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Our Depression Obsession

By Robert J. Samuelson
Monday, April 20, 2009

The Great Depression of the 1930s was the most momentous economic event of the 20th century. It was a proximate cause of World War II, having fed the Nazis' rise in Germany. It inspired a new American welfare system as a response to mass misery. Everywhere, it discredited unsupervised capitalism. Given today's economic crisis, our renewed fascination with the Depression is natural. But we ought not stretch the parallels too far.

The Depression was exceptional in its economic ferocity. As Liaquat Ahamed writes in his book "Lords of Finance": "During a three-year period, real GDP [gross domestic product] in the major economies fell by over 25 percent, a quarter of the adult male population was thrown out of work. . . . The economic turmoil created hardships in every corner of the globe, from the prairies of Canada to the teeming cities of Asia."

Anyone who wants to know why should read this engrossing book. Ahamed, a professional money manager, attributes the Depression to two central causes: the misguided restoration of the gold standard in the 1920s and the massive inter-governmental debts, including German reparations, resulting from World War I.

His story builds on the scholarship of economists Milton Friedman, Anna Schwartz, Charles Kindleberger, Barry Eichengreen and Peter Temin. But Ahamed excels in evoking the political and personal forces that led to disaster. His title refers to four men deeply implicated in the era's perverse policies: Montagu Norman, governor of the Bank of England; Benjamin Strong, head of the New York Federal Reserve Bank; Émile Moreau, head of the Banque de France; and Hjalmar Schacht, head of Germany's Reichsbank. Their determination to reinstate the gold standard -- seen as necessary for global prosperity -- brought ruin.

Under the gold standard, paper money was backed by gold reserves. If gold flowed into a country (normally from a trade surplus or a foreign loan), its money and credit supply were supposed to expand. If gold flowed out, money and credit were supposed to contract. During World War I, Europe's governments suspended the gold standard. They financed the war with paper money and loans from America. The appeal of restoring the gold standard was that it would instill confidence by making paper money trustworthy.

Unfortunately, the war damaged the system beyond repair. Britain, the key country, was left with only 7.5 percent of the world's gold reserves in 1925. Together, the United States and France held more than half the world's gold. The war had expanded U.S. reserves, and when France returned to gold, it did so with an undervalued exchange rate that boosted exports and gold reserves. Meanwhile, German reparations to Britain and France were massive, while those countries owed huge amounts to the United States. The global financial system was so debt-laden that it "cracked at the first pressure," writes Ahamed.

That came after a rise in American interest rates in 1928 forced other countries to follow (no one wanted to lose gold by having investors shift funds elsewhere) and ultimately led to the 1929 stock market crash. As economies weakened, debts went into default. Bank panics ensued. Credit and industrial production declined. Unemployment rose. Weakness fed on weakness.

Sadly, this tragedy has modern parallels. Like the 1930s, a worldwide credit collapse is a danger. Global stock, bond and bank markets are interwoven. Losses in one may prompt pullbacks in others. Money flowing to 28 "emerging market" countries in 2009 will drop 80 percent from 2007 levels, projects the Institute of International Finance. Currency misalignments have, as in the 1920s, distorted trade. China's renminbi is clearly undervalued.

Still, striking differences separate now from then. The biggest is that governments -- unencumbered by the gold standard -- have eased credit, propped up financial institutions and increased spending to arrest an economic free fall. The Federal Reserve and the International Monetary Fund have made loans available to emerging-market countries to offset the loss of private credit. Nor is there anything like the international rancor that followed World War I and impeded cooperation: In 1931, the French balked at rescuing Austria's biggest bank (Creditanstalt), whose failure triggered a chain reaction of European panics.

When countries left the gold standard -- the United States effectively did so in 1933 -- their economies began to recover. Some indicators now imply that the present decline is ebbing ("glimmers of hope," says President Obama). China shows similar signs of improvement. All this diminishes the dreary comparisons with the Depression. But if these omens prove false, a more somber conclusion could emerge.

The mistakes of the Depression were rooted in prevailing economic orthodoxies, which had been overtaken by new realities. The present policies likewise reflect today's orthodoxies. But what if they, too, turn out to be misguided because the world has moved on in ways that become obvious mostly in retrospect?

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