Thursday, October 9, 2008

Government Failure: Ohanian on How the Great Depression Was Not Caused by a Financial Crisis

In this important article in the WSJ, Ohanian alerts for misguided comparisons between the Great Depression and the current financial crisis (HT Mankiw). He explains how the popular historical interpretation that the Great Depression was caused by a financial crisis is wrong:

President Bush argued that the passage of the Treasury rescue plan was necessary to prevent the U.S. from entering a severe downturn. Yesterday, the Federal Reserve announced it will begin buying commercial paper ... Unfortunately, [these measures] have created considerable fear about the underlying strength of the U.S. economy. This panic has roiled stock markets and led to comparisons between today's crisis and the Great Depression of the 1930s. ... This is based on the very common misperception that the banking crises of the 1930s helped turn a garden variety recession into the Great Depression.

Banking panics did not create the Great Depression, nor did the elimination of panics via the introduction of deposit insurance generate economic recovery. The first banking crisis of any national significance didn't occur until the fall of 1931. ... However, the Great Depression was already "great" at this point -- industrial production and employment had fallen by more than 35%. The genesis of the Great Depression was not a banking crisis.

He then reminds us that misguided governmental responses based on populist politics aggravated the crisis and produced the Great Depression. This was one of the most important cases of government failure in the history of the US:
There are many historical precedents of bad policies following crises. The worst case was after the stock-market crash in October 1929, which produced a truly perfect storm of bad policies. Tax rates rose, tariffs rose (reflecting special interest groups attempting to insulate domestic producers from foreign competition), and both Presidents Herbert Hoover and Franklin Roosevelt strongly promoted industry-labor cartels that were designed to stifle domestic competition.

In the absence of these policies, the Great Depression would almost certainly have been like every other U.S. recession -- short-lived and relatively mild. Normal recovery didn't begin until the most onerous of these policies were reversed, a process that didn't begin until the end of the 1930s when antitrust activity was resumed, and during World War II when the National War Labor Board reduced union bargaining power by limiting negotiated wage increases to cost-of-living adjustments only.
Among possible responses based on solid economic principles he proposes "lower tax rates and more skilled immigrants":

We should encourage the immigration of prime-age individuals. ... Increasing immigration would increase the demand for housing and raise home prices. And note that the benefit would be immediate. Home prices -- and the value of subprime obligations -- would rise in anticipation of a higher population base. The U.S. particularly needs highly skilled workers. These workers not only would purchase homes, but would generate higher living standards for all Americans.

PS: Chinn criticizes Ohanian arguments here.

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