The good news is that Federal Reserve Chairman Ben Bernanke is an academic expert on the Great Depression of the 1930s, and he’s pretty sure he knows what not to do.
Bernanke, who once wrote that “to understand the Great Depression is the Holy Grail of macroeconomics,” confessed during a speech he gave to celebrate the 90th birthday of the renowned economist Milton Friedman that he was convinced by Friedman’s argument that the Fed had caused the Depression by squeezing the money supply and taking liquidity out of the market.
“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve,” was how Bernanke concluded his speech. “I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.”
Well, maybe. Certainly the Fed, along with the European Central Bank and the Bank of Japan, has pumped liquidity into the markets in the last two weeks. If Friedman was right and the money supply was the problem, then this is the solution.
But there are never single causes in economics. It is now clear that loans to sub-prime borrowers were extended recklessly and that the computer-driven investment systems of the hedge funds were not well programmed to deal with extreme volatility and with the kind of psychological panic that gripped markets in recent days.
And there was also another factor in making the Great Depression as bad as it was, a time when real output in the United States fell nearly 30 percent and unemployment rose from about 3 percent to nearly 25 percent. That other factor was the collapse of world trade after the U.S. Congress passed the Smoot-Hawley Act of 1930 that imposed a 60-percent tariff on more than 3,200 goods imported into America.
U.S. imports collapsed by two-thirds, falling from $4.4 billion in 1929 to $1.5 billion in 1933. Exports fell from $5.4 billion to $2.1 billion. Unable to sell into the U.S. market, European companies went bankrupt, banks collapsed, and European governments defaulted on their loan repayments to the United States. The resulting Depression brought Adolf Hitler to power.
So perhaps the most worrying single remark made by a responsible banking official during the current crisis came from Jochen Sanio, the head of Germany's banking regulator BaFin. He warned on Aug. 1 that his country could be facing the worst banking crisis since 1931 -- a reference to the collapse of Austria's Kredit Anstalt, which provoked a wave of bank failures across Europe.
So the really worrying prospect this summer is the possibility that a new version of the Smoot-Hawley Act could be in the works. And something of the kind has been brewing in the U.S. Congress for months, a version of the Schumer-Graham bill that threatens to impose sweeping tariffs on Chinese imports unless China revalues its currency.
The recent wave of scandals about the quality of Chinese goods, from adulterated dog food and toothpaste to lead-painted toys, has already sparked some trade skirmishes as China imposed countervailing health controls on some U.S. food imports. A sweeping tariff against Chinese goods could start a real trade war. And sitting on $1.3 trillion of reserves, much of it in dollars and U.S. Treasury bonds, China has the heavy weapons.
Last December Bernanke tried to head off this grim scenario. He removed from a speech he gave in Beijing the potent phrase that China’s manipulation of its currency amounted to an “effective subsidy” of its trade -- a phrase that had been in the prepared text. He removed it because such a phrase could itself trigger retaliation under current U.S. law.
A U.S.-China trade war is the last thing the tottering global financial system needs right now. It would be the worst-case scenario. The United States would have two policy responses. The Fed could raise interest rates to shore up a falling dollar, which would mean mortgage foreclosures, mass bankruptcies and a severe recession, if not worse. Or it could let the dollar collapse, which would turbo-charge inflation and let the rest of the world deal with the fallout as their debts were repaid in devalued dollars.
Versions of this have happened twice before. In the mid-1980s the Louvre and Plaza agreements among the G7 finance ministers arranged an orderly fall of the dollar that saw it halve in value against the deutschmark. And in another dollar crisis in 1971, U.S. Treasury Secretary John Connally told Europe’s bankers, “The dollar is our currency, but it’s your problem.”
It may not get so bad, if Congress (with a presidential election coming, so this is a very big “if”) can be persuaded to drop its threats against China. After all, the fundamentals of the real economy are sound. Every major economy is growing, and corporate debt levels are not high. In the United States they have fallen from the 1996 level of 40 percent to 32 percent, and from 38 percent to 25 percent in Japan and from 24 percent to 23 percent in the eurozone. Defaults on speculative grade corporate debt have been lower than expected in each of the last three years and are running at an average of a mere 2 percent against 11 percent in 2002.
The current crisis should be manageable, so long as the China-bashing politicians in the U.S. Congress keep calm, and so long as the Chinese behave responsibly and let their currency continue to rise in value against the dollar. It has risen by 9 percent over the last two years, which is not a bad start. But right now it is in everybody’s interest, not least China’s, to let it rise by at least another 5 percent. The alternative could just be another 1931.
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