Wednesday, May 22, 2013

Who prevented the second Great Depression?

Since the beginning of our current financial crisis, policy makers and central bankers have continually used as justification for their policies the claim that no matter how distasteful their policies are necessary to prevent a second Great Depression.

This raises an interesting question.  In response to the Great Depression, did the policy makers in the 1930s put in place a financial system to prevent another Great Depression or not?

Current policy makers would like to claim that the Dodd-Frank Act is all about preventing another Great Depression.  If current policy makers were focused on preventing another Great Depression, there is no reason to assume that policy makers in the 1930s did not have the same agenda.  Particularly because the policy makers in the 1930s were living through and had first hand experience with the Great Depression.

Furthermore, if policy maker in the 1930s did have the agenda of preventing another Great Depression, is it possible that their policy prescriptions alone were adequate to have prevented our current financial crisis from becoming the second Great Depression?

Regular readers know that the 1930s policy makers did in fact put in place all the elements that were necessary for dealing with our current financial crisis and avoiding a second Great Depression.  These policy makers assumed that the lessons of the Great Depression would be forgotten (after all, bankers are very good salespeople) and that another period of excess credit creation could occur.

The 1930s policy makers put in place the elements necessary for dealing with the excess credit in the financial system.  Specifically, they understood that the Swedish Model is the way to deal with a bank solvency led financial crisis.  Under the Swedish Model, banks are required to absorb the losses on the excess debt in the financial system and protect the real economy and the social contract.

The 1930s policy makers designed banks to be able to absorb losses should there ever be a credit bubble and still continue to support the real economy.

Banks can do this because of the combination of deposit insurance and access to central bank funding.  With deposit insurance, taxpayers effectively become the banks' silent equity partners during the years the banks are retaining pre-banker bonus earnings and rebuilding their book capital levels after absorbing the losses on the excess debt.

The 1930s policy makers also put in place the concept of automatic economic stabilizer programs.

So what did our current policy makers contribute to handling our current financial crisis and preventing a second Great Depression?

First, they adopted of the Japanese Model.  Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.  As a result, the burden of the excess debt is put on the real economy where it diverts capital needed for reinvestment, growth and the social contract to debt service.

So rather than use the financial system as it is designed and bringing an end to our current financial crisis, our current policy makers chose to maximize both the length of our financial crisis and the damage the financial crisis does to the real economy and the social contract.

Of course, the choices made by our current policy makers haven't hurt everyone.  For bankers and their bonuses, it is close to if not the best of times.

Second, despite our current policy makers' claim to have prevented a second Great Depression, this claim is premature until such time as the excess debt has been purged from the financial system and all programs adopted to deal with our current financial crisis are ended.

An example of the programs that must be ended are monetary policies like zero interest rate and quantitative easing.  What will happen to the real economy and the financial markets when central banks try to unwind these policies?  Will unwinding these policies precipitate the second Great Depression our current policy makers claim to have prevented?

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