Chris Gay: Are we smarter about economics than we were 80 years ago? Yes, but …





[Chris Gay is a writer and editor living in New York.]

It's widely thought that another Great Depression is impossible these days because monetary-policy makers and other policymakers simply know more, and have better tools, than their predecessors did 80 years ago. But is that wishful thinking? What, exactly, do we know now that we didn't then, and how could knowing it prevent a depression?

Of course, there is no precise, universally accepted definition of a depression, as described here. But, as this New York Times article reports, there is a strong consensus among economists that a deep, prolonged downturn of 1930s severity is virtually impossible now because of institutional changes and intellectual advances made since then.

Some changes are simply the fruit of experience—knowing what not to do. It's hard to imagine the Fed tightening under current conditions as it did in 1929 (by letting interest rates rise) and again in 1936-37 (by raising reserve requirements). It's hard to imagine Congress raising taxes (as it did under Herbert Hoover) or passing trade-restricting measures such as the infamous Smoot-Hawley tariff (even if, as Pat Buchanan, Robert Shiller, and others contend, that had little to do with the downturn).

By contrast, today virtually everyone endorses tax cuts and stimulus measures while putting balanced budgets on the back burner. That's because the notion of government as economic stimulator is far better understood and more widely accepted today than it was in 1933. The most influential expression of the idea, John Maynard Keynes' The General Theory of Employment, Interest and Money, was not published until 1936. Regardless of where one stands on Keynesianism as a rationale for deficit spending ("Keynes was no Keynesian," says economist and former presidential adviser Allan H. Meltzer, author of an authoritative history of the Federal Reserve), Keynes' influence in this regard simply was not available in 1930....

So, we have a lot more protections in place than we did 80 years ago. But does that make another depression impossible or just a lot less likely? There is a broad consensus, from Friedman to Paul Krugman, that what caused the Great Depression was the Fed's failure to arrest the 33 percent contraction in broad money supply that occurred from 1929 to 1933. It follows, then, that the key to preventing a depression is flooding the banking system with liquidity. "Deflation is the easiest thing in the world to avoid," Friedman used to say. "You just print more money."

But maybe it's not that simple. Many would counter that the mixed results of Japan's "quantitative easing" earlier this decade refute Friedman. Economist Mark Skousen notes that the broad U.S. monetary aggregates did not shrink in real terms during the severe recessions of 1970s and early 1980s, suggesting that contractions are possible even while the Fed inflates. Others (like economist Russ Roberts and Friedman colleague Anna Schwartz) say what we have today is an insolvency problem, not a liquidity problem, and that the Fed is once again getting it wrong.

Has the FDIC really made serial bank failures a thing of the past? The number of banks taken over by the FDIC jumped to 25 in 2008, about eight times the number posted annually since the S&L crisis. Can anyone guarantee that raising coverage to $250,000 per account (until the end of 2009) will prevent a revival of Depression-era bank runs? Some economists even say U.S. adherence to what's called a "fractional reserve system"—which allows banks to have on hand funds equal to only a small percentage of what they lend out—could be enough to spark runs if, for whatever reason, there's a surge in mistrust of the banking system. (Many Austrian School economists advocate full-reserve banking as a safer alternative.) Others have argued that the FDIC, like any form of insurance, actually creates a moral hazard that encourages banks to take greater risks than they would otherwise....


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