Event Summary by Richard C. Longworth
Barry Eichengreen, an expert on the uses and abuses of economic history, told The Chicago Council Wednesday night that a misreading of the Great Depression weakened the recovery from the Great Recession.
“We won the battle. We kept the system from collapsing,” Eichengreen said. “But we lost the war. We haven’t put in place measures to ensure that it (the Recession) will never happen again.”
Eichengreen, a prolific and much-quoted economic historian, is professor of economics and political science at the University of California at Berkeley and professor this year of American History and Institutions at Cambridge University. He appeared on The Chicago Council’s Global Economy Series to talk about his latest book, Hall of Mirrors: the Great Depression, Great Recession, and the Uses – and Misuses – of History.
As Eichengreen said, many readers will look at his book and say, “Oh no, not another book on the financial crisis.” But many previous books appeared shortly after the 2008 Crash, when the world—America and Europe especially—was coping with a baffling crisis. Now, he said, “we have enough context” to look back and see what went right and what went wrong. In particular, he said, we can see how his profession, economics, “didn’t do a better job of anticipating the crisis and responding to it.”
Or, as Queen Elizabeth II asked a gathering of British economists, “Why didn’t you see it coming?”
History, he said, explains both what went right and what went wrong.
First, what went right?
When the Recession began, Eichengreen said, policy-makers fell back on the history of the Depression, because it was all they had. All, including Federal Reserve Bank Chairman Ben Bernanke, were influenced by Chicago economist Milton Friedman, who saw shocks to the banking system as a key to the Depression.
Armed with this history, he said, the policy-makers didn’t make the same mistakes. They avoided protectionism, flooded financial markets with money, cut interests to zero, propped up banks and stimulated the economy.
It worked, Eichengreen said. Unemployment peaked at 10%, instead of the 25% reached in the Depression. “There were hundreds of failed banks—but not thousands.” In general, policy-makers dealt with the impact of the crisis “much better this time.”
So far, so good. But as Eichengreen said, “This is a happy narrative but a bit too happy.”
What went wrong?
Again, history played a role.
Policy-makers thought the Depression wouldn’t repeat itself because we’d corrected the banking weaknesses that Friedman cited, Eichengreen said, but “we were dreadfully wrong.” This is because “we studied how the Great Depression unfolded, but not why it happened.”
Instead, policy-makers focused on commercial banks and ignored the shadow banking system, including hedge funds and the proliferation of unregulated derivatives, something outside Friedman’s scope.
Because Lehman Brothers was not a commercial bank with retail depositors, it was allowed to go under—“the single biggest mistake of the crisis.”
Then, when the crisis exploded, governments and the Fed successfully kept it from turning into another Depression. But the results, he said, “were decidedly less than triumphant. I don’t think that policy-makers did as much as they could have or should have to support a vigorous recovery.”
One reason: stimulus measures, while preventing a total collapse, produced a “lethargic” recovery that undermined political support for the greater stimulus that was needed, he said. Another was the fact that, because another Depression didn’t happen, politicians and economists went back to normal policies, instead of pursuing further necessary measures.
“So there’s an irony,” Eichengreen said, “that success was the mother of failure, that our success in preventing the worst led to not having more stimulus.”
The same irony undermined reforms, he said. The government instituted sweeping reforms during the Depression—the Glass-Steagall Act, federal deposit insurance and other measures—because the earlier regime had been discredited and “the banking lobby was disenfranchised.”
This time, he said, the government saved the banks, “which was the right thing to do,” but as a consequence, “the banking lobby was able to regroup.” The result was the Dodd-Frank Act, “weak soup” compared to the Depression-era reforms.
In other words, Depression history provided a good guide to dealing with the immediate impact of the Recession, but didn’t help prepare for the next crisis. Still left undone, he said, are regulation of derivatives, control of the shadow banking system, an end to the rating agencies’ conflicts of interest, and raising banks’ capital reserves.
“If (banks) are going to be too big to fail,” he said, “we’ve got to make them too safe to fail.”
Have economists learned anything? Eichengreen said most veteran economists are retreating to their old positions. But he held out hope for students like his, who are using data to be “more responsive to what’s going on in the real world.”
Richard C. Longworth is a distinguished fellow at The Chicago Council on Global Affairs. Read more of his program summaries and recent publications or follow his blog.
Event Summary by Richard C. Longworth