The Banking Crisis Through the Eyes of Amity Shlaes
Amity Shlaes is a senior fellow at the Council on Foreign Relations, a columnist for Bloomberg, and a frequent contributor to both the Wall Street Journal and the Washington Post. In addition to that, Shlaes is one of today’s best-known economic historians. Most recently she wrote The Forgotten Man, a modern history of the Great Depression that debunked many of the myths surrounding its cause.
With many commentators today suggesting that the present financial crisis mirrors that which occurred during the Depression, Shlaes agreed to an interview with RealClearMarkets where she addressed today’s problems in terms of her extensive knowledge of what happened nearly 80 years ago. Her answers are below:
RealClearMarkets: Can you draw parallels between the 1930s and now?
Amity Shlaes: The underdiscussed parallel is the international component. Back then the world seemed to be falling apart, and then, the U.S. as well. Now, not only do we have our domestic challenge but also China has just about stopped growing. Europe is feeling pretty smug these days but their entitlement obligations mean that can’t last, Brits excepted. A simultaneous downturn world over will worsen the trouble.
RCM: What else?
AS: In his book, Allan Meltzer went back and looked at banking policy in the 1920s and 1930s. He concluded that one of the problems was the so-called “real bills doctrine.” Others have also written about this --- Thomas Hall and J. David Ferguson in The Great Depression.
Real bills said lending on anything other than good commercial paper was inflationary. If no one came to borrow, the Fed should remain idle. Real bills also implied that if the Fed bought government securities, inflation would follow because they are not real bills. The effect was to help banks that are healthy and not help those that weren't.
The doctrine was perverse because it was “procyclical” – when you were in trouble was when you weren’t helped. Nowadays we believe in “countercyclical” policy, which says “loosen” when the country or the banks are in trouble.
The “mark to market” accounting rules of today are similar: procyclical when we need countercyclical measures. Just when you do want to sell, your balance sheet suddenly looks worse. That’s because you have to account for an asset by its price at the moment. Both the real bills doctrine and mark to market can be Catch 22s for financial markets.
But what if presently there is no market for the asset, of what if the market is thin? The analogy would be a town where only one house has sold, say a shack. The government then comes along and says that the mansion on the other side of town needs to be priced like the shack because the market had signaled that the shack price was the value for houses.
RCM: Beyond the parallels, do you see Washington making similar mistakes that prolonged the downturn in the '30s, and that will prolong any pain today?
AS: What mattered was not the 1929 Crash, or even the many aftershocks and the bank runs of the early 1930s. What mattered was the duration of the Depression, from 1929 to World War II. Imagine if the Dow did not come back to its highs of, say, October 2007 until 2032. That is what happened then – the Dow didn’t reach its 1929 levels until the mid-1950s. “Everybody a Millionaire Era Ended Quarter Century Ago in Plunge that Still Chills” was the New York Times headline in October 1954 when the Dow finally hit that 381 baseline.
What can cause such a long duration? Monetary policy and banking policy for sure, but also a government either a) overly involved in commerce or b) hostile to commerce.
A) Involved in Commerce: What the Paulson Treasury bailout reminds me of is the National Recovery Administration. The NRA gave wide license to industry to self-police and manage recovery. The NRA was all about deals – picking winners and losers. That’s the element of the Treasury proposal that is hard to like.
B) Hostility to Commerce: The New Dealers blamed the street, and so did Hoover before them. They also drove labor prices up too high relative to productivity, as Lee Ohanian of UCLA has shown.
Our equivalent scenario would be: raising taxes, ignoring Latin America, conducting “Pelosi Hearings” in the place of the Pecora Commission hearings of yore. In The Forgotten Man there’s a chapter called “A Year of Prosecution,” about 1934. When the New Deal didn’t bring complete recovery, the New Dealers tried to prosecute their way to economic success. That impulse is extremely destructive. The story this past weekend about President Uribe of Colombia visiting America seemed separate from the Treasury bailout story. But the two are related. Cutting back protectionism increases chances of saving Latin America politically. But it is also good for our economy.
RCM: Andrew Mellon is heroic in The Forgotten Man for his elevation of business and lower taxes, but ultimately he gave in to President Hoover's desire to raise the success penalty. What about being on the gold standard then required him to do that, and what do you think the impact would be today if the next president seeks to pass tax increases?
Under a gold standard, there needs to be gold in the bank for the economy to expand. Under a gold standard, too, countries compete for that gold. The gold goes to the countries in the best budgetary shape. If you are running a deficit, you are more of a credit risk than a country in surplus. In order to grow and get dollars, America needed good credit. Therefore it needed to balance the budget and increase federal revenues. Hence the tax hike of 1932.
This comes clear in the testimony of the men at Treasury, who were reluctant to hike taxes but felt they had to. “You cannot restore the credit structure of the country by increasing the public debt,” said Treasury Undersecretary Ogden Mills in 1932. The Treasury also put forward new car taxes, radio taxes, taxes on malt syrup and brewers, even an estate tax. This must have driven Andrew Mellon nuts since he disliked death taxes, especially. He’d seen the tax eat away at his friend Henry Clay Frick’s estate.
The gold standard was less forgiving than the current system. Under our post-Bretton-Woods arrangement, the case for lower rates to get higher revenues is more compelling.