What Caused the Economic Crisis

Simon Heffer, who writes a mordantly right wing column for the London Daily Telegraph recently wrote that we all know what caused the economic crisis. Perhaps he does, though he did not actually tell his readers what the cause was. I am altogether sure that I do not. I am struck by how little our understanding of a crisis has improved since the years of the Great Depression of the 1930s. In those days, a major economic literature was created, followed by an historic revision in the years after the Second World War, but no consensus emerged, either on the causation or on the appropriate policy responses.

Of the contemporaries we have Irving Fisher, Maynard Keynes, Friedrich von Hayek, Joseph Schumpeter and a group of less well known figures, including the disciples of Keynes, such as Roy Harrod, who became his first biographer. The post war writers include J.K. Galbraith and Milton Friedman. These are among the distinguished economic theorists of the twentieth century. The explanations and policy proposals include Fisher’s Debt Deflation theory, Schumpeter’s theory of “creative destruction”, Hayek’s theory of the cycle of expansion and decline – written in 1927, Keynes’s General Theory, published in 1936, monetarist and psychological explanations, pro-gold and anti-gold, pro- and anti- inflation and deflation. The statesmen who took the decisions at the time include Herbert Hoover, who did better than the myth of his inadequacy, Roosevelt, who was an inflationist, but probably at the right moment, Neville Chamberlain in the U.K., and the combination of Hjalmar Schacht and Adolf Hitler in Germany. Roosevelt believed in large scale Government intervention for infrastructure projects, Chamberlain believed in low interest rates and Government economy, Hitler believed in trade autarky and massive rearmament; there was even Pierre Laval in France and Benito Mussolini in Italy, both of whom could politely be described as pragmatists. If one had to award prizes for success in restoring growth to national g.d.p. one would have to award the top prizes to Schacht, for successful manipulation of the Central Bank role, and, however distasteful if may be, to Hitler for reflating the Germany economy through rearmament.

I have been more and more struck by the lack of progress, not only in the period since 1929, but in the period since the Panic of 1907. In 1907, there was no Federal Reserve Board, and the resources of the Federal Government itself were limited by the small size of the tax base – the Supreme Court had previously declared that a Federal Income Tax would be unconstitutional, and the constitutional amendment which made income tax possible only came after 1907. In the absence of a Central Bank and of taxing power, the U.S. Government in 1907 could not use either of the two modern weapons of control, interest rates or Government spending. In fact, the panic was stabilised by the action of a small consortium of New York banks, led by the great banker, J.P. Morgan himself. He divided the sheep from the goats. The Knickerbocker Trust went down as too insolvent to be saved. Other houses were declared sound, and J.P. Morgan made good his word. In 1907, the panic was halted and the subsequent recession was comparatively mild. The management of the 1907 panic was firmer and better defined than that of 1929 or 2009.

We still do not know what causes a depression, how to prevent it or – short of a rearmament programme – how to reverse the momentum of the contraction. We do not even know whether to inflate or deflate, or when to do so. These will be the questions for debate after 2009, just as much as they were after 1933, or indeed after 1907.

William Rees-Mogg
for The Daily Reckoning Australia

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