The New Year opens with greater nervousness in financial markets and among policy makers than at any time since the Great Depression.
The gloom is deeper even than in the aftermath of the collapse of Lehman Brothers Holdings Inc. in 2008, a much greater calamity than anything that actually happened in 2011 (as opposed to what people feared might happen). This dark outlook stems from a state of mind we share with those who lived through the Depression era: the conviction that available policy tools are limited in their effectiveness.
The modern crisis has two parts: an inability to envisage the long-term future; and a realization that, as a consequence, there is no such thing as a safe or secure asset. This combination makes for short-termism.
The difference between now and the Lehman episode is that in 2008-2009, policy makers and average people still had faith that magic policy bullets existed to address the crisis. In particular, there was a broad consensus that contra-cyclical fiscal and monetary policy could prevent a Great Depression.
Monetary policy did help stabilize expectations in 2009, but the actions taken by the big industrial countries, in particular the U.S., have been criticized in some emerging markets -- notably Brazil and Turkey -- as a cause of inflation and asset bubbles.
In addition, the aftermath of the fiscal stimulus from the first phase of the crisis has been disappointing. President Barack Obama’s $747 billion package in 2009 was presented as a necessary step to reduce unemployment below 9 percent. Judged by that goal, it hasn’t been effective. China’s 4 trillion-yuan ($630 billion) stimulus kept growth going, but at the cost of an asset and bank bubble that is now bursting.
European nations were urged by the European Union and by other countries -- notably the U.S. -- to coordinate stimulus of their own. But that only made many of them vulnerable when the sustainability of sovereign debt was reassessed. After a succession of failed summit meetings that merely exacerbated tensions, the European Central Bank gave a new infusion of credit to banks, allowing them to buy short-term government paper, but that hasn’t stabilized expectations, either.
Policy makers face three quandaries in their efforts to pursue short-term recovery and long-term stability; each has an analogy from the Great Depression.
First, monetary policy is constrained in many countries by exchange-rate choices. By adopting a currency, the euro-area members threw away the exchange rate as a tool of policy by adopting a single currency, in the same way as did countries returning to the ties of the gold standard in the 1920s. Yet ending that commitment would lead to a revaluation of liabilities and would increase debt burdens that are already regarded as intolerable.
So both keeping to the commitment mechanism and exiting the currency are unbearably painful choices.
Second, just as in the 1930s, policy makers don’t know how to handle the fiscal issues posed by the financial crisis. Doubts about the sustainability of government debt produce sudden surges in interest rates, as risk premiums rise dramatically with perceptions that default is likely. Such increases occur not in a linear way, but with great suddenness.
For countries on the brink, a perverse logic follows. Government-debt service had, in general, become easier because of the low-interest-rate environment. But hints of new fiscal imprudence or of abandoning plans for long-term debt consolidation and reduction would drive up borrowing costs.
In those circumstances, the additional costs of debt service easily exceed any gains that might come from some measure of fiscal relaxation. So a policy of Keynesian stimulus that might make sense in the short term may produce long-run instability. The debate about Greece, for example, is intense not because of that country’s weight in the international economy, but because of concerns that its troubles could presage what will happen in Italy, which, in turn, may be a harbinger of developments in France.
Third, as in some countries during the Depression era, the ineffectiveness of policy is magnified by the consequences of banking instability and crisis. It is the interplay between sovereign-debt issues and financial-sector weakness that makes the new uncertainty about country debt so toxic. In the summer of 1931, a series of bank panics emanated from Central Europe and spread financial contagion to the U.K., then to the U.S. and France, and then to the whole world. This financial turmoil was decisive in turning a bad recession (from which the U.S. was already recovering in the spring of 1931) into the Great Depression.
But finding a way out of that spiral was very tough in the 1930s and is just as difficult now. There are no obvious macro-economic responses to financial distress. The answers, if they exist, lie in the slow and painful cleansing of balance sheets, and in designing an incentive system that compels banks to operate less dangerously and to take fewer risks. But cleaning up banks immediately makes them likely to reduce lending, and thus exacerbate the downturn.
The only area in which we are still sure we can draw applicable lessons from the Great Depression is trade policy. In the early 1930s, cascading trade-protection measures were used to combat monetary deflation.
What political process produced that reaction? The trade quotas and tariff restrictions came about as a result of log-rolling in Congress, as well as from a general demand for political action. A contemporary analysis of the process, by the political scientist E.E. Schattschneider, inspired measures that transferred responsibility for trade policy from the U.S. Congress to the president.
The modern equivalent of those lessons from trade policy would be to think about mechanisms to bring about the long-term improvement of fiscal policy making. In particular, it would be helpful to devise a system to identify potential risks to fiscal stability (such as those implied by an overextended banking and financial system). An example of such action would be the creation in the U.S. and elsewhere of an independent fiscal council similar to the one established by Sweden after its own experience of severe crises in the 1990s.
Moreover, there is a need to limit legislative pressure -- log-rolling -- for additional spending on locally important, but generally dysfunctional, projects. This would be a good first step toward narrowing the deficit and restoring confidence.
The constructive (and relatively quick) response to the Great Depression in trade policy didn’t pay off immediately. But in the long run it produced a much better policy environment.
This is the moment for European nations and the U.S. to make an analogous move to reform and rationalize the political processes that produce fiscal policy. That also is the task they are finding so difficult.
(Harold James, professor of history and international affairs at Princeton University, is the author, most recently, of “The Creation and Destruction of Value: The Globalization Cycle.” The opinions expressed are his own.)
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