The world economy is beginning to awaken from a nightmare. What hit us, and what was the tossing and turning all about? The popular simile is a comparison with the Great Depression, as in “This is the worst downturn since the 1930s.”
In fact, unless we get hit with another hammer before we fully wake up, the Great Recession is very unlike what the world went through some seven decades earlier.
The Great Depression, like the recent collapse, began with a banking crisis, but of a different kind. Instead of emanating from huge financial institutions in major money markets, the earlier one spread outward from small midwestern banks in the United States and led eventually to a near total loss of confidence.
Depositors pulled their money out into cash or gold, and the U.S. banking system shut down. Investors in other countries also moved heavily into “safe” assets.
Exchange rates became unstable, and international trade began to break down. Then, instead of putting a coordinated stimulus in place, governments and central banks flailed about with little understanding of how to stabilize the economy, and with no institutional structure for coordinating economic policies.
The result was a decade of stagnation and loss, of deflation, unemployment, and depression in every sense of the word.
Today, the future is not that bleak.
Compared with the 1970s
A better comparison is with the 1970s: not because the origins are similar, but because the consequences may be. That decade began with worries about the overvalued dollar, as the U.S. economy overheated. The whole system of fixed exchange rates soon unraveled, and that trauma was followed quickly by the arrival of a global power shift toward oil exporters.
The value of the dollar was dropping, the price of oil was soaring, and an unwanted and ugly new word—stagflation—entered our vocabulary.
The consequence of the shocks of 1973–74 was that we could “not go home again.” The world of the 1960s, in which trade could flourish in the comfort of price and exchange stability, and consumption could flourish in the comfort of cheap and readily available energy, was gone forever. The challenge was not to find a way back to those comforts. The challenge was to find ways to live in a very different world.
The quest took several years, and it did not entirely succeed. Much like our recent and not quite finished nightmare, the world economy went through two years of serious recession while policymakers and their economic advisers tried to absorb the new reality and devise plans to adjust and reform.
Some countries put in place fiscal stimulus policies to combat unemployment, while others tightened monetary policies to combat the inflationary effects of the shift in the global oil market. The major industrial countries then tried to organize a coordinated effort to designate the stronger countries as locomotives for recovery.
Roadmap for recovery
The OECD’s 1977 McCracken Report and the G-7’s 1978 summit meeting in Bonn laid out a roadmap for recovery.
It was based primarily on a stimulus to be led by Germany, which was thought to have the most room for maneuver to increase government spending and raise economic growth. That judgment turned out to be far too optimistic. More inflation and a second upsurge in oil prices were the main results. Not until a U.S.-led anti-inflation effort finally took hold did a real recovery get under way.
Even then, the emerging markets of Latin America were left behind, as the need to adjust quickly to higher interest rates and a strengthening dollar undermined their economic systems.
Now, as then, we cannot go home again. The Great Recession has destroyed the possibility of consuming and investing on cheap and easily available credit without regard to quality. Households in major industrial countries will have to borrow less and save more than they did before the crisis.
At the moment, interest rates are extremely low while central banks try to offset the withdrawal of credit from financial institutions, but when rates return to normal levels the new reality of expensive credit will register fully. Moreover, the world economy may have to absorb this shock at the same time that governments begin to withdraw fiscal stimulus.
The history of the 1970s warns us not be overly ambitious in trying to reflate economic activity as the crisis recedes. The boom times that we have lived through are not the norm, and they have not been sustainable. We are not doomed to repeat history, but reaching a new path to a more lasting prosperity is likely to take a major effort and much patience.
Related material: Thinking Beyond the Crisis