Marcus Nunes beat me to it, highlighting Christina Romer’s column in today’s New York Times, but her column today deserves all the attention and praise that it can get, and a lot more besides. Romer debunks then notion that real downturns that follow financial crises are necessarily deeper and longer-lasting than ordinary downturns, showing that the policy pessimism engendered by the notion that recoveries from recessions precipitated by financial crises are necessarily weak and drawn out, given currency by the recent book by Rogoff and Reinhart This Time Is Different, is not at all justified by the historical record.
I will just elaborate on a couple of points made by Romer. Citing the account of the Great Depression in the United States given by Milton Friedman and Anna Schwartz in their Monetary History of the United States, Romer observes:
The Friedman-Schwartz study found four distinct waves of banking panics in the early 1930s. After the first three, output plummeted. But after the last one, in early 1933, output skyrocketed, with industrial production rising nearly 60 percent from March to July. That time was very different.
What accounts for the difference? Romer explains:
[T]he policy response largely explains why output fell after the American banking panics in 1930 and 1931, but rose after the final wave in early 1933. After the first waves, the Fed did little, and President Herbert Hoover signed a big tax increase to replenish revenue. After the final wave, President Franklin D. Roosevelt abandoned the gold standard, increased the money supply and began a program of New Deal spending.
I don’t disagree with that, but I understand the process differently. It was the gold standard itself that had caused the downturn, because gold was appreciating (meaning that prices and wages were falling), causing profits to drop and business and households to stop spending. Bank failures were caused by a deflation that made it impossible for debts fixed in nominal terms to be repaid, so that the assets held by banks were becoming worthless. Bank failures were not the cause of the problem, they were a symptom of a problem — falling prices — inherent in and inseparable from the perverse dynamics of the gold standard. Once FDR abandoned the gold standard, the dollar depreciated relative to gold allowing dollar prices to start rising, the money supply increasing more or less automatically as a result.
Romer also disscusses a paper comparing the severity of the Great Depression in Spain and in the US.
Why was the Great Depression so much worse here than in Spain? According to an influential paper by Ehsan Choudhri and Levis Kochin, Spain benefited from not being on the gold standard. Its central bank was able to lend freely and increase the money supply after the panic. By contrast, in 1931, the Federal Reserve in the United States raised interest rates to defend its gold reserves and stay on the gold standard, setting off further declines in output and exacerbating the banking crisis.
It’s true that freedom from the gold standard allowed Spain to take monetary measures it could not have taken while on the gold standard, but the more important point is that by not being on the gold standard, prices in Spain did not have to fall to reflect the increasing value of gold. So the deflationary forces that suffused all the countries on the gold standard simply bypassed Spain and other countries not on the gold standard. It was not the increase in interest rates by the US that was caused the deflation in the US it was the gold standard. Raising interest rates were necessary only insofar as a country did not want to allow an export of its gold reserves.
In closing, I will just mention that the paper by Choudri and Kochin contains a diagram on p. 569 showing that Belgium experienced a rapid deflation and a big drop in industrial production in the early 1930s. In my post last week about the analysis of the Deutsche Bank comparing the euro crisis to the 1930s gold standard crisis, the diagram copied from the DB analysis seemed to indicate that Belgium did not suffer a substantial drop in real GDP. The Choudri and Kochin paper provides further reason to be skeptical about the graph in the DB analysis.