Whenever today’s economic crisis is discussed, analogies to the Great Depression are never far away. In its latest World Economic Outlook, the IMF examines the analogy explicitly, in terms not only of the collapse of financial confidence, but also of the rapid decline in global trade and industrial activity. In general, history, rather than economic theory, seems to offer a guide to interpreting wildly surprising and inherently unpredictable events.
Almost every contemporary use of the depression analogy takes the year 1929 as a reference point. But two completely different pathologies were manifest in the Great Depression; each called for different diagnoses — and different cures.
The first, and most famous, pathology was the stock market crash of October 1929 in the US. No other country had a stock market panic of similar magnitude, in large part because no other country had experienced the euphoric run-up of stock prices that sucked large numbers of Americans, from very different backgrounds, into financial speculation.
The second pathology was decisive in turning a bad recession into the Great Depression. A series of bank panics emanated from central Europe in the summer of 1931 and spread financial contagion to Great Britain, then to the US and France, and finally around the world.
The 1929 panic has dominated all analysis of the depression for two rather peculiar reasons. First, no one has ever been able to explain satisfactorily the October 1929 market collapse in terms of a rational cause, with market participants reacting to a specific news event. So the crash presents an intellectual puzzle, with economists building their reputations on trying to find innovative accounts.
Some people conclude that markets are simply irrational. Others strain to produce complicated models, according to which investors might have been able to foresee the Depression, or ponder the likelihood of protectionist reactions in other countries to the US tariff act, though the US legislation had not yet even been finalized.
The second reason that 1929 has been popular with academic and political commentators is that it provides a clear motive for taking particular policy measures. Keynesians have been able to demonstrate that fiscal stimulus can stabilize market expectations and thus provide an overall framework of confidence. Monetarists tell an alternative but parallel story of how stable monetary growth avoids radical perturbations.
The 1929 crash had no obvious cause, but two very plausible solutions. The European banking disaster of 1931 was exactly the other way round. No academic laurels are to be won by finding innovative accounts as its cause: The collapses were the result of financial weakness in countries where bad policies produced hyper-inflation, which destroyed banks’ balance sheets. Intrinsic vulnerability made for heightened exposure to political shocks, and disputes about a Central European customs union and about war reparations were enough to topple a house of cards.
But repairing the damage was tough. Unlike 1929, there were — and are — no obvious macroeconomic answers to financial distress.
Some famous macroeconomists, including Larry Summers, the current chief economic thinker of the administration of US President Barack Obama, have tried to play down the role of financial-sector instability in causing depressions.
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