IV. A POSTSCRIPT TO THE READER

I’m an historian with a professional background in finance. I’m not an economist, although I am comfortable with most of the literature and have read hundreds of papers in preparing this book. A number of star economists—see the Acknowledgments—were quite generous with their time in responding to my questions, pointing me to sources, and clarifying ideas. The economists who have been in the forefront of Depression studies have done prodigious work in digging into the musty crannies of bank files, diaries, legislative investigations, and similar sources that make history come alive and often call into question long-accepted maxims. Yes, employment is usually an inverse function of the real wage, but not always, even in the absence of government interference. Businesses have multiple values that are reflected in their hiring practices, economists have learned, and they have developed a catch-all concept called the “efficiency wage” to sweep in all the exceptions.

The focus on empirical work, along with the enormous advances in computer power, has stimulated the development of new statistical tools that can turn a spotlight on hitherto unexpected relationships. Alex Field’s demonstration that the transactional balances in brokers’ accounts during the late-twenties stock market boom significantly reduced the available money supply is a good example. Depression studies also lend themselves to rich narratives, such as Thomas Ferguson’s and Peter Temin’s small masterpiece “Made in Germany,” their account of the last days of Weimar. One of its great virtues is to recognize the importance of contingency—the fact that history is “one damn thing after another.” The short-lived Laval-Briand government in France may really have been willing to shovel some of its vast gold hoard into Germany before von Hindenburg and the German nationalists killed it with their pocket battleships and Austrian customs union.

Charles Calomiris is one of the few economists who explicitly puts contingencies front and center. He writes, for example, “Because the financial system is path-dependent, disturbances to the allocation of wealth and the viability of financial intermediaries… cannot in general be reversed” by retracing your steps, for the damage has already been done. Remedial action might alleviate the harm, but you can’t run the tape backward and restore the status quo ante. Calomiris has also commented on Depression-era Fed policy that “one cannot expect the Fed to have learned the lessons of the Great Depression before it happened.”²⁹

Theo Balderston, an economist and historian who specialized in Weimar studies, may have said it best:

[T]he insights of economic theory should not be overrated. Economic theory is the attempt to imagine rational relations between data in relation to what has taken place. The imagination is always influenced by the knowledge of what happened later—and by the prevailing economic “paradigm.” We forget the infinity of other unimagined rational relations that could “explain” the data, let alone temporary irrational derangements. Neither the simple economics used here, nor any logically superior macroeconomics of present or future, can leap the chasm that divides us from the minds of the historical actors.… The sombre connection of the history studies in this book and the Nazi catastrophe should make the historian ready to doubt what he thinks he knows.³⁰

The idea of a mental regime or a paradigm is a powerful one, and is especially applicable in Depression studies. Time and again, the researcher sees highly intelligent people make serious mistakes because they were unwitting prisoners of an idea. The prime example, of course, is the almost slavish adherence to the gold standard, which was for many discerning folk a moral issue. Especially when dealing with the gold standard episode, many economists cannot resist poking at the “ignorance” of the day’s policy makers.

But that’s unfair: history doubtless has far more examples of inflationary movements destroying economies than deflationary ones. Consider the experience of the 1970s. In his first term as president, Richard Nixon found himself stuck in a “stagflation”—with unemployment and interest rates rising at the same time. With the 1972 election looming, Nixon did a Roosevelt—floated the dollar, slapped on wage and price controls, and earned a landslide victory. When he was finally forced to remove the wage and price controls, inflation flared out of control. President Carter and his hapless Fed chairman, G. William Miller, flooded the world with “petrodollars.” By the end of the decade, the price of a barrel of oil spiked as high as $568, inflation was running almost 14 percent a year, and the long bond market was a distant memory. With Ronald Reagan’s strong backing, Paul Volcker embarked on a deflationary squeeze over two agonizing years that a Heinrich Brüning or Émile Moreau or Oliver Sprague would have been proud of. It took a Fed discount rate of 19 percent and three-month Treasury bills paying 20 percent before the fever broke.

Wall Street blossomed, and a new mental regime took shape—“The Great Moderation,” compounded of a faith that deregulation, rational expectations, and a mix of neoclassical and monetarist economics, was creating a new nirvana, called “complete markets.” It is the kind of frictionless, perfectly clearing economy that neoclassical economists dream about. Its special feature is that any asset or risk position can be seamlessly converted into a contingent claim—that is, a financial derivative. Alan Greenspan and later, yes, Ben Bernanke, blinded by theory, bought that proposition, and so allowed the rickety towers of overpriced debt instruments, erected on foundations of fraud and wishful thinking, to mount skyward higher and higher until it all came tumbling down.

Should they have known better? Of course, in retrospect it’s obvious that if traders are playing with the house money, they will be tempted to take large risks. When the rewards can run into the tens of millions, and the worst outcome is just getting fired, the choice is pretty easy. The implicit premise of the Great Moderation was an assumption that all financial players would work for the best long-term outcomes of their institution, even if they could make pots of money by putting their own interests first. “Naïve” hardly covers the case.

But there were warnings. An investment partnership called Long-Term Capital Management (LTCM), run by one of Wall Street’s most successful traders, with the participation of two professors who had won Nobel prizes for their insights into capital markets, found itself badly overextended in 1998. The Fed, under its chairman, Alan Greenspan, arranged a bailout by Wall Street banks, which was appropriate because the firm had built a portfolio of $100 billion on an equity base of $1 billion, and was about to generate losses that could have prostrated half of the Street.

Some in the Congress criticized Greenspan’s involvement in such a rescue, but he stressed:

Had the failure of LTCM triggered seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own.³¹

But just a few years after that, at a Chicago investment conference, Greenspan said:

Critics of derivatives often raise the specter of the failure of one dealer imposing debilitating losses on its counterparties, including other dealers, yielding a chain of defaults. However, derivative markets participants seem keenly aware of the counterparty credit risks associated with derivatives and take various measures to mitigate those risks.³²

In effect, so long as you’re willing to risk the occasional crash of “the economies of many nations,” you should put your trust entirely in the self-surveillance of the finance industry. That is an error that matches any by a Depression-era financial regulator.

Alan Greenspan retired from the Fed in 2002, so he wasn’t in office when the Great Recession hit the entire world—the “economies of many nations” that Greenspan had invoked in 1998. Ben Bernanke was, though, and except for a year serving on the President’s Council of Economic Advisers, had been serving on the Fed since 2002. He was also a notable proselytizer of the Great Moderation and the complete markets paradigm.

We were fortunate that Bernanke was a leading scholar of the Depression, which gave him an admirable tool kit for repairing the damage. Conceivably no other Fed chairman, without his particular experience in Depression studies, could have done as well, and we should be grateful for his service. But his record will forever be blackened by his failure to see the crash coming, victim of his own blinding mental regime.