The Great Recession and the Great Depression

Introduction

John Maynard Keynes wrote in the depths of the Great Depression that, “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” This acute observation is applicable to our current Great Recession as well. In fact, the newly discredited ideas are not too different from the old, suggesting that Keynes may have overestimated the ability of people to learn from their mistakes (Paul Knigman, pp 34-78). I discuss the parallels between these two watersheds in recent economic history in three steps. The first and most important step is the causes of the crises and their relation to economic theory. The second step is the spread of the crises as they affected the whole world. I close with the final step, recovery—at least as far as we can see it at this point. Marx said famously that history repeats itself, “the first time as tragedy, the second as farce.”2 I argue that this observation also fits our current condition. Both of these dramatic and costly economic crises came from the interaction of economic imbalances in the world economy and the ruling ideology of financial decision makers who confronted these imbalances. The first imbalance came from the First World War. This paroxysm of violence brought the long economic expansion of the nineteenth century to a sudden end. Britain, the workshop of the prewar world, was exhausted by the struggle. America, the rising economic behemoth, was unready to take responsibility for its new role in the international economy. Germany, having unsuccessfully challenged the Anglo Saxon powers, refused to acknowledge its defeat.

Analysis

The easiest way to see the imbalance is through the international movement of capital. There were many reasons why this imbalance was allowed to grow over the postwar decade, and one of the most important was the ruling economic theory of the Gold Standard. David Hume explained in the eighteenth century how currencies valued in gold would maintain stable values relative to each other. Assume there is a shock to one country that decreases its exports (Paul Knigman, pp 34-282). This will result in an outflow of gold according to Hume, which will lower prices in the exporting country. Lower prices then will encourage exports and decrease imports, leading to an inflow of gold. Prices will rise again, recreating the previous equilibrium. This is known among economists as the “price specie-flow mechanism (Irving Fisher, pp 45-282).”

Hume' s contribution is still useful today, although we now realize how many assumptions need to be made in order for it to work as described. In particular, prices have to be determined in competitive markets and fully flexible for this simple process to operate. These assumptions have become characteristic of economic models in the years since Hume wrote, and they express a view of the economy often attributed to Adam Smith and taught in introductory economics classes. They are the starting point for many journal articles and referred ...