the fall in output.
This time round, we had more luck. The Chairman of the Federal Reserve, Ben Bernanke, was an academic who specialised in the economic history of the 1930s. In the terrifying autumn of 2008, neither he nor anyone else knew exactly what to do. But he knew what not to do.
Bernanke understood that there was a real risk of a dramatic cascade of bank failures. So after Lehman Brothers, no other bank was allowed to fail. He realised the catastrophic impact of tight monetary policy in the 1930s, hence quantitative easing.
So policy has been completely different this time round, and much more successful. Output in the US fell only 4 per cent, compared to the 27 per cent in the 1930s.
The world was very fortunate that the Chairman of the Fed was an economic historian and not from the academic economic mainstream. There, the bizarrely named ‘dynamic stochastic general equilibrium’ models dominate. Their policy prescriptions might very well have precipitated a repeat of the 1930s. But the calls from people like Krugman and Layard for fiscal expansion and bigger deficits, argued from the best of motives, can be just as dangerous.
As Published in City AM on Wednesday 10th October 2012