Via- IBD
Many see the current financial crisis as rivaling the Great Depression. In some ways they're right . . . but for the wrong reasons.
The two are comparable, certainly. But there are also fundamental dissimilarities. By looking at both, what really becomes clear is the current crisis' unique character.
While the Depression is commonly attributed to 1929's stock market crash, its real cause was more prosaic: money. As Nobel economist Milton Friedman demonstrated in his 1963 masterpiece, "A Monetary History of the United States, 1867-1960," the Depression resulted from a steady and dramatic decrease in the nation's money supply.
This monetary contraction triggered a domino effect of financial collapses — stocks, bonds, banks and the economy itself.
Friedman showed money's role in the Depression and its importance in the overall economy, noting that "from the cyclical peak in August 1929 to the cyclical trough in March 1933, the stock of money fell by over a third."
Each collapse during the Depression could have been relatively easily addressed, resulting in much smaller economic contractions, if the money supply weren't so constricted. Instead, each collapse swept away more of the nation's financial infrastructure. Eventually, more than one in three banks went under.
The simplest form of financial infrastructure is money. It's so basic, we tend to overlook its importance — as Friedman's predecessors and contemporaries did.
Its proper management is as central to an economy as water is to agriculture. Collecting naturally, water is relatively unproductive; it does limited work. Properly channeled and dispersed, it becomes more efficient and supports more agriculture.
In the economy, money's productivity is measured by its velocity — the ratio of money income to the stock of money. Friedman showed money's velocity declines during economic contractions, increases during expansions and does so in proportion to the size of each.
How much work money does can be calculated by comparing the size of the money supply to the size of the economy supported. It is instructive to look at money velocity now. As the adjacent table shows, velocity — of both M1 and M2 — appeared relatively stable in 2007. In that year's fourth quarter, M2's velocity swung slightly negative and has remained there since.
M1 did not turn negative until the third quarter of 2008. When it did, it did so with a vengeance. Both measures of money fell precipitously in 2008's fourth quarter — when real GDP dropped 6.2%, its sharpest decline since 1982.
This seems akin to the circumstances in the Depression, when a collapse of the financial infrastructure slowed money velocity by nearly a third from 1929 to 1933.
However, there's a crucial difference between the two downturns.
As the table shows, rather than constricting money supply as it did during the Depression, the Fed has been aggressively increasing it in the current crisis.
According to the Fed's statistics, M1 grew at a seasonally adjusted annual rate of 17% in 2008 while M2 grew at a 9.9% rate. Both accelerated rapidly as the crisis deepened — M1 increasing at a 39.6% and M2 at a 18.4% SAAR in 2008's fourth quarter.
In contrast with the Depression, money's velocity during the current crisis is not slowing because its supply contracted. Instead, the channels that had distributed it throughout the economy abruptly ceased to function. Following the irrigation simile, a vast extent of the economy is now parched.
What has made the current financial crisis so unnerving to policymakers is a realization that even the vigorous use of conventional monetary tools has had little effect. Without a sophisticated financial infrastructure, our economy cannot function at the level America expects.
As more and more of its sophisticated mechanisms fail and the infrastructure becomes more basic, we see this clearly.
The current financial crisis is similar to the Depression in its collapse of financial facilities. However, it has done so for dissimilar reasons. The current collapse wasn't caused by a constricted money supply, and it hasn't been cured by an expanded one. Even with a larger money supply, the financial infrastructure has broken so quickly and effectively that it can't distribute the increased money supply.
What defines the current crisis is not its similarities or dissimilarities to the Depression, but its uniqueness. It's hard not to sympathize with policymakers trying to disburse liquidity around a failing system. They're like a bucket brigade seeking to disperse water — trying to prime a pump here and repair a channel there.
Young served in the Treasury Department and the Office of Management and Budget from 2001 to 2004 and as a congressional staff member from 1987 to 2000.
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