Macroeconomic paradigm shifts and Keynes’s General Theory

Matthew N Luzzetti, Lee E. Ohanian, 31 January 2011



This month marks the 75th anniversary of the publication of Keynes’s The General Theory of Employment, Interest, and Money (Keynes 1936). The impact of the General Theory is unquestionable. It became the dominant paradigm through the 1960s and today’s policymakers still cling to many of the General Theory’s tenets.

Topics: Frontiers of economic research, Macroeconomic policy
Tags: economic thought, Great Depression, Keynes

A recession to remember: Lessons from the US, 1937–1938

Nicholas Crafts, Peter Fearon, 23 November 2010



OECD countries are recovering from the worst recession and financial crisis since the Great Depression. Policymakers’ problems are now those of designing the right exit strategy. Withdraw stimulus too soon and tip the economy back into recession; leave it too late and see inflation take off.

Topics: Economic history, Global crisis, Macroeconomic policy, Monetary policy
Tags: fiscal stimulus, global crisis, Great Depression, quantitative easing

Did France cause the Great Depression?

Douglas Irwin, 20 September 2010



A large body of economic research has linked the gold standard to the length and severity of the Great Depression of the 1930s, primarily because fixed exchange rates precluded the use of monetary policy to address the crisis (see for example Temin 1989, Eichengreen 1992, and Bernanke 1995)

Topics: Economic history, Global crisis, Monetary policy
Tags: France, gold standard, Great Depression, US

Diminished expectations, double dips, and external shocks: The decade after the fall

Carmen M Reinhart, Vincent Reinhart, 13 September 2010



"The process of contraction, like the process of expansion, is cumulative and self-reinforcing. Once started, no matter how, there is a tendency for it to go on, even if the force by which it was provoked has in the meantime ceased to operate."--Gottfried Haberler, Prosperity and Depression, 1937

Topics: Global crisis
Tags: double dip, financial crises, Fiscal crisis, global crisis, Great Depression

Social trust, social fragility and the financial crisis

Paul Seabright interviewed by Romesh Vaitilingam, 10 Sep 2010

Paul Seabright of the Toulouse School of Economics talks to Romesh Vaitilingam about his book ‘The Company of Strangers: A Natural History of Economic Life’, recently issued in a revised version, which applies the ideas about social trust and social fragility to the financial crisis. Among other things, he outlines the three lessons mistakenly learned from the experience of the 1930s. The interview was recorded at the annual congress of the European Economic Association in Glasgow in August 2010.


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Romesh Vaitilingam interviews Paul Seabright for Vox

August 2010

Transcription of an VoxEU audio interview []

Romesh Vaitilingam: Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview is with Paul Seabright from the Toulouse School of Economics. Paul and I met at the European Economic Association’s annual meeting in Glasgow in August 2010, where we spoke about his book The Company of Strangers: A Natural History of Economic Life. The book has recently been reissued to take account of the financial crisis. But I started off by asking Paul to explain the basic idea of his book.

Paul Seabright: You got to the street in the morning and you maybe buy a newspaper from somebody or you buy a cup of coffee. You can sit down with your cup of coffee and you read the newspaper in a cafe. And you're doing something that your prehistoric ancestors would have found suicidal. You're trusting your life to people who have absolutely no reason to want to help you. And as we now know from the studies of hunter gatherers and apes and so on, have every reason to want to kill you.

What the book is about is this small but extraordinary miracle that although in many ways in our brains we have all the inherited psychology of the great apes, and in particular of the hunter and gatherers humans that succeeded them, which should lead us, based on everything we know, to be suspicious of strangers, to be very cautious before we ever get into a situation where they can do us any harm. In fact, we constructed a social life that depends on them to an extent that is so extraordinary that we've forgotten how it happens.

If you took away all of the things that other people do to you, people who you've never met, all of the goods they prepare for you to wear and to use, the food they prepared for you to eat, you'd starve within a few weeks, so would I.

I'd be quite incapable of surviving without the help of all of these unknown individuals; I expect you would be too. The book is about the fact that we've managed to do something which everything in our psychology ought to suggest would be impossible, but which is the foundation of the prosperity of the societies we know today.

Romesh: So, it's really about how trust evolved, how we got to a position as individuals to treat strangers as “honorary friends,” in the terms you used in the book.

Paul: Absolutely. Given that we've evolved to be very good at trusting people we know well and we have somehow managed to use that talent to trust people we don't know at all.

Romesh: In the new edition of the book, which you've written since the financial crisis and the Great Recession, you've applied this idea. Can you explain how that trust issue relates to the financial crisis?

Paul: Absolutely, yes. One of the ways we have learned to trust other people is that we trust the institutions within which they work. So, there's a knock on the door in the morning and I go to the door and there's a strange man I've never met before. You might think the natural, sensible thing to do would be to shut the door in his face and not to let him anywhere near my house. But, suppose, he's wearing a uniform, and he's a repair man from the company that sold me my washing machine. Well, I'll let him in. I don't know anything more about him than that, but the uniform acts as the kind of badge that makes me willing to trust him.

Now, almost everything we do in our day to day life is borne up by that kind of badge wearing. The reason I can go up to a stranger and ask him for a cup of coffee is because there's a Starbucks sign discreetly nearby or whatever it might be. So our life is constructed around what you might think of as a series of passports people use to persuade others that they really are trustworthy.

Now, the most sophisticated of those passports come from financial institutions. If somebody comes up to me in the street and asks me to give them many thousands of pounds, or somebody sends me a nice email from Nigeria or whatever, then in general I'll have nothing to do with that.

On the other hand, I might well go into a building and hand over many thousands of pounds to somebody I've never met before, because they come with the authority behind them of a financial institution. And what happened in the financial crisis was that we learned about the uses and the abuses of that kind of trust.

What in particular I want to describe is the fact that the reason why the architecture of our financial system became so fragile was not that the whole system was run by greedy people. We know that most of life is run by greedy people anyway and that doesn't explain why it became fragile at the particular point it did.

What it explained why it became fragile at the particular point that it did was, paradoxically, that it was working so well that we no longer asked ourselves questions about the foundations of that success. In particular, we treated it as a black box, which could be relied on to go on working all the time. So, it's looking a bit like the autopilot in a plane. If the autopilot works really, really well, then the pilots go to sleep.

You want to have some kind of system in which you can trust the autopilot most of the time, but for the rare occasions when the autopilot might misfunction somebody has got their eye on it and somebody knows what to do. In some sense, too much of our financial architecture was on autopilot, to mix metaphors from architecture and aeronautics.

The result of that was that when the fragility started to become evident, then first of all there's a bit of a scramble because everybody thought it was somebody else's responsibility. And when it became too big to ignore, nobody quite knew how to react.

Romesh: You also make an analogy to go on from aeronautics and from architecture, you use the analogy of the electricity supply, in a way financial services are a key part of our infrastructure. Can you unpack that analogy a little bit more?

Paul: Yes. That analogy I borrowed from a financial economist in America called Gary Gorton, who has written some very interesting stuff on the crisis. He makes a very interesting point. I think that when we use financial institutions and financial instruments, we have to know very little about the detail of the way they work. If I write you a check for £50 you know that it's worth the same as a check for £50 written by somebody else written on a different bank. You don't normally have to sit down and think, "This £50 check on Lloyds is worth the same as a £50 check on the Royal Bank of Scotland." The whole point about the institution of banking and deposit taking is that claims on those deposits have a value that doesn't have to be constantly called into question.

And that will be quite different for example, if we used--as we might well use--our mutual funds to settle our ordinary payments. And if you offered me a one nth share of your mutual fund account, and it was different from somebody else's mutual fund account, then I might have to ask all sorts of questions about whether the one nth share that you offered me as a payment was worth the same as the one nth share that somebody else is offering me.

Now, the great thing about deposit taking institutions, we don't have to ask that question. And Gary Gorton puts his finger on it when he says that a well functioning banking system allows people who know nothing about financial instruments to use the benefits of financial instruments in exactly the same way as an electricity grid that allows a person who's not an electrician to get the benefits of using electricity. And that's great.

You know, I plug in my kettle to the grid without really having to know anything about physics or the electronics of it. And most of the time, I can ignore it. Now, we know that electricity grids sometimes break down. And they sometimes break down for reasons that might have to do with sudden spikes in demand because it's the break in the World Cup final. They could do for more complex reasons as when the electricity grid in California blacked out some years ago. And when that happens, that's usually because people become too complacent about how well it's all working.

In exactly the same way, when everybody becomes too complacent about how well a financial system is working, then you have to worry. And that's particularly true because in finance, as we were discovering, the rate of technological innovation is so much faster than the electricity. And so, the new instruments that are being developed all of the time, some of them have the capacity to undermine the very stability that is making everybody stay complacent about how the system works.

But, in a sense, the point that I think that very nice analogy of Gary Gorton’s makes is that if the system were working terribly and were not delivering great benefits, then it would be mysterious why it should have this capacity to catch us so unawares. You know, people who say, "Oh, you know, modern finance is a disaster," in a sense, haven't grasped the essentials of that point. Modern finance can trap us in this way, precisely because it does deliver such real and such valuable benefits, and is so trustworthy for such a remarkable part of the time.

Romesh: And over that time, you really date it back to the period where we've really built up this trust since the last time there was a huge collapse, which was back in the 1930s. And, you seem to suggest that we came out of the Depression and learned the wrong lessons in terms of how we think about the financial sector.

Paul: Yes we did. There's nothing more dangerous than to think that we've learned the lessons of history and, therefore, we can relax. In particular, the lessons that we thought we'd learned from the 1930s, I think, comprise three rather dangerous simplifications.

The first idea was that in the 1930s we thought banks had failed because people panicked. And as I say in the book, this is sort of the little bit like the theory that it's running away from the lions that causes the lions to eat you. You know, there is some truth in that. But, if you go to a game reserve, it's not a truth on which you really want to rely.

And, similarly, we've been discovering since then that I think as a result of careful historical work by economic historians that although there was quite a lot of panic, and although many banks failed, in most cases, the panic was well founded. It wasn't the panic that caused the failure. The failure was caused by incompetence and dishonesty in exactly the same way as it's been caused recently by incompetence and dishonesty.

Now, how did that feed into the other bad lessons we learned? Well, the second lesson we thought we'd learned was that the people you had to worry about were the small depositors the households, the individuals, the small firms, and so on. They didn't really know very much about finance. They couldn't be expected to worry their little heads about it. And so, naturally, they had to be reassured. And they had to be reassured by deposit insurance, and everything had to be done to make them avoid panicking.

The grown ups, the people who are the professional investors, they don't need reassurance. They understand about finance. They're not going to panic. So, essentially, it's going to be possible, providing we protect the small depositors, to let the big depositors take care of themselves.
And that turned out to be a big mistake, because what happened, for example, when Lehman Brothers went belly up, was not that there'd been a panic of the small depositors, it was that the professionals panicked. And, in some sense, it was the banks that stopped trusting each other before we, the rest of the public, could realize it was time to stop trusting the banks.

Now, many people think of the Northern Rock episode, when there was a run --the first run on British banks since the 19th century--has been emblematic of the crisis. But it wasn't. It was a radical exception to everything else that happened in the crisis. And it happened for completely different reasons because the deposit insurance coverage in the UK was somewhat incomplete, which is a problem that's since been fixed.

But the panic of the small depositors, the kind of people who lined up outside Northern Rock, posed no real threat to the banking system at all. It was the panic of the big people, of the financial investors. It was when nobody who had money on overnight deposit was willing to trust institutions in which they were trying to put that money. In other words, it's when the corporate treasurers and when the treasurers of the banks themselves were not trusting other banks that we really had a seizure in the financial system.

So, the idea was that we didn't have to worry about professional investors. We realize now that professional investors are precisely the people we have to worry about most of all. That kind of lesson, we now, I think, understand much better. But, we still have to find ways of making those professional investors behave in ways that are more consistent with the long term health of the financial system.

And, if I can just say, the final lesson the we thought we'd learned was because we thought it was the small investors who were prone to panic, and we didn't have to worry about the big ones, the general message was that confidence had to be sustained in the financial system even if the underlying reasons why we might have to be confident are not always very sound.

So, the importance of maintaining confidence led policymakers right across the world to welcome things that looked as though they were confidence restoring, like the increase in house prices which made everybody more confident. Those things were in fact making people feel more confident, but at the same time, simultaneously undermining the objective basis that they had to be confident. And we now realize that what's important is not making people feel confident, but making sure that the system in which their confidence rests is actually deserving of that confidence.

Romesh: Your book draws on evolutionary ideas as well as material from economic analysis and from history, and some other disciplines: Is there some kind of evolutionary flaw in humankind that makes us prone to not learn the lessons of history, or learn the wrong lessons from history?

Paul: Well, I think that's being a bit tough to us and where we've come from. You know, there's a whole discipline called behavioral economics within which I work, and which obviously I think is full of rich and interesting insights, but which has a tendency to see human beings as rather imperfect, rational calculating machines.
I don't think we're imperfect, rational calculating machines, I think we're extremely sophisticated apes. And it's much more interesting and perceptive, I think, to see us as sophisticated apes than as imperfect computers.

Now, as sophisticated apes, we do quite a lot of things that other apes also do. For example, we care intensely about status.

So, for example, when we do things like manage portfolios for financial institutions, we care enormously about big bonuses, and we manage our investment strategies in order to get those big bonuses, not necessarily because we desperately need to spend large amounts of money, but because those bonuses are signals of our relative status in a peer group. And everything in our primate history tells us that caring about relative status in our peer group is one of the most dominating concerns and passions that anybody can have.

Similarly, one of the things that apes do and do very successfully is try to out strategize each other, and they do so pretty successfully to what I think of as a remarkable degree of sophistication. That's to say, chimpanzees can perhaps anticipate one degree of strategic complexity. Human beings can perhaps manage three degrees of strategic complexity.

In order to be able to solve a dynamic stochastic general equilibrium model and apply it to the real world, you have to be able to solve an infinite number of degrees of strategic complexity, and I don't think it's reasonable to expect us to do that.

Romesh: [laughs] Final question, Paul. You end the book by talking about fragility, which I think really comes across as a very powerful message. The fact that, you think that it's an extraordinary achievement, the evolution of human beings into this position where we benefit hugely from the company of strangers. But, it does feel, perhaps particularly in the early years of the 21st century, that we are in a very fragile position.

We've had the financial crash, which is another once in a generation event, but there's also all sorts of other challenges like climate change, terrorism, war. Can you just describe a little more how you think about the fragility of this achievement?

Paul: Well, it's always difficult to know whether you see the glass half full or the glass half empty. I think an interesting analogy between economics and other disciplines comes from medicine where, even if you study disease and you're aware of the terrible ways in which the human body can break down, you can only begin to see how those things happen if you've gone through the process of being extraordinarily impressed by how well the human body functions in the first place. Nobody can be a good doctor if they're not essentially a good physiologist first.

And I think similarly, understanding the crisis, it's not enough to say, we know that capitalism is dysfunctional. You have to understand, in some sense, dare I say, the beauty of capitalism in order to have understood why it can be so terribly flawed. And the flaws are not just that there are breakdowns and crises, but that even when capitalism is working well, it can leave some people terribly out of the prosperity enjoyed by others. And there are parts of the world where, in some sense, capitalism has never properly taken root, and that's a tragedy.

Now, the sense of fragility, I think, is, therefore, engendered by an awareness that because it's so remarkable how far we've come, it's also possible that some of those achievements might be destroyed, either by inadvertence or by conscious malice on the part of some people who want the sophisticated web of human interaction to breakdown.

Clearly, the more imaginative and ingenious terrorists in the modern world try to strike at both symbolic and actual hubs of modern society for precisely that reason. The reason you take out the Twin Towers is not because intrinsically, you think that that particular chunk of US GDP is going to matter. It's because you think the symbolism is going to help to unravel people's ways of feeling trust and confidence in each other in a particularly damaging way and you see it, I mean, the current US controversy over whether to build an Islamic center in the neighborhood of Ground Zero is a terrible testimony to how effective the Bin Laden assault has been. I can't think of any greater tribute to Bin Laden's objectives than to say all Muslims in America should be presumed to have been a party to his plan.

Now, that suggests, therefore, that if we're looking, we need to take a different approach to inadvertent threats to the stability of modern society from malicious threats. And clearly, malicious threats tend to pick the more vulnerable hubs much more than random chance would do. And so clearly, we need to treat those kinds of threats in a different way.

But, the general point is absolutely right. The more sophisticated are the interactions that modern society allows, encourages and develops, the greater the risk that certain kinds of keystones in the architecture might turn out to have much more damaging effects when removed than anybody had previously imagined, and that's a threat we're going to be living with for decades.

Romesh: Paul Seabright. Thanks very much.

Paul: Thank you.

Topics: Development, Financial markets, Institutions and economics
Tags: global crisis, Great Depression, social fragmentation

Is this your grandfather’s mortgage crisis?

Kenneth A. Snowden, 10 September 2010



The current mortgage crisis in the US is more severe than any since the 1930s. So it makes good sense to examine the origins, impacts, and consequences of that last great mortgage crisis great mortgage crisis – indeed many commentators have made a direct comparison between the two (see for example Eichengreen and O'Rourke 2010).

Topics: Financial markets, Global crisis
Tags: financial regulation, global crisis, Great Depression, subprime crisis, US

The labour market and economic recovery in the Great Depression

Timothy J Hatton, 9 September 2010



The sharp and deep recession that followed the global economic crisis looked very much like the Great Depression to start with, but so far it has not turned out that way (see Eichengreen and O’Rourke 2010).

Topics: Economic history, Global crisis, Labour markets
Tags: global crisis, Great Depression, jobs, labour market flexibility, New Deal

Two centuries of commercial banking: crises, bailouts, mergers and regulation

Richard S. Grossman interviewed by Romesh Vaitilingam, 23 Jul 2010

Richard Grossman of Wesleyan University talks to Romesh Vaitilingam about his new book ‘Unsettled Account: The Evolution of Banking in the Industrialized World since 1800’. Among other things, they discuss the problems of striking a balance between a dynamic banking system and a stable banking system. The interview was recorded at a conference on ‘Lessons from the Great Depression for the Making of Economic Policy’ in London in April 2010.


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Romesh Vaitilingam interviews Richard Grossman for Vox

July 2010

Transcription of an VoxEU audio interview []

Romesh Vaitilingam: Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview is with economic historian Professor Richard Grossman from Wesleyan University. Richard and I met in London in April 2010 when he spoke about his new book "Unsettled Account: The Evolution of Banking in the Industrialized World since 1800".

Richard Grossman: The idea is to look at banking structure over the last 200 years and to look at sort of four types of events that have shaped banking system. So I looked at financial crisis, topical at the moment, bailouts, also topical, merger movements and government regulation; actually, all four of those. How wonderful. All of those are topical and what I try and do is looked comparatively across Western Europe, the United States, Canada and Japan, what we would think as the advanced industrialized, OECD type countries that were among the first to develop commercial banking and to look at that and to look at some of the commonalities.

It is very hard. Again, it is a little humbling because I will admit to you that I don't read Finnish or Japanese for that matter and then probably one or two other languages of countries that I cover. But the problem I find with a lot of what's missing from a lot of comparative studies of banking I find is that they are written, they are usually a conference volume and you have one person writing on Britain, one person writing on France and one person writing on Japan. And you put this all together and if you are lucky, they'll be a well read editor who will sit down and who will do some comparative piece at the beginning or the end.

But I was a little bit--what I think is needed is someone to actually, even though they are not necessarily experts of this different countries or conversant with the material or the languages that the laws and histories are written in, to do an in depth comparative study. And so to say, “How were financial crisis generated across different countries and how do bailouts differ over time. What were responsible for merger movements?” And so the idea is to take a truly comparative look across these countries over the last 200 years and to try and get some sense as to what are the main forces that are responsible for banking evolution.

Romesh: So perhaps you can take one of these topics and focus on the financial crisis you say is very topical, perhaps you can give us a picture of the differences and how different banking systems, different national banking systems have coped with crisis.

Richard: Sure. Well, in terms of how crisis are generated. I sort of divide crisis into three, I think of three key things that have generated crisis. The one by far the largest is what I call in book “Boom Bust”, which I think would be relevant for what's been going on for the last few years. And this is the sort of thing that was described by Irving Fisher, 70 or so years ago, by Hyman Minsky and Charles Kindleberger. And the notion is that you have an economic expansion that gets a little bit out of control. There's an expansion of credit. There may be a creation of new banks but the banks that are there start making more and more loans and as the expansion grows, banks continue to make loans even beyond the point where these loans make economic sense.

And as Fisher writes about it in his book, he says, "If only the process would stop at equilibrium." But of course it doesn't and the boom continues. This usually includes speculation in one or more types of securities or assets and at some point, there is an overreaching and it all collapses. And the collapse leads to a collapse of the banks and it leads to a collapse of the people who owe banks money which leads to a further collapse and a knock on effect.

The financial crises have been remarkably consistent over time and they have affected different countries. I would say that most of these have been quite similar in the sense that you see a great commonality across all countries. Countries with very different financial systems, very different economic systems and you still see this boom-bust situation.

There are other factors, structural factors. One of the reasons why during the Great Depression, Britain I would say was relatively stable, was the fact that Britain was composed of a few large banks, which has benefits in terms of especially when the economy turns down. If you only have a dozen or so very large banks, it is easier for them to protect themselves there. They are larger. They are able to cooperate with each other. They are better able to defend themselves.

So one of the things that looking cross-country has shown is that countries with more extensively branched banks--larger banks, more concentrated banks, these things all seem to go together--that those countries were generally more successful at avoiding banking crisis.

In terms of dealing with them there have been different styles. I sort of have classified. I have classifications for everything. I have classifications of how countries rescue banking systems. One would be the bailout and that is we would have a financial concern that is in trouble and the government lends it money or goes and somehow and provides assistance.

This is a very old type of bailout; the bank of New South Wales did it back in the 1820's in Australia. In Germany, there was the Stadt Hausen Bank and these were subjects of bailouts and these are targeted at one particularly important firm that the government or other financial firms considers to be essential. And this is the too-big-to-fail argument.
Now, in general, economists are worried about bailouts because bailouts can lead to moral hazard. If I know I am going to be bailed out then I am going to take a completely different approach to my risk profile, it will be different than if I know that I am completely on my own.

The second sort of form of rescue, this is pioneered by the British, and that is what was known as the lender of last resort operations. And that is the case where the firm or bank maybe in perfect good shape. They just don't have cash to pay out. The notion being that it may be that the bank is in fine shape but there is no market for its collateral so if I’ve made loans against certain securities, and there’s no markets for those securities, I can't sell them for a moment so I as a bank will be liquidity strapped and so what I could do is if there is a lender of last resort like the bank of England, then I just go to the lender of last resort. And I give them my securities and then they lend me money against them or I sell them the securities.

Forrest Capie who is at the bank of England now and City University has a wonderful phrase. He talks about the lender of last resort as a frosted glass window that's raised a couple of inches above the desk and you come to the central bank and you push your securities under the glass. And they give you money bank and they don't care who it is which is completely like a buyout. They don't care who you are, they just discount good collateral.

So that would be the second type and again, this was pioneered in Britain and has been developed over the years but really the British was the first to do it. And Walter Bagehot certainly made it famous in his 1873 book "Lombard Street".

The third is something what I call more extreme measures and this is when the government nationalizes banks, takes over the banks and declares a banking holiday or has somehow more extensive intervention. And again it is not so much that one country did one thing and one country did another thing. But it is that different circumstances have brought out different things. But over time I would say lender of last resort became popular.

During the Great Depression, more extensive, more emergency measures came into play because it was more severe that anything that had happened before and I would argue anything that had happened since. So these more extreme measures--the Italians nationalized the banks, the Americans declared bank holidays so that banks couldn't go out of business because they were closed. And so you couldn't withdraw money from your bank because your bank was closed or you couldn't take bank to court for not paying deposits. So in other countries in Scandinavia declared deposit moratoria saying that you couldn't take out deposits and government-issued guarantee. So these are extensive measures. Again, the more severe the crisis, it seems to be these are the measures that seem to come up more and more. And in the current crisis, not to divert us to what is going on now. I would say that those have become more likely outcomes.

Romesh: Let us talk a little bit about lessons for the current crisis. One of the big issues being discussed at the moment in debate about the future of banking, regulation is about this distinction between universal banking sand separating to into narrow banks and “casino” banks, for want of a better term. What kind of light does your comparison history have to shed on that discussion?

Richard: It is a very interesting question. Well, there's the difference between universal banks and separated commercial and investment banks and then there is also sort of the unregulated banks. One the difficulties in writing this book was that you think of commercial banks as banks. But as it turns out of course, you have savings banks and other kinds of mortgage…building societies and different. Every country has many different varieties of financial institutions and so there is the issue between of the regulated and the unregulated. And the unregulated would be what's popularly known as the shadow banking system, and hedge funds, and many insurance companies.

I have come to the conclusion that having a lot of unregulated financial activity is maybe not such a good idea. It's a tricky business, though, because the market moves very rapidly. This is little bit of a problem I have with the Basel Acccords and that is the market moves very rapidly. A lot of the Basel Accords allows banks to use the internal ratings-based approach…I can't remember the acronym, but in terms of rating capital, in terms of rating assets and what sort of capital it has to be.

I think the market moves very rapidly, and I think that the market is much more nimble that either regulators have been or ratings agencies have been. It's extraordinarily difficult to do that and I don't know the answer as to how that should be done, but I think, clearly, we need more regulation and more ways of thinking about how to achieve that sort of sufficient regulation without over-regulating.

After the Great Depression, there was such a total financial meltdown that countries around the world instituted what I call in the book a financial lockdown. Interest rates were regulated. Banks were regulated in terms of what they could do. In the United States, for example, we had Glass Steagall. The Belgians, at this point, also got rid of universal banking, or they separated commercial and investment banking. There was some nationalization. There were a lot of different things that were done to restrict banks in terms of what they could do.

That lasted from the end of World War II until the late '60s, early '70s. This was the breakdown of Bretton Woods. There were interest rate pressures. When market rates go up, it's hard to have capped deposit rates and lending rates. And so, all this sort of broke down. But the thing about this period of lockdown is there were no financial crisis. Banking didn't evolve very much but there were no financial crisis between 1945 and 1972, really. There were none.

And then you had Bank Haus der Stadt in Germany, and you had Franklin National in the US, and it sort of went on from there. And so, the downside of having all that super regulation, that very tight regulation, is that the banking industry or banking didn't evolve very much for 20 or 25 years. That's the downside.

The upside is we had a very stable banking environment. I guess the example that I would use is that you could reduce fatalities on the M1 to practically zero on the motorway if you just reduced the speed limit to 20. I think that's what the situation was with banking. We reduced the speed limit to 20, and we had no fatalities, but we didn't really have much throughput on the M1.

Striking this balance is just so difficult. I don't claim to have the answers. I'm getting a sense when we've gone too far, but I think it's very hard for anybody to say exactly where we need to be. But I think that's the issue of striking the balance between our desire for safe and sound banking as it states in Basel on safety and stability, versus… Again, I don't agree with people who say that finance somehow doesn't contribute. Finance contributes a lot to the development of the economy, and financial innovation is very important. It allows people to use funds that they might not have.

I don't mean to say that we should ban all financial innovation, but we somehow have to strike a balance between financial innovation and maintaining safety and soundness. That's what I think is the crucial issue.

Romesh: You're looking over a very long period of time, over 200 years, across a range of different countries. Has there, over time, generally been a kind of convergence in the form of banking systems, or do national banking systems still seem very distinct and different?

Richard: There has been a fair bit of convergence, I would say, and the outlier here being the United States where we have many, many, many more banks per person than pretty much any other industrialized country. That's got to do with our very strange and wonderful system of regulation and states. What you see if you look from the beginnings of industrialization through the Great Depression--so the Great Depression is a great dividing line—but if you look from, say, 1800 onwards, what you see is the birth of commercial banking; rapid growth. If you just look at a graph of the number of banks in a country, you see this wavelike pattern. A huge increase, and then you reach a point and where that point is, that magical point where it maxes out is hard to say, but at that point you can either have a financial crisis, or you can have the development of a merger movement, or you can have the development of a financial crisis that is followed quickly by a merger movement, as banks get taken out.

But there's something that leads to a turnaround, and what you see in almost all of these countries is a rapid increase and then a gradual--I'm describing it in terms of a smooth line, but the line is never smooth--but then there's a greater concentration.

So you do see a real convergence. There's a greater amount of concentration. Even in the United States the number of banks is falling, but it's clear if you look at this wave. I'm waving with my hand which, of course, doesn't do your listeners any good. You just see this rapid increase and then this gradual decline over time. That's quite similar.

Then you hit the Great Depression and everything stops. Everything is pretty much frozen in time from then until after World War II. Things stay pretty much static until the late '60s, early '70s when, again, there's inflation, the breakdown of Bretton Woods, the breakdown of domestic limits on interest rates.

And then things really start to happen, and that's where we get into this newest round of deregulation. Politicians think the way to get around these things is to deregulate it. In some sense, I think, probably, it was right. I think, probably, having interest rates that are more flexible sort of makes more sense than having tight limits on interest rates.
Because, having the interest rate on your savings account limited to 2.5% when you can go and buy commercial paper that's paying a percent more just punishes individual savers. Again I don't want to come across as someone who's opposed to deregulation, but on the other hand, it's got to be done well. It's got to be done with appropriate safeguards. And of course that's the devil in the details.

Romesh: Final question. Originally is there, looking across all the countries in Europe, looking across all the periods of time, is there a star performer amongst them? Is there a banking system that, in a sense, has combined not being too susceptible to financial crisis, and at the same time being reasonably innovative in its banking system?

Richard: There's so many peculiarities and so many differences. There are some that have been relatively crisis free. Canada has not had much in the way of banking crises. Canada, in a sense like Britain, was dominated by a few large banks. People have made the comparison between Canada and the United States for a long time. Canada is a country that's much smaller, but has a dozen or two dozen banks, whereas the United States has many thousands of banks. Of course, there was a Canadian Banker's Association that did a great deal of self regulation. So Canada has been a little bit less crisis prone, certainly than the United States. The United States really stands out next to anyone. I have to say, we have perfected having banking crises in the United States. It does have a lot to do with having had a lot of small banks, but I would argue that's not really our main problem, but that is certainly one of the issues.

Britain has been on the banking system; after the Baring crisis in 1890, Britain was really quite stable through the Great Depression. Britain didn't have a banking crisis during the Great Depression. Some of this had to do with the fact that concentration had been quite advanced in Britain.

If you look at a graph of British banking concentration it goes way up, and by the time you get to World War I, there are a dozen banks. Britain is much bigger than Canada; bigger in terms of population, so it's a much more populous country; really a small number of banks. High banking concentration, and you could argue that the banks are able to act very defensively, perhaps even like a cartel.

And so, Britain becomes quite stable, British banking, and it remained so during the Great Depression. There's no banking crisis in Britain during the Great Depression. There's also no banking crisis in Canada.

Again, this issue of how much concentration is good. This gets me to talking about another part of the book about mergers, but again the issue of how much concentration, how concentrated you want your banking system to be.

If you were designing one from scratch, you would probably want it to be more concentrated than that in the United States where we have too many. I would argue you might not want it quite as concentrated as a place like Canada. You do lose something in terms of dynamism, I think, in the development of banking.

But again, we're back on this point of where do you want to draw the line? Where do you want to strike the balance between a dynamic financial system and a stable financial system? I don't want to say that you want to have dynamism or boring, but there is this question of how expansionary and contractionary you want your banking system to be, and I think the judgment of that one is still up in the air.

Romesh: Richard Grossman, thank you very much.

Richard: Thank you.

Topics: Economic history, Financial markets
Tags: banking, Great Depression, institutions

Exit strategies for central banks: Lessons from the 1930s

Kris James Mitchener , Joseph Mason, 15 June 2010



During the financial crisis of 2007-8 and the ensuing recession, policymakers undertook a variety of actions aimed at alleviating distress (Eichengreen and O’Rourke).

Topics: Global crisis, Monetary policy
Tags: exit strategy, global crisis, Great Depression

US monetary and fiscal policy in the 1930s – and now

Price Fishback interviewed by Romesh Vaitilingam, 30 Apr 2010

Price Fishback of the University of Arizona talks to Romesh Vaitilingam about whether the current US economic situation is really comparable to the Great Depression. He argues that today’s monetary policy response is heavily and positively influenced by the failures of the past – but that today’s fiscal stimulus is far stronger than in the 1930s and out of proportion to the problem. The interview was recorded at a conference on ‘Lessons from the Great Depression for the Making of Economic Policy’ in London in April 2010.


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Topics: Economic history, Macroeconomic policy, Monetary policy
Tags: global crisis, Great Depression, monetary policy

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