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How Long Before Full Recovery? J. Bradford DeLong Professor of Economics, U.C. Berkeley Research Associate, NBER October 27, 2009

Now that the global recession is over, how long will recovery take? How long before patterns of employment and levels of capacity utilization get back to what we used to think of as “normal”? And what steps should the world’s governments take to make them normal? The instinct of central bankers—and, increasingly, governments—is to do little: to talk about balancing their budgets and about “exit strategies” from the time of very low interest rates. This is almost surely a mistake, as a look back at the Great Depression tells us. After all, the first instinct of governments and central banks faced with this gathering Depression began was to do a little as possible. Businessmen, economists, and politicians (memorably U.S. Secretary of the Treasury Andrew Mellon) expected the recession of 1929-1930 to be self-limiting. Earlier recessions had come to an end when the gap between actual and trend production was as large as in 1930. They expected workers with idle hands and capitalists with idle machines to try to undersell their still at-work peers. Prices would fall. When prices fell enough, entrepreneurs would gamble that even with slack demand production would be profitable at the new, lower wages. Production would then resume. The Federal Reserve and the Treasury thought it knew what it was doing: it was letting the private sector handle the Depression in its own fashion. It saw the private sector’s task as the “liquidation” of the American economy. And it feared that expansionary monetary policy or fiscal spending and the resulting deficits would impede the necessary privatesector process of readjustment. The “liquidationist” doctrine—that in the

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long run the Great Depression would turn out to have been good medicine for the economy, and that proponents of stimulative policies were shortsighted enemies of the public welfare—drew anguished cries of dissent from those less hindered by their theoretical blinders. the “liquidationist” view carried the day. Even governments that had unrestricted international freedom of action—like France and the United States with their massive gold reserves—tended not to pursue expansionary monetary and fiscal policies on the grounds that such would reduce investor “confidence” and hinder the process of liquidation, reallocation, and the resumption of private investment. Thus governments strained their muscles to balance their budgets—thus further depressing demand—and to reduce wages and prices—in order to restore competitiveness and balance to their economies. In Germany the Chancellor—the Prime Minister—Heinrich Bruening decreed a ten percent cut in prices, and a ten to fifteen percent cut in wages. But every step taken made matters worse. In the Great Depression, countries that worried too much about their exchange-rate did not have the luxury of even attempting to expand their economies. A government that wished to stimulate demand in the Great Depression would seek to inject credit and bring down interest rates to encourage investment, which would mean higher imports, which would reduce the value of the currency. There were exceptions that proved the rule. Scandinavian countries cast off their golden fetters at the start of the Great Depression, pursued policies of stabilizing nominal demand under the intellectual influence of the Stockholm School of economists, and did relatively well. In Japan fiscal orthodoxy and budget balance were abandoned in 1931, when Korekiyo Takahashi became Minister of Finance. Industrial production in Japan in 1936 was half again as much as it had been in 1928; in Japan the Great Depression was over by 1932. But these were unusual exceptions. As Barry Eichengreen has pointed out, it was only once countries in the Great Depression had abandoned concern

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with the values of their currencies—had cast off the golden fetters of the interwar gold standard—that the crisis was transformed into an opportunity. Policies to expand demand and production no longer required international cooperation once the gold standard framework had been abandoned. But as he has also pointed out, “liquidationism”—and fears of financial and political chaos—kept governments from beginning to fight the Depression in a serious manner for much of the 1930s. The Great Depression is the greatest case of self-inflicted economic catastrophe in the twentieth century. As Keynes wrote at its very start, in 1930, the world was “... as capable as before of affording for every one a high standard of life.... But today we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand.” Keynes feared that “the slump” that he saw in 1930 “may pass over into a depression, accompanied by a sagging price level, which might last for years with untold damage to the material wealth and to the social stability of every country alike. And he called for resolute, coordinated monetary expansion by the major industrial economies to “restore confidence in the international long-term bond market... restore [raise] prices and profits, so that in due course the wheels of the world’s commerce would go round again…” The first lesson of recovery from the Great Depression was this: the earlier you abandon the gold standard, concern for your exchange rate, “liquidationist” schools of thought that hold that the private sector must be allowed to cure itself, and worry about short-term fiscal soundness, the better. The earlier you start your national “New Deal,” the better. So far we have managed to avoid a Great Depression in the world today. But the principle reason that we have managed to avoid the Great Depression is that central banks and governments have not repeated the policies of Herbert Hoover and Andrew Mellon, of Montagu Norman and Pierre Laval of trying to balance their budgets and limiting monetary expansion. In the Great Depression, attachment to the gold standard prevents expansionary monetary policy, buying-up Treasury bonds for cash, that might have boosted demand and output. In the Greate

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Depression, attachment to the gold standard prevents the government budget deficits—fiscal policy—that might have boosted demand and output. In the Great Depression, attachment to “liquidationist” schools of thought prevents banking rescues: failures are, after all, good things—a pruning-back of speculative excess. The lesson of the Great Depression is that the earlier you start your New Deal, the better. Japan and Britain abandoned the gold standard and started their New Deals in 1931; Germany and the U.S. started their New Deals in 1933. France had not started its New Deal as of 1936. Those (plus Canada, which is so integrated into the United States so as not to have its own interwar business cycle) are the major industrial powers of the globe in the 1930s. They spread out remarkably in their speed of recovery depending on when they started their New Deals. Now, however, across the globe governments that had deliberately diverged from Great Depression-era policies two years ago are rethinking. Governments that were anxious to engage in deficit spending are now worried about long-run fiscal stability and budget balance. Governments that were eager to open up the money-supply spigots are now worried about weakness in their currencies. Governments that were open-handed in their treatment of their financial sectors are now worried about the political blowback from recovery plans that appear to have been tuned to make sure that rich and well-connected bankers “recover” earliest and most completely. It is my belief that it is a mistake. The main lesson to derive from the experience of the Great Depression is that, if it was attempted during the Great Depression—don’t do it. From this respect, the thing to note is that during the Great Depression not only did governments try to do nothing at its start, but that they—the U.S. government especially—were eager to abandon what stimulative policies they did undertake and return to financial gold-standard balanced-budget orthodoxy. The consequence was a very deep secondary depression: unemployment rose in the U.S. in 1938 back to within six points of its

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1933 high. It is for this reason that, all around the world, it is important that thoughts of reversion to normal policies—whether monetary, exchange rate, fiscal, or banking—needs to be delayed until global recovery to normal is nearly completed.

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