World in Depression Redux

There’s an interesting new preface to Charles Kindleberger’s The World in Depression, 1929-1939 by U.C. Berkely Economics Professors Brad DeLong and Barry Eichengreen over at vox. It argues we’re making many of the same mistakes today as were made 80 years ago and they note three key lessons as detailed below.

First, panic. Kindleberger argued that panic, defined as sudden overwhelming fear giving rise to extreme behaviour on the part of the affected, is intrinsic in the operation of financial markets. In The World in Depression he gave the best ever “explain-and-illustrate-with-examples” answer to the question of how and why panic occurs and financial markets fall apart. Kindleberger was an early apostate from the efficient-markets school of thought that markets not just get it right but also that they are intrinsically stable. His rival in attempting to explain the Great Depression, Milton Friedman, had famously argued that speculation in financial markets can’t be destabilising because if destabilising speculators drive asset values away from justified, or equilibrium, levels, such speculators will lose money and eventually be driven out of the market.  Kindleberger pushed back by observing that markets can continue to get it wrong for a very, very long time. He girded his position by elaborating and applying the work of Minsky, who argued that markets pass through cycles characterised by self-reinforcing boom, next by crash, then panic, and finally by revulsion and depression. Kindleberger documented the ability of what is now sometimes referred to as the Minsky-Kindleberger framework to explain the behaviour of markets in the late 1920s and early 1930s – behaviour about which economists otherwise might have arguably had little of relevance or value to say. The Minsky paradigm emphasising the possibility of self-reinforcing booms and busts is the organising framework of The World in Depression. It then comes to the fore in all its explicit glory in Kindleberger’s subsequent book and summary statement of the approach, Mania, Panics and Crashes.

Kindleberger’s second key lesson, closely related, is the power of contagion. At the centre of The World in Depression is the 1931 financial crisis, arguably the event that turned an already serious recession into the most severe downturn and economic catastrophe of the 20th century. The 1931 crisis began, as Kindleberger observes, in a relatively minor European financial centre, Vienna, but when left untreated leapfrogged first to Berlin and then, with even graver consequences, to London and New York. This is the 20th century’s most dramatic reminder of quickly how financial crises can metastasise almost instantaneously. In 1931 they spread through a number of different channels. German banks held deposits in Vienna. Merchant banks in London had extended credits to German banks and firms to help finance the country’s foreign trade. In addition to financial links, there were psychological links: as soon as a big bank went down in Vienna, investors, having no way to know for sure, began to fear that similar problems might be lurking in the banking systems of other European countries and the US. In the same way that problems in a small country, Greece, could threaten the entire European System in 2012, problems in a small country, Austria, could constitute a lethal threat to the entire global financial system in 1931 in the absence of effective action to prevent them from spreading.

This brings us to Kindleberger’s third lesson, which has to do with the importance of hegemony, defined as a preponderance of influence and power over others, in this case over other nation states. Kindleberger argued that at the root of Europe’s and the world’s problems in the 1920s and 1930s was the absence of a benevolent hegemon: a dominant economic power able and willing to take the interests of smaller powers and the operation of the larger international system into account by stabilising the flow of spending through the global or at least the North Atlantic economy, and doing so by acting as a lender and consumer of last resort. Great Britain, now but a middle power in relative economic decline, no longer possessed the resources commensurate with the job. The rising power, the US, did not yet realise that the maintenance of economic stability required it to assume this role. In contrast to the period before 1914, when Britain acted as hegemon, or after 1945, when the US did so, there was no one to stabilise the unstable economy. Europe, the world economy’s chokepoint, was rendered rudderless, unstable, and crisis- and depression-prone. That is Kindleberger’s World in Depression in a nutshell. As he put it in 1973:

“The 1929 depression was so wide, so deep and so long because the international system was rendered unstable by British inability and United States unwillingness to assume responsibility for stabilising it in three particulars: (a) maintaining an open market for distress goods; (b) providing counter-cyclical long-term lending; and (c) discounting in crisis…. The world economic system was unstable unless some country stabilised it, as Britain had done in the nineteenth century and up to 1913. In 1929, the British couldn’t and the United States wouldn’t. When every country turned to protect its national private interest, the world public interest went down the drain, and with it the private interests of all…”

Though I enjoyed and highly recommend Mania, Panics and Crashes: A History of Financial Crises, I’ve not read this account of The Great Depression that, according to DeLong and Eichengreen is told mostly from a European point of view. That oversight is now being corrected via Amazon’s One-Click ordering.