Eichengreen – Hall of Mirrors

1. Introduction

There are parallels between then Great Recession of 2008-09 and the Great Depression of 1929-1933 
The “lessons” of the Great Depression shaped the response to the events of 2008-09  prevented the
worst.

After the failure of Lehman Brothers , they asserted that no additional systemically significant financial
institution would be allowed to fail and then delivered on that promise  They resisted the beggar-thy-
neighbor tariffs and controls that caused the collapse of international transactions in 1930.

Governments ramped up public spending and cut taxes, Central banks flooded financial markets with
liquidity and extended credit to one another in an unprecedented display of solidarity  Governments in
the 30s succumbed to the protectionist temptation, cut public expenditure and sought to balance budgets
when stimulus spending was needed  they failed to restore confidence in the public finances.

Central bankers  real bills doctrine  They should provide only as much credit as was required for the
legitimate needs of business  more credit when business was expanding and less when it slumped,
accentuating booms and busts  Neglecting their responsibility for financial stability, they failed to
intervene as lenders of last resort  Result: cascading bank b¡failures, starving business of credit, prices
allowed to collapse (debts unmanageable)  CBs responsible for the crisis 1930s.

1930 Failure of predecessors to cut interest rates and flood financial markets with liquidity

2008 Now a response with expansionary monetary and financial policies.

1930 Failure to stem banking panics had precipitated a financial collapse.

2008 Deal decisively with the banks.

1930 Efforts to balance budgets had worsened the earlier slump.

2008 They would apply fiscal stimulus.

1930 Collapse of international cooperation had aggravated the world’s problems.

2008 Use personal contacts and multilateral institutions to ensure that policy was adequately
coordinated this time.

Different response  Unemployment in USA peaked at 10% (2010), high but far below than in the 30s.
100s of failed banks, not 1000s. Financial dislocation widespread but the collapse of the 30s was averted.
Policy was better, the decline in output and employment, the social dislocations, and the pain and suffering
were less.

1920s Real estate boom in some regions of USA, as in the XXI in USA, Ireland and Spain. Sharp increase in
stock valuations (heady expectations of the future profitability of trendy information-technology
companies) RCA in the 20s, Apple and Google later.  Dubious practices in the banking and financial
system  Gold standard role after 1925 and euro system after 1999: amplify and transmit disturbances.
1920s: It was said the world had entered a New Era of economic stability with the Fed and independent
central banks in other countries  Great Moderation  Policymakers’ complacency by self-satisfaction
and positive reinforcement by the markets did nothing to prepare for the impending calamity.

Crises result also from contingencies no one can predict. Financial crises can arise from the unanticipated
repercussions or idiosyncratic decisions taken without full awareness of their ramifications. Policy was not
more successful at limiting financial distress, containing the rise of unemployment, and supporting a
vigorous recovery. The belief that bank failures were the key event transforming a garden-variety recession
into the Great Depression caused policy makers to mistakenly focus on commercial banks at the expense of
the shadow banking system of hedge funds, money market funds and commercial paper issues.

The Basel Accord setting capital standards for internationally active financial institutions focused on
commercial banks. Regulation generally focused on them. Deposit insurance was limited to them too.
Because the runs by retail depositors that destabilized banks in the 1930s led to creation of federal deposit
insurance, there was the belief that depositor flight was no longer a threat.

As the history of the Great Depression was the frame through which policy makers viewed events, it caused
them to overlook how profoundly the financial system had changed  it pointed real and present dangers
but overlooked others miss the consequences of letting Lehman Bros fail, which made the money funds
suffer runs by frightened shareholders  runs by large investors on the money funds’ investment-bank
parents  collapse of securitization markets. The failure to endow Treasury and the Fed with the authority
to deal with the insolvency of a nonbank financial institution was the single most important failure of the
crisis.

1932 The Reconstruction Finance Corporation, created to resolve the country’s banking problems,
similarly lacked the authority to inject capital into an insolvent financial institution  constraint relaxed
when the 1933 crisis hit and Congress passed the Emergency Banking Act.

In part this policy failure reflected officials’ concerns with moral hazard  with the idea that more rescues
would encourage more risk taking. Liquidationism the idea that failure was necessary to purge the
rottenness out of the system  may have fallen out of favor owing to its disastrous consequences in the
1930s, but in this subtler incarnation it was not entirely absent.

Policy makers were aware that any effort to endow Treasury and the Fed with additional powers would be
resisted by a Congress weary of bailouts and opposed by a Republican Party hostile to government
intervention  a full-blown banking and financial crisis would be needed, as in 1933, for the politicians to
act.

The leaders of the advances industrial countries issued their joint statement that no systematically
significant financial institution would be allowed to fail. US Congress Troubled Asset Relief Program: to
aid the banking and financial system  governments took steps to provide capital and liquidity to
distressed financial institutions with massive programs of fiscal stimulus and a financial marked flooded
with liquidity by the CB.

Post crisis recovery in the Stated was lethargic and Europe did even worse, experiencing a double-dip
recession and renewed crisis starting in 2010. Growth is slowed by the damage to the financial system,
banks hesitate to lend and households and firms restrain their spending to reduce the debt.

Governments can step up and lend, provide liquidity without risking inflation, run deficits without creating
debt problems, given the low interest rates prevailing in subdued economic conditions.
And it can keep doing so until households, banks, and firms are ready to resume business as usual. How fast
you can rise depends on how far you fall in the preceding period. The economies of the US and the world
could have done better.

The economies took a hard right turn toward austerity. Spending under the American Recovery and
Reinvestment Act peaked before heading steadily downward, and later came expiry of the Bush tax cuts for
top incomes, the end of the reduction in employee contributions to the Social Security Trust Fund  all this
took a big bite out of aggregate demand and economic growth.

In Europe the turn towards austerity was more dramatic  In Greece spending was out of control. Even the
UK, which had the flexibility, afforded by a national currency a national central bank, embarked on an
ambitious program of fiscal consolidation, cutting government spending and raising taxes.

The Fed undertook 3 rounds of quantitative easing but hesitated to ramp up those purchases further. If the
Fed was reluctant to do more, the ECB was anxious to do less  In 2010 prematurely concluded that
recovery was at hand and started phasing out its nonstandard measures. In the spring and summer of 2011
it raised interest rate twice  Anyone seeking to understand why the European economy failed to recover
and instead dipped a second time need look no further.

The longer the Fed continued to purchase mortgage-backed securities, the more the institution’s critics
complained that policy was setting the stage for another housing bubble, and ultimately another crash.

In the case of the ECB, for it to do more to support growth would just relieve the pressure on governments,
allowing excesses to persist, reforms to lag, and risk to accumulate (moral-hazard on politicians)  ECB
enforcer of fiscal consolidation and structural reform.

In the case of fiscal policy, the argument for continued stimulus was weakened by its failure to deliver
everything promised.

Academics  Their modeling mind-set pointed to government meddling as the cause of the crisis and slow
recovery alike.

Europe

 The lesson of the crisis was that a single currency and a single financial market but twenty seven
separate national bank regulators was madness

 2012 European leaders agreed to stablish this banking union but countries with strong banking systems
hesitated to delegate to a centralized authority. The crisis of democracy forecast by those anticipating the
euro’s collapse failed to materialize.

Conclusion

Policy makers should respond swiftly and forcefully to incipient financial distress but given the disruption to
financial markets, it will not be enough to prevent a serious recession. The emergency response should be
forceful but also temporary and it should be wound down when private spending recovers, to prevent
debts from spiraling out of control.

The flawed monetary, fiscal, financial and social policies that allowed the crisis to develop should be fixed
through comprehensive reforms put in place before the sense of urgency has passed.
Milton Friedman and Anna Schwartz made the case for forceful central bank action to prevent banking
crises, deflation and depression. Keynes made the case for public spending to counter depressed economic
conditions. Polanyi made the case for social and regulatory reform.

Policy makers in the USA and other countries responded quickly and forcefully to events. CB cut interest
rates and flooded financial markets with liquidity. Collapse of the monetary and financial system was
averted. Support for democracy and the market economy did not crumble  This was no Great Depression
but it was failure too  recovery was marred by slow growth and high unemployment  paradox: we
failed to anticipate and prepare for the crisis.

The long period of economic stability, the Great Moderation, encouraged investors to take an additional
risk. The longer the period of stability persists, the greater the risks.

Policy makers in the 20s and 30s were forced to take decisions on the basis of partial information about the
state of the economy; just as the Fed or Obama’s economists lacked information  the conditions were
not clear

The crisis of the 30s resulted from runs on banks that governments and cbs did too little to prevent and
whose effects they did too little to contain. This focus on the banks cause 21st century policy makers to miss
the growing importance of derivative securities and other nonbank financial claims. Federal deposit
insurance did nothing to enhance confidence in money market mutual funds, whose shareholders were
now as prone to run as bank depositors in the 30s.

Capital requirements for banks did nothing to deter excessive risk taking or provide a buffer against losses
when the risky assets were held by the offshore arms of insurance companies.

Some countries like Britain, fortunate to have been spared a banking crisis in the 1930s, were less than
alert to the need for the CB to act as a lender of last resort  they provided only limited deposit
insurance first bank run in 150 years.

Failure  Adopting the euro  Economic pain and political turmoil that would result when the only
available response was austerity.

The Europeans, as the Americans, did just enough to prevent the collapse of their monetary system and
avoid another Great Depression  The policy success allowed governments and CBs to heed the call to
return to normal policies as soon as the emergency passed. Unfortunately, the return preceded the return
to normal conditions. As governments scaled back their spending, CBs felt compelled to do more. The
policies were unconventional (weird). Inflation aversion rendered moot the idea of raising the inflation
target as a way of bringing down the cost of borrowing in this exceptional slump. Hesitation to turn
unconventional policies ven when deflation became the immediate threat  political criticism

Worry that low interest rates were encouraging investors to move into riskier assets and moral hazard (In
Europe too much CB support for the prices of government bonds and even for economic growth would
weaken the pressure on governments. Once the emergency passed, sustaining cooperation became harder.

That policymakers did just enough to prevent another Great Depression weakened the incentive to think
deeply about causes. Having avoided financial collapse, it was still possible to defend America’s banking
and financial system and Europe’s monetary union as the worst alternatives expect for all the others. As a
result, there was little discussion of executive compensation practices, in the financial sector and generally,
and their implications for financial stability. In the wake of the crisis, there was the short-lived Occupy
Movement, which questioned the merits of financialization and warned of growing inequality.

Too little was done to make the world a safer financial place. ALTHOUGH BANKS ARE NOW SUBJECT TO
MODESTLY HIGHER CAPITAL AND LIQUIDITY REQUIREMENTS, modestly is the operative word. Big banks are
required to write living wills. Averting the worst allowed money market mutual funds and insurance
companies to mobilize the lobbyists. They were able to avoid being designated as systemically important by
the Financial Stability Oversight Council.

The crisis created a sense of urgency, but not enough to overcome the problems, only to try to not sink
 Probably a new crisis in less than 80 years