Here’s an interesting new Evan Soltas piece in Bloomberg:
The U.S. economy slips into recession. The stock market takes a tumble as heady expectations for future growth cool. Interest rates fall as the Federal Reserve quickly trims the discount rate in hope of cushioning the business cycle.
The low interest rate environment sets off a massive wave of home construction and an asset bubble in real estate. By the time the Federal Reserve takes action, the boom is completely out of control. Bank balance sheets and household savings have become dependent on the profound mispricing of real estate and other equity holdings.
The heedless extent of leverage makes the financial system extremely vulnerable to capital losses. As the housing bubble implodes, it pushes the economy into a long, deep recession.
This is the economic story of the last decade — and of the 1920s.
After a sharp deflationary recession at the end of World War I, the newly created Federal Reserve slashed interest rates, setting off a housing bubble of such an incredible scale that it dwarfs its recent counterpart. When the bubble ended, what seemed to be a calm and contained contraction turned violent, culminating in the macroeconomic implosion of the Great Depression.
It sounds a lot like the recent crisis, but I also see some important differences:
1. Monetary policy was not expansionary during the 1920s. And indeed Evan doesn’t present any evidence suggesting it was easy. Take whatever criteria you like, starting with interest rates. Evan mentions that interest rates fluctuated between 3% and 7%, but fails to mention that the 1920s began with deflation (1920-21), and then saw level prices for the rest of the decade. With inflation expectations near zero (typical of a gold standard regime) real rates ranged for normal to high. The monetary base was flat during the 1920s, a decade that saw rapid growth in population and RGDP. Even if you take sub-periods where the base increased, it was certainly not expansionary compared to most other periods of history. NGDP rose slightly during the 1920s, but fell sharply in per capita terms (which is very unusual.) And there was no “bubble” in real estate prices, Soltas mentions a price bubble in Manhattan, which did occur, but there was no significant nationwide change in either real or nominal house prices during the 1920s.
2. Although money wasn’t easy, it’s still possible that the huge rise and fall in housing construction somehow caused a depression to begin in 1929. But it’s hard to see how that would have occurred. Suppose NGDP had remained stable after 1929, instead of falling by 50%, does anyone seriously believe a housing decline would have caused a depression? I suppose one could use a re-allocation story, but then other sectors should have been booming, and they were also declining. Furthermore, a substantial amount of decline took place between the peak of 1926 and mid-1929, and yet the economy continued booming. Previously I’ve pointed to the fact that the US economy didn’t fall off a cliff between January 2006 and April 2008, despite a huge decline in housing construction. But the 1926-29 period is even more problematic for bubble worriers, as while 2006-08 saw an economic slowdown, 1926-29 was actually a boom period. It’s not obvious why the boom could not have continued into 1930.
3. So the problem wasn’t tight money, and the problem wasn’t the decline in housing construction. Perhaps the decline in housing construction somehow caused a banking crisis, which dragged down NGDP (due to the gold standard.) But why would a decline in housing construction have caused banking crisis? Even worse, in 2007 we saw the banking system come under great stress, despite the economy not even being in recession. Now contrast that with the period from August 1929 to October 1930, which saw a recession even deeper than 2009, and no banking crisis at all! Why the difference? I can only speculate, but perhaps there were two key differences. In the 2000s banks made the sort of highly risky mortgage loans that banks did not make in the 1920s (although loan quality fell off a bit late in the 1920s.) And second, in the 2000s there was a huge increase and then decrease in home prices. Because there was no price bubble in the 1920s, there was no banking crisis in the first 14 months of the Depression. Instead, tight money by the Fed, the BOE, and the Bank of France created world-wide deflation and drove NGDP much lower during 1929-30. The banking crises only began to develop when falling NGDP drove nominal incomes much lower.
4. Now it is true that the fall in NGDP did eventually get so bad that a banking crisis developed, but you’d expect that with any severe decline in nominal incomes. A very mild banking crisis occurred in Tennessee in November 1930, and then a more severe one developed all over the world in mid-1931. That’s what you’d expect in a world on non-indexed debt and rapidly falling NGDP. And that led to gold and currency hoarding, which drove NGDP still lower.
Of course in pointing to the fall in NGDP I’m not telling Evan anything he doesn’t already know, and indeed has written eloquently about. If you don’t want a collapse in RGDP, tell the central bank not to allow a collapse in NGDP.
And make sure you don’t screw up the supply-side of your economy with disincentives to produce.