Fighting the depression, losing the war

May 3, 2011

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. — If bank failures and deflation frighten you, we are managing the economy in the right way, but if you worry about drops in output and investment, we’ve not made much progress.

In other words, policy makers are very good at re-fighting the Great Depression, but may have simply reallocated the damage.

A study of the interaction of credit, the economy and financial crises by economists Moritz Schularick and Alan Taylor looked at the period between 1870 and 2008, casting a shadow over the usefulness of modern activist central banking.

“The impact of financial crises was more muted in the postwar era in absolute numbers, but of comparable magnitude relative to trend,” according to the study, authored in 2009 but presented last month at a conference hosted by the Atlanta Federal Reserve.

“Measured by output declines, financial crises remain severe in the post-1945 period. The maximum decline in real investment activity was somewhat more pronounced before WW2, albeit with a sharp bounce back after 4 to 5 years.”

Schularick and Taylor looked at 14 developed economies over the 138-year period, examining the growth of bank loans, bank assets and money supply and how they compared to overall economic growth. What they found is that credit creation has become unmoored from the creation of money, allowing for an ever larger banking system.

In an earlier era that ended in 1939, money and credit jumped around a great deal, reflecting the more laissez faire attitude of the authorities, but they tended to have a reasonably stable relationship to one another. That meant difficult periods of balance sheet contraction and deflationary pressure.

After World War II, however, bank assets and loans grew strongly relative to both the economy and to money supply. This happened, most likely, because banks leveraged up, borrowing heavily to lend more heavily than their deposit base would allow. Non-banks, such as investment banks, grew even more strongly, as we know.

Under our current system, much credit is created by the financial markets, giving them a more central role in the economy’s health but also making it subject to the whims and crazes of investors. This explains the Fed’s determination to support asset prices, but it also underlines the way in which the Fed, and the rest of us, are hostage to confidence and successive bubbles.


Central bankers learned the lesson of the Great Depression, in that they eased more aggressively in the post-Depression period. That has meant that we’ve not seen the collapses in money supply and grinding deleveraging that characterized many old school recessions.

While that has arguably led to fewer failures in the financial system and has seen off long periods of deflation it actually hasn’t improved the economic impact of financial crises.

That may be unfair, partly because we don’t know how bad the modern-era crises would have been if the Fed and other central banks had not eased quickly and aggressively. After all, the more heavily financialized an economy is, presumably the worse a crisis centered in the banking system will become if no circuit breaker is applied.

That’s just where the madness of the current system becomes apparent; we ease to avoid a depression, but in doing so we fertilize the financial sector which grows so large that we are ever less able to face up to allowing it to suffer. Ultimately, as in 2008, we feel we have no choice but to apply blanket guarantees. The important point is that the financial system has not grown because it is successful, or based on demand, but because it enjoys protected and favored status.

All the while, at least based on the data, the damage to trend growth is about what it used to be. Interestingly, the data covers not just the highly banked English-speaking world, but many other economies as well, and is pretty consistent.

While the benefits of the system of insurance and Fed guarantee are questionable, some other effects are not. It has created a much larger financial sector in the U.S., as well as in the rest of the world, and this has grown alongside economic inequality. In this light it is wrong to look at growing inequality, and all it brings, and conclude that this is the result of a market system rewarding winners and punishing losers.

Increasing inequality may well be the fruit of a system of government intervention in markets, as whomever can get closest to the spigot of warm cash flowing from the government guarantees does best.

This system also, inevitably, breeds bubbles and crises which are tending to get larger and larger and which must eventually overwhelm states’ ability to underwrite them.

The fun is in guessing what the next bubble will be, but at some point that particular game will be up.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)


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Posted by Time is Short… « True Patriot Media | Report as abusive

The next great bubble could be oil. If R&D stay on track, we should see dramatic increases in battery storage capacity, solar reception and transportability.

Posted by pHenry | Report as abusive

I agree. The govt needs to but out.

Posted by zotdoc | Report as abusive

I would agree with this analysis. We have learned very little. It seems like building a stabile platform to work from has never been taught or allowed to be developed. When you have a dirivitives market and a stock market with no stability, then you have just a big shell that is vulnerable to every tap on the outside because it has no backing and a very thin layer of veneer.

Posted by fred5407 | Report as abusive

I would agree with this analysis. We have learned very little. It seems like building a stabile platform to work from has never been taught or allowed to be developed. When you have a dirivitives market and a stock market with no stability, then you have just a big shell that is vulnerable to every tap on the outside because it has no backing and a very thin layer of veneer.

Posted by fred5407 | Report as abusive

Mr. Saft : You don’t mention the GI bill. My father came back from WWII and spent several years in college where he was able to pursue a engineering degree. Actually his education was interrupted by the war and he was able to go back and resume it. This was at the government’s expense and it made it possible for people like my father – who was one of millions of men who were able to pursue higher education, get married and even have children. My sister and I were born in the early 50’s.

The GI bill changed the social structure of this country enormously. Men like my father were not born into the higher economic tier. It altered the idea that only the elite went to college.

He also moved with my mother into one of those vast new – quickly built and inexpensive homes that began to spring up all around the country. Sam Levitt didn’t quite invent the tract house. Bailey Savings and Loan in “It’s a Wonderful Life” was in the same business and that was about the same time as the GI bill but I don’t think the movie mentioned it. But notice how small the development is in that movie and the difference between it and what his father was financing prior to the war. Millions of smaller starter homes were built after the war and that’s what spurred the consumer society I grew up in and am defined by.

As I understand it – there was an enormous pool of pent up savings that was able to be drawn on after the war. WWII diverted production to the war effort. People saved what money they had and waited for better times.

The developed economies are now in a reverse trend where higher education is again becoming the preserve of the very affluent. Recent changes by the British Government reducing financial aid to students prompted the attack on Prince Charles car a few months back. And I was disgusted that he was so blaze about it. Maybe he really is a dim bulb?

There is also no vast pool of savings to draw on as you know. Now the economy seems to require that people spend what they don’t have or they have even less. And my generation is aging. The economy is counting on our enormous health care costs as we rot and die.

This is not a demographic or economic picture that is conducive to “global supremacy” or expensive and protracted warfare. The men I know in my less than affluent neighborhood are not coming back to a world of new opportunities but to one that is shrinking and all of those people seem to have major medical problems.

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