Are We Looking at the Wrong Depression?

Innovation, deleveraging  and economic realignment 

By Stephen Davies

Today a lot of people are looking to economic history for help in understanding the current world economic situation and the options open to us. (This includes economists, many of whom have finally rediscovered an interest in economic history.)

Most of this attention is being paid to the Great Depression of the 1930s. However, it is worth pointing out the important ways in which the present situation differs from that of the 1930s. Many observers (most notably Paul Krugman) argue that we are presently in a classic liquidity trap, where monetary policy has no purchase on the real world economy. The main evidence for this is that despite massive expansion of the basic money supply by the Federal Reserve and other central banks, there has not been the kind of inflation that many had predicted. The argument is that this situation is similar to the one Keynes identified in the early 1930s and that therefore the same policy response—fiscal stimulus—is appropriate.

Leaving aside whether the “Keynesian” analysis and prescription were correct in the 1930s (or indeed whether that was the argument Keynes actually made), it is worth pointing out a number of big differences between the events of the last four years and those of 1929–32. Most important, we have not seen the kind of decline in prices that took place then; indeed there have been short-term spikes in a number of prices, notably food and fuel. Furthermore, and fortunately, there has not been the kind of dramatic collapse in economic activity and employment that we saw in the entire world in the early 1930s. Although the present unemployment situation in the United States is not good, it is not catastrophic in the way it was by 1932. In other parts of the world, notably the United Kingdom, job losses have actually been less than most economists feared and predicted. Moreover while there is economic stagnation or very low growth in the United States, Europe, and Japan, the world economy as a whole is still growing, even if at a slower rate than a few years ago. So far there has not been the kind of sharp and sustained decline in world trade and economic activity that happened after 1930.

In other words what we are seeing is stagnation in large parts of the world economy instead of a sudden and acute contraction globally.

Perhaps we are looking at the wrong “Great Depression.”

Until as late as the 1950s, “Great Depression” in economic history generally referred to the period between 1873 and 1879 (in the United States) or 1873 and 1896 (in the United Kingdom and much of Europe). When we look more closely at those years, the likeness to where we are now becomes noticeable. The “Long Depression” (as it has come to be known) was sparked by a global financial panic in 1873, which arose from the bursting of several speculative bubbles, particularly in railroads and real estate. The panic started in Europe, then had a second phase in the United States before returning to the other side of the Atlantic. What followed were 30 years of gradually declining prices (deflation) in most parts of the world. Agricultural prices collapsed. This caused serious hardship for many farmers and peasants, and led to a massive movement of labor from agriculture and the hard-hit parts of the world (such as southern Italy, Scandinavia, and Russia) to places like the United Kingdom, United States, and Argentina. Most historical GDP records show a significant slowdown of growth in most of the world for at least part of the period between 1873 and 1896. On the other hand there was not the kind of dramatic collapse seen after 1930.

However, this picture of prolonged stagnation needs to be severely qualified. One early observer who questioned this widespread perception at that time was the American economist and historian David Ames Wells. His argument, and that of many other economic historians, was summed up in a short work by S. B. Saul, The Myth of the Great Depression, 1873–96. Wells pointed out, among other things, that the years after 1873 saw very large increases in global output of a number of key products, not only in agriculture but also steel and a range of manufactured products. As Wells explained, this was because of an unprecedented series of innovations in both technology and business organization. In fact the 30 to 40 years after 1870 saw the advent of technologies that would define modern life, including electricity, the internal-combustion engine, the telephone, the diesel engine, and the modern petroleum industry.

As a result, the official figures are seriously misleading. While nominal wages stagnated or declined, real living standards increased because of the falling cost of products. Output increased, but this is not captured unless one applies a GDP inflator to account for the increasing value of money. So the Long Depression of the 1870s and 1880s was not a simple story of economic standstill.

So what happened? Essentially a set of innovations in technology and business organization made in the later eighteenth and early nineteenth centuries had exhausted their potential to raise productivity and growth by the 1860s. This, combined with mistaken policies, had led to malinvestment and a significant buildup of debt by the early 1870s in both Europe and the United States.

What followed, Irving Fisher argued, was a crisis brought about by the realization that many investments were not going to pay enough and the consequent need for sustained “deleveraging” (paying back or writing off of debt). At the same time there was a burst of technological and organizational innovation. This increased productivity and created many new products but also led to large adjustments as older industries and forms of employment shrank, prompting a large movement of labor. This took some time, so the costs of the transition in human terms were significant.

A shift in the focus of the world economy also took place—away from established areas such as the United Kingdom and France (both of which were more adversely affected by the changes and for a longer period than other parts of the world) toward the new developing parts of the world, such as Germany, the United States, northern Italy, and Japan. Significant parts of the population in many places were worse off, but the majority gained because of the rise in living standards brought about by technical innovation and the consequent “benign deflation.”

Increasingly it looks as though the world as a whole is going through the same kind of experience: an exhaustion of profitable investment opportunity in some places and sectors, leading to an artificially stimulated bubble the bursting of which has triggered sustained deleveraging and a decline in growth in many parts of the world. At the same time other parts of the world are enjoying continued growth. This is not simply “catch-up growth,” since much of it comes from a shift in activity brought about by the early stages of a new wave of innovation. There is going to be a change in the patterns and locations of employment, but a rise in living standards for the majority because of the innovation and global growth.

This means that a fiscal stimulus would be ineffective and wasteful, since the underlying problem is one of a long-term economic realignment rather than a simple decline in demand.