Lessons from the Great Depression

The last time the economy was in such bad shape was 90 years years ago during the Great Depression. What have we learnt?

I love the quote by George Santayana that "those who cannot remember the past are condemned to repeat it". I love it so much I've used it previously in this post on The Ghosts of Economic Past. As we enter a period of massive uncertainty, it's important to remind ourselves of what we have learnt from previous economic crises. It would be tempting, for instance, for nations to be more protectionist, focus inwards and disengage from trade with other countries. That would be a mistake. Here are some of the things we have learnt from the Great Depression that are relevant for today.

1) Prop up aggregate demand to sustain the economy and jobs

One of the commonly cited causes of the Great Depression was a fall in expenditure leading to reduced employment and income levels. The economy relies on people spending. Without spending businesses have less revenue and incentive to produce. I have written about falls in demand previously. We can see a similar fall in demand with coronavirus. With many people staying home or practicing other forms of social distancing a lot of the spending in the economy has disappeared. There has been a massive fall in demand that makes it hard for businesses to continue as usual. Seeing this, many governments are putting a lot of effort into boosting demand through different forms of stimulus like cash payments and public projects.

2) Avoid protectionist trade policies

Beggar thy neighbour was popular during the Great Depression with countries putting up trade barriers to protect their own industries. In the United States the Smoot-Hawley Tariff act was passed which raised tariffs on imported goods. Tariffs support local industries by raising the price of products from foreign countries. While protectionism might support local industry, it is ultimately ruinous. As other countries retaliated during the Great Depression trade plummeted. The market for exporters products fell tremendously and everyone suffered. Put simply, as the pie shrank everyone got a smaller slice. Domestic demand isn't always sufficient to sustain businesses in a global economy.

Think about this if you are a fan of blocking foreign products and protecting local industries through legislative measures. While it will be tempting to do all we can to support local businesses and jobs in the wake of coronavirus, it is critical not to put up significant barriers to trade and risk the international system. All it does is shrink the whole pie. Buying local is fine, particularly for environmental reasons. But maintaining trade is critical to ensure we can mutually benefit from other countries economic strengths.

3) Don't allow the crisis to happen

Oh yea that's easy, just don't let it happen right? Why didn't we think of that. Sounds simple but let me break it down. During the Great Depression the US Federal Reserve let banks fail by not providing liquidity. Bank failure caused panic and a loss of confidence in the financial system. Standing by and doing nothing made the crisis much worse, even if this is free market doctrine.

We learnt from this in the GFC and provided banks a lifeline, though I know many people weren't exactly happy about that. Governments have the means to fight back when the economy is in trouble. During coronavirus if the government acts to keep businesses afloat we will be in a much stronger position with many more people employed coming out of the crisis. If we make the right choices the recession doesn't have to be as bad.

4) Pessimism is contagious, act to restore confidence

Consumer and business confidence fell big time during the Great Depression. With low levels of confidence people invest and consume less. It's a vicious cycle. As spending falls, more people lose money, so people lose more confidence and spend less. If spending falls this can cause deflation as businesses reduce prices to encourage sales. Saving money becomes a logical thing to do, but it also makes the problem worse because there is less demand for goods and services. It's a pretty nasty problem to solve.

I don't know if we are in the same situation today, but the signs are there. We can already see confidence is low with many businesses looking to reduce employment and consumer spending way down.

Governments have options to restore confidence but it's not easy. How people feel is influenced by many factors that are hard to control. No doubt when social distancing measures end and life becomes more normal people will feel better. Large scale investment programs that put money in people's pockets can also help. The soft skills of our leaders matter a great deal too. Government messaging, empathy and management of expectations can be key levers for helping people through a crisis. There isn't a quick fix to restore confidence, but it can be rebuilt.

A big part of this comes down to what people expect. During the Great Depression people expected tomorrow to be worse than today. It wasn't until Roosevelt was elected promising regime change under the "New Deal" that people began to be more optimistic. Government's that are effective at managing expectations can probably restore confidence quicker and be more successful at controlling coronavirus.

To wrap up

We have learnt a lot from the Great Depression that can be applied to today. It's never completely like for like but there are important lessons, particularly around stimulating demand and restoring confidence. I have presented these as five separate lessons but they are connected just as the economy is connected. If one part of the economy fails it tends to bring other sectors down with it. It is worth mentioning here the global nature of such a crisis. Until the large economics (e.g. China and the US) are back on their feet we can expect economic activity globally to be subdued. Government's need to be coordinated in their response.

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A New Zealand based politics and economics blog

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