A refresher on the 1930s 
The Economist Sept 18, 1998

With investors reeling and recession on the march, thoughts turn to
the Great Depression. Could it happen again? Maybe, if
governments try hard.

From a distance of more than 60 years, it should be possible to view the
1930s objectively. What went wrong, how things were handled and how
they should have been-all this ought to be understood by now, you might
think. If it were, lessons could be drawn to guide policymaking in difficult
times such as these. Unfortunately, it isn't.

The century's greatest economic minds have examined the subject without
producing anything like a consensus. Still, enough is known to refute the
folk-memory version-namely, that the Depression started with the Wall
Street crash of October 1929; that the slump persisted because
policymakers just sat there; and that it took Roosevelt's New Deal,
heralding the modern era of enlightened activism, to put things right.
Briefly, the Depression did not start with the stock market crash; 
American policymakers were not passive, they were incompetently active; 
and on balance the New Deal, far from ending the slump, most likely 
prolonged it.

At around the beginning of 1928 the Federal Reserve, worried about
financial speculation and inflated stock prices, began raising interest rates.
Industrial production turned down in the spring of 1929, and overall growth
turned negative in the summer. A recession had started. In the two months
before the Wall Street crash, industrial production fell at an annual rate of
20%. When the crash came, however, it was savage: stunning drops on
October 24th, 28th and 29th, then a rally, then another fall. By
mid-November the market had declined by a half.

Coming on top of a recession that had already begun, the crash set the
scene for a severe contraction-but not for the decade-long slump that
ensued. The key question about the Depression is why a bad downturn just
kept getting worse, year after year, not just in the United States but around
the globe.

In 1929 most of the world was on the gold standard. Allowed to work, this
system should have helped stabilise the American economy. As demand
there slowed, its imports fell, its balance of payments moved further into
surplus and under the ordinary "rules of the game" gold should have
flowed into the country, expanding the money supply and buoying the
economy. But this mechanism was deliberately shut down by the Fed,
which was still worried about the effect of easier credit on speculation. The
inflow of gold was "sterilised" by the sale of government debt, and money
grew tighter.

Double jeopardy

Abroad, meanwhile, outflows of gold had their customary effect of
reducing the money supply and curbing demand. Governments everywhere
then tried to reduce imports through tariffs, with America kicking things off
with the Smoot-Hawley act of 1930. The effort was futile: the monetary
pressure wasn't eased, and collapsing trade only added to the plight of
industry. The Fed's policy, together with Smoot-Hawley, had turned the
gold standard into a global recession machine.

There was worse to come. In 1930 American banks began failing. The Fed
let them, again not out of neglect but as a deliberate act. Its policy was to
insist on collateral before it would help out, but the kind it wanted
(commercial bills) the banks didn't have. Before the Fed was created in
1913, the banks had had their own clearing house arrangements for helping
each other resist runs; now, with those arrangements all but defunct, the
banks looked to the Fed to do the job, and nothing happened. As the crisis
of confidence spread, more banks failed, and then more. By 1933 more
than 11,000 of America's 25,000 banks had failed. As people rushed to turn
bank deposits into cash, the money supply collapsed.

So much for monetary policy. Fiscal policy was little better. Hoover
notoriously raised taxes in 1932, to help balance the budget and "restore
confidence". But history has been unfair to Hoover, who tried to get the
Fed to do more for the banks, and too generous to Roosevelt. His New
Deal delivered no substantial fiscal stimulus-Roosevelt, like Hoover,
believed in balancing the budget. On the good side, it brought in
bank-deposit insurance (a wise move, though not without problems). On the
other hand, it piled taxes on business and sought to prevent "excessive
competition". To stop prices falling, controls were brought in, alongside
other new and avowedly anti-business regulations.

In 1935 the economy was recovering-by now America was off the gold
standard and the money supply was expanding again-but unemployment
stayed up, partly because of the New Deal. In 1937-38 the economy
moved into recession again. In 1939 the jobless rate was still 17%. It was
the war, not the New Deal, that restored full employment in America.

A study of the 1930s offers rather little comfort in 1998. It shows how
much damage bad policy can do, and how fragile economies can be. The
policies of those years now seem grossly mistaken, but that was not
obvious at the time, and every age has its own flawed orthodoxies. Indeed
some rationales for bad policy in the 1930s have echoes in today's
debates-the need for fiscal austerity to "restore confidence", the "moral
hazard" argument against extending assistance to countries in financial
distress, and so on. But the best cure of all for complacency is to reflect on
the fact that banks, the crux of what went wrong in the 1930s, are still
causing mayhem 60 years on, and regulators haven't yet worked out what
to do with them.