The Fed's Critics Are Wrong: We Need to Avert Depression

What was the root cause of the financial crisis? Greed? Deregulation? No. It was ignorance of financial history.

Last week the world’s central banks—including the American Federal Reserve—acted in concert to try to prevent history from repeating itself. Their critics on both sides of the Atlantic showed a dangerous ignorance, and not for the first time.

Republican presidential wannabe Ron Paul warned that the Fed was “flooding the world with money created out of thin air.” Paul’s remedy for our financial ills is to go back on the gold standard. More alarmingly, German Chancellor Angela Merkel reiterated her opposition to monetary easing as well as to the creation of common “euro bonds.” Her latest proposal is that each European state should set up a national debt-reduction fund.

In normal times it would be legitimate to worry about the consequences of money printing and outsize debts. But history tells us these are anything but normal times.

We teetered on the edge of this same precipice 80 years ago, in 1931. A succession of major European banks went bust. Bailing them out was beyond the resources of fiscally overstretched governments. Failure to agree on orderly debt reductions led to disorderly defaults, tariff wars, and a further worldwide collapse of production and employment.

People often forget that the Great Depression was like a soccer match—there were two halves. The first half was dominated by the aftermath of the 1929 U.S. stock-market crash. The second half, which made the depression truly “great” in both its depth and its extent, began with the European banking crisis of 1931.

To understand what has been happening in our own borderline depression, you need to know this history. But hardly anyone does. Since the crisis began, I’ve regularly addressed conferences of bankers, investors, fund managers, regulators, policymakers, and economists. In the first half of the crisis, I used to ask who in the room had read Milton Friedman and Anna Schwartz’s Monetary History of the United States, the single most important book about American financial history ever written. On average, two people out of every hundred had read even a part of it.

These days, as we enter the second half of the crisis, I ask who has read Barry Eichengreen’s Golden Fetters: The Gold Standard and the Great Depression.The results are even worse. I’ve seen entire ballrooms full of financial professionals, not one of whom has read this hugely important book.

Friedman and Schwartz argued that the stock-market panic of 1929 turned into a depression because of avoidable errors by the Fed. Instead of easing monetary policy by cutting interest rates and buying bonds, the Fed tightened. The result was a catastrophic chain reaction of bank failures, which caused the money supply to contract by approximately a third, and economic output with it.

Eichengreen’s book tells the sorry story of the second half. First, the rules of the gold standard forced central banks to transmit the American shock around the world. Then an increasingly polarized political atmosphere made it impossible to reach agreements about the enormous war and reparations debts that weighed down European governments. Despite multiple international conferences, the global financial system collapsed. Countries recovered only when they abandoned the gold standard and focused on job creation. Unfortunately, the most effective way of doing this proved to be rearmament. The country that did this most successfully was Germany. You know what came next.

We are indeed fortunate that at least the world’s leading central bankers have studied this history: not only Ben Bernanke but also the heads of the Bank of England, the Bank of Canada, and the European Central Bank.

The bad news is that so few politicians and voters understand what they are trying to do, or why. The even worse news is that central bankers by themselves may not be able to stop our depression from turning great.