Can We Avert the Next Financial Crisis?

Consider the following picture: It is a time of peace and prosperity, of capitalism triumphant. The Republican Party has overwhelmingly won the past three presidential elections, apparently establishing a permanent lock on the White House--and why not, because Republican policies have brought steadily rising employment and consumption. Businessmen are the heroes of the age; organized labor is in retreat.

There are, of course, a few blots on the picture. Battered by low export prices and the burden of their foreign debt, less developed countries do not share in the prosperity of the industrial world. Protectionist pressures are rising. There are strains on the international system because the traditional leader of the world economy is in relative decline, while the most economically dynamic major nation remains unwilling to take on its full responsibilities. Nonetheless, the fundamental picture is so strong that few would suppose that disturbances in the financial markets could produce more than a brief, mild recession.

The year, of course, is 1929. Herbert Hoover is President. Britain is the declining leader of the international system, and the United States the dynamic nation unwilling to step into Britain’s shoes. And the greatest economic catastrophe of modern history is about to happen.

As the market hiccupped this year on Friday the 13th, the question that everyone asked two years ago came around once more: Can it happen again?

A group of economists and policy-makers met recently in Cambridge, Mass., to discuss just that issue. Although the discussion was full of disagreements, and off the record anyway, I concluded several things from it.

First, in a purely financial sense, crises on the scale of 1929 are if anything even more likely than they were 60 years ago. Black Monday in 1987 was actually worse than Black Thursday in 1929, and the global spread of the stock crash in 1987 was faster and more complete than that of 1929. Computers and faster communications apparently don’t make markets any more rational; they just allow panic to spread more efficiently.

Furthermore, the modest reforms undertaken since 1987 have done little if anything to reduce the vulnerability of the market to crashes. As it turned out, Friday the 13th didn’t develop into a full replay of Black Monday--but it certainly could have.

On the more optimistic side, financial crises do not have to turn into real depressions. In October, 1987, a few sensible things were done, and the effect was to insulate the real economy almost completely from the effects of financial panic.

Essentially, the Federal Reserve acted quickly to pour credit into the economy after the crash, abandoning for the time being both its monetary targets and any attempt to stabilize the dollar. Money growth accelerated to levels that horrified monetarists, and the dollar plunged 17% against the Japanese yen; but the crisis was contained. For most of the population, the stock market crash was purely a spectator event.

What I learned from the historical discussion, however, was that the contrast between disaster in 1929 and successful containment of crisis in 1987 was not because of any fundamental change in the vulnerability of the economy. Had the Federal Reserve acted in 1929 as it did in 1987, there would almost surely have been no Great Depression. On the other hand, had the Federal Reserve acted in 1987 the way it did in 1929, we would not now be shrugging the whole thing off as a temporary market aberration. The difference between then and now was primarily one of leadership, not institutions.

The leaders deserve praise, of course, but it is worrisome when so much hangs on having a few men do exactly the right things. As one conference participant put it, we have relied on brilliant chairmen of the Federal Reserve to deal with financial crises twice in one decade; will our chairmen always be so brilliant?

What is particularly worrisome is that many economic pundits advocate policies that would have ruled out the actions that insulated the real economy from financial panic in 1987. Suppose, in particular, that the kind of economists favored by the Wall Street Journal--people such as Stanford’s Ronald McKinnon or Columbia’s Robert Mundell--had been at the helm in the weeks after Black Monday. What would these people, whom we may refer to as “global monetarists,” have done? The answer is, nothing--or worse than nothing.

As advocates of a real or simulated gold standard, they would have fiercely opposed the policy of rapid credit expansion that sterilized the real impact of the crash while driving down the dollar; this is especially true because the global monetarists insist on regarding the dollar as seriously undervalued. Since the crash would have placed downward pressure on the dollar even without a rapid credit expansion, and since this downward pressure would have been reinforced by speculation about possible future dollar depreciation, a global monetarist approach would actually have required a considerable credit contraction.

The result would have been to turn the market slump into a major real slump as well. Probably our economy is not as depression-prone as the economy of 1929, but the result would still have been disastrous.

The purpose of this scenario is not to emphasize how bad the economic analysis is at the Wall Street Journal or how bad the advice given by some economists is (although both points are true enough). Instead, the point is that we were all very lucky: The sensible and timely policies that actually averted disaster were carried out in the teeth of advice from seemingly reasonable and respectable voices.

Someone once pointed out that the reason that the Romans, not the Greeks, ended up ruling the world was that while Hellenistic armies could perform miracles under brilliant leadership, Roman armies could manage adequately with mediocre generals--which is more important in the long run. Unfortunately, we seem to have a Greek, not a Roman, world financial system. So the answer is yes--it can happen again, though not under current management.

Yet that was not the observation that most depressed me about the conference on crises. For the time being, at least, we seem to know what to do about stock market crashes and to have a leadership that is prepared to act on what we know. There is, however, another kind of international financial crisis: the kind of crisis that happens when a heavily indebted country’s creditors decide that it is no longer a good risk. This is the kind of crisis that hit Latin America in 1982 and that may someday hit the United States.

Unfortunately, we do not seem to know how to manage debt crises. The same people who averted financial crises in 1982 and 1987 have attempted to deal with the Latin American problem for the past seven years. They have organized emergency loans, collective bargaining between debtors and creditors, international coordination on a grand scale. And the result? A decade of declining living standards, soaring unemployment and hyper-inflation.

Latin America has done worse in the ‘80s than it did in the ‘30s. Predictions of a hard landing for the United States have so far not come true, but then people who worried about Third World debt were widely regarded as cranks right up to the moment of crisis.

So there won’t be a replay of 1929 in the near future; but if you want to see America turn into Argentina, it’s a possibility.