The “We Prevented a 2nd Great Depression” Lie has Proven Very Costly
As the billionaire boys gather at Davos, it is time to reflect on how costly the lie the policy responses to the Great Financial Crisis prevented a second Great Depression has been. However, before toting up the losses, let’s focus on why this claim of prevention was at the time and still is a lie.
Exhibit I is a very important, though clearly unintentional observation made by Nobel prize winning Economist Paul Krugman.
So the world financial system and the world economy failed to implode. Why?
We shouldn’t give policy-makers all of the credit here. Much of what went right, or at least failed to go wrong, reflected institutional changes since the 1930s. Shadow banking and wholesale funding markets were deeply stressed, but deposit insurance still protected a good part of the banking system from runs. There never was much discretionary fiscal stimulus, but the automatic stabilizers associated with large welfare states kicked in, well, automatically: spending was sustained by government transfers, while disposable income was buffered by falling tax receipts. [emphasis added]
Professor Krugman finds it was the institutional changes made during and since the 1930s that prevented a second Great Depression. These institutional changes include deposit insurance and the welfare state (which was begun under FDR and subsequently expanded under Lyndon Johnson’s Great Society).
Was there any reason to think the people who lived through the Great Depression wouldn’t have put in place everything needed to prevent a second Great Depression? NO!
Was there any reason the existence of deposit insurance and automatic stabilizers the Great Depression generation put in place wouldn’t have been knowable at the very beginning of the acute phase of the Great Financial Crisis in 2008? NO!
If you were aware of what the Great Depression generation put in place, was there any reason to think a second Great Depression was possible in 2008? NO!
For the record, I pointed this out in 2008 and I am not even a Great Depression scholar. As I said in the introduction to my book:
For me, one of those events occurred on September 23, 2008, when the United States, the world’s only superpower, surrendered to Wall Street without a single shot being fired.
Shortly thereafter, England and the European Union also surrendered.
Why did governments around the world surrender to Wall Street and England’s version, The City of London? How could governments around the world allow the bankers to continue rigging the global financial markets and looting Main Street without any resistance?
What happened on September 23, 2008?
On that day, U.S. Treasury Secretary Hank Paulson, accompanied by then Chairman of the Federal Reserve Ben Bernanke, requested from the U.S. Congress an initial payment to Wall Street of $700 billion dollars to buy toxic assets from the largest commercial and investment banks.
In making this request, Secretary Paulson demonstrated the salesmanship and political shrewdness that saw him reach the top of one of the largest investment banks, Goldman Sachs, before becoming Treasury Secretary.
He laid out the case that the U.S. economy and particularly Main Street was facing serious problems if the banks weren’t bailed out.
It was not what Mr. Paulson said that gave his argument credibility, but rather Fed Chair Bernanke and his reputation.
Before joining the Federal Reserve Board, Mr. Bernanke had been a Princeton economics professor who prided himself on his studies of the Great Depression. In fact, he called himself a “Great Depression buff”.[1] In 2000, he published a book, Essays on the Great Depression, which included nine articles he coauthored over a period of two decades. He felt these articles presented a “largely coherent view of the causes and propagation of the Depression.”[2]
For Secretary Paulson’s argument to carry any weight, he needed Fed Chair Bernanke’s agreement with his analysis that without using taxpayer funds to bail out the banks, Main Street was facing a second Great Depression. After all, Fed Chair Bernanke had access to the same information as Secretary Paulson, and it was assumed if there was anyone who should be able to assess if this was necessary and the U.S. was potentially heading into a second Great Depression, it was Fed Chair Bernanke.
As Fed Chair Bernanke sat there with his ashen, panic-stricken face, there could be no doubt he truly believed we were headed into a second Great Depression. His visual appearance and testimony sealed the deal.
Congress did not immediately give Mr. Paulson what he wanted. Instead, they waited for over a week before surrendering.
While watching Secretary Paulson’s virtuoso performance, a single thought kept recurring to me: What am I missing? Why was the need to surrender to Wall Street for fear of a second Great Depression not credible?
It wasn’t credible because in redesigning and rebuilding the financial and banking systems during the Great Depression, the FDR Administration and Congress, seeing the damage caused by an opacity driven financial crisis, took steps to insure the banking system could survive another opacity driven crisis without being explicitly bailed out.
The FDR Administration and Congress actually went further than just redesigning and rebuilding the financial and banking systems. They demonstrated how to use the new financial and banking systems to end an opacity driven crisis and restrain Wall Street.
Why did I know there was no need to surrender to Wall Street, but nobody in the Congressional hearing on that day seemed aware of this fact or was willing to mention it?
[1] Bernanke, Ben S. (2000), Essays on the Great Depression, Princeton, New Jersey: Princeton University Press, page vii.
[2] ibid, page viii.
Exhibit II is the Queen of England’s famous question to the Economics profession: why did no one see it coming. In responding to this question, Professor Krugman made another of his very important, but clearly unintentional observations:
To be fair, the DSGE models that occupied a lot of shelf space in journals really had no room for anything like this crisis.
Not only did these models (and central banks run particularly complex versions of these models) not predict the financial crisis, but they performed particularly poorly in forecasting over the entire acute phase of the Great Financial Crisis (say 2008-2010).
Why did they perform so poorly?
One reason they didn’t predict the financial crisis is they didn’t include the financial sector. It was intentionally left out because the Economists constructing these models couldn’t imagine a financial crisis might originate in the financial sector and have an impact on the real economy.
By the way, this assumption wasn’t a bad assumption IF the financial crisis had remained in the financial sector as the Great Depression generation intended. Unfortunately, this is not what happened. Instead, there was the Great Depression scholar Ben Bernanke leading the charge to transform the financial crisis from one contained in the financial sector to one burdening the real economy (I think this was referred to as socializing the losses).
At this point, citing the spurious results of their fundamentally flawed DSGE models, Bernanke and the rest of the global central bank crew began a furious economic experiment. Included in this experiment were zero interest rate and quantitative easing.
Is there any reason to think reliance on these fundamentally flawed models didn’t produce or justify policies that actually made the financial crisis worse? NO!
Consider for a moment, Walter Bagehot (the guy behind modern central banking) and John Maynard Keynes (had something to say about a financial crisis) said 2% was the interest rate floor. Why? They saw rates less than this causing their own economic headwind or as they put it “John Bull can stand many things, but he cannot stand two percent”.
Of course, this wasn’t reflected in any DSGE models (I worked on the early DSGE models at the Fed; we didn’t have a line of code in our models for this so it is doubtful anyone thought to add it; this is further confirmed based on my conversations with dozens of economists including many central bankers, they were all surprised to find out what Bagehot/Keynes said). The DSGE models assumed economic behavior below 2% was the same as economic behavior above 2% (consequently they consistently overstated the speed of the recovery).
However, Bernanke and company promptly went to effectively 0% rates and cited these models as suggesting a negative interest rate of 3% might be more appropriate. Given this desire for lower rates, Bernanke and company also implemented quantitative easing (a policy even the BIS cannot find a single benefit from).
The important point here is having lied about the possibility of a second Great Depression, the central bankers then used their fundamentally flawed DSGE models to justify all sorts of bad policies.
I can hear the central bankers protesting and saying “but we couldn’t just sit there, we had to do something”.
I will never say the central bankers weren’t suppose to do something. What I will say is what they were suppose to do is perform their roles as lender of last resort and, if your were the Fed, as bank supervisor. The former role meant lending money at high rates during the acute phase of the crisis (this wasn’t done as Bernanke favored giving taxpayer money to the banks in the form of low interest rate loans). The latter role meant forcing the banks to recognize all their losses on the bad debt they were exposed to (this too was not done as led by Tim Geithner the Fed preferred to foam the runway for the banks).
Instead of doing what they were designed to do, central bankers engaged in economic experimentation with all sorts of bad outcomes.
Consider low rates. This undermined savers.
Consider QE. This generated massive inequality.
Consider not making banks absorb their losses? This wiped out the household finances of a huge part of the middle class who the bankers had been happy to give much more debt than they could ever afford to repay.
When you start toting up the costs of this economic experimentation justified by the lie of preventing a second Great Depression, you realize just how costly the lie was and still is.
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