The boom/bust cycle in asset prices typifies the present downturn, as it did the Great Depression. This has led to suggestions that the world economy could operate far below capacity (i.e., with high unemployment) for an extended period--as it did in the 1930s.
Key characteristics of the current business cycle are reminiscent of the Great Depression (1929-1933):
Credit flows and asset prices.
Today, the centrality of credit flows and asset prices is fueling interest in the "Austrian school" approach to the business cycle, which emphasizes difficulties inherent in unwinding credit-driven asset price bubbles:
-- Asset locus. Both the current credit crisis and Great Depression saw U.S. debt to income levels deviate significantly from long-term averages, driving up asset prices and leading to a "mean reversion" entailing significant asset-price reversals.
-- Boom/bust. The bust followed a long period of favorable conditions for asset-price bubbles. Low inflation allowed the Fed to keep interest rates low in the 1920s. Indeed, it relaxed policy during the 1928-1929 stock market boom, drawing criticism that it was fueling stock market exuberance. (It also reduced the discount rate in an effort to ease pressure on the U.K. external account to help the Bank of England adhere to the gold standard.)
Financial shock.
During both periods, the key disturbance was to the financial system, originating from disturbances elsewhere, that is:
--the stock market crash in the inter-war episode; and
--the subprime crisis in the current episode.
This contrasts with most post-war recessions, where inflation played the key role:
--Monetary tightening dented the real economy as higher interest rates depressed aggregate demand.
--Casualties in the banking system were secondary, and easily contained
--even the 1980s savings-and-loan crisis came in the aftermath of recession, rather than preceding it.
Emergency response. A further parallel entails crisis management:
-- Inter-war. The emergence of the Fed in 1912 confused the response to financial crisis. The private sector's own crisis-management mechanisms ("banking holidays" organized through clearinghouses) were not triggered after the 1929 stock market collapse and subsequent bank runs, in deference to the new central bank.
Yet the Fed viewed crisis management--i.e., liquidity provision--as incompatible with its mandate to keep the currency convertible into gold, and failed to fulfill its role as lender of last resort to the banking system. The modern consensus is that this failure turned a downturn into the Great Depression.
-- Today. The Fed today is under no such restraint. Yet crisis management in the financial sector is in similarly uncharted territory--in the "shadow banking" sector in particular (i.e., the non-bank financial institutions with short-term liabilities and long-term assets, such as hedge funds or structured investment vehicles).
Best responses to the current credit market seizure might become clear only after the fact, when more moderate responses have been proved inadequate. One example is public purchase of private assets such as subprime mortgage-backed securities. Even if this proves necessary to restore financial intermediation, it will probably not be exercised until lesser remedies fail--at considerable pain to the economy.
Silver lining?
Overshadowed in historical recollection by the Great Depression and Second World War, the late 1930s saw a dramatic U.S. recession that had the makings of another global depression. Yet the sharp U.S. downturn, which itself was quickly reversed, did not badly affect the world economy. Parallels with today are striking:
"Decoupling." The 1937 episode provides the only antecedent for the "decoupling" hypothesis of today's emerging markets. The emerging markets of that era were net international creditors--as they are today, and have not been at any time in between. Their huge stores of foreign reserves allowed them to sustain domestic demand even as export receipts temporarily tailed off.
Currency pegs. That era's emerging markets were known as the sterling bloc, a group of net exporters whose currencies were faithfully pegged to sterling. In fact, today's East Asian exchange-rate arrangements are far more similar to the sterling bloc's than Bretton Woods, to which they are frequently likened. In both cases, pegs were de facto, consensual and unilateral, rather than internationally obliged, as under Bretton Woods.
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