The current financial crisis and the ones that came before

“If you asked a modern economic historian like me why the world is currently in the grips of a financial crisis and a deep economic downturn, I would tell you that this is the latest episode in a long history of similar bubbles, crashes, crises, and recessions that date back at least to the canal-building bubble of the early 1820s, the 1825-1826 failure of Pole, Thornton & Co, and the subsequent first industrial recession in Britain. We have seen this process at work in many other historical episodes as well – in 1870, 1890, 1929, and 2000.

For some reason, asset prices get way out of whack and rise to unsustainable levels. Sometimes the culprit is lousy internal controls in financial firms that over-reward subordinates for taking risk. Sometimes the cause is government guarantees. And sometimes it is simply a long run of good fortune, which leaves the market dominated by unrealistic optimists.

Then the crash comes. And when it does, risk tolerance collapses; everybody knows that there are immense unrealized losses in financial assets and nobody is sure that they know where they are. The crash is followed by a flight to safety, which is followed by a steep fall in the velocity of money as investors hoard cash. And that fall in monetary velocity brings on a recession.

I will not say that this is the pattern of all recessions; it isn’t. But I will say that this is the pattern of this recession, and that we have been here before.”

J. Bradford DeLong, “The anti-history boys”, Stabroek News (4 October 2009).

J Bradford DeLong is Professor of Economics at the University of California at Berkeley and a Research Associate at the National Bureau of Economic Research.

To DeLong, the anti-history boys in the title of his article are the modern macroeconomic theorists and econometricians who try and explain the current crisis in terms of economic models and real factors such as technological advance, organizational change, and destructive government policies. It’s not so much that in his view they are wrong (although he clearly thinks they are in their technical analysis) but that they ignore economic history.

Although I am not a fan of DeLong’s, I think there is something to this. Modern macroeconomic theory is too divorced from the lessons of the past and too focused on mathematical descriptions that are too abstract to reflect the actual complications of the real world. They take our attention away from historical factors that are important considerations in the conduct of economic policy.

I agree with DeLong we should pay more attention to economic history. We would learn that there is such a thing as too much national debt, and that at some point it has economic consequences in terms of inflation, higher interest rates, slower growth and/or a falling dollar.

What is especially frightening is that no one in government (and not many outside government) seem concerned at the huge build up in the Federal debt. Nor does it seem that anyone is paying attention to the deteriorating financial condition of the states and localities; the fact that the Federal government now owns or insures (mainly through Fannie and Freddie) 80 per cent of the $14½ trillion in outstanding home mortgages, many of which are greater than the houses are worth; that the FDIC is now greatly overextended; that Social Security, Medicare and Medicaid now take in less in contributions than they pay out in benefits, something that wasn’t expected until 2017; and that this year entitlement programs of the government will absorb more than 100 per cent of all Federal tax receipts, leaving all other functions of government, including defense, education and interest payments to be funded by more and more borrowing. Economic models focus too closely on only a few relationships and simply do not provide “the big picture” needed to see where the economy is headed.

In the face of this deteriorating situation, indeed, at a time when the financial system can be said to be teetering on the brink of collapse, the government is about to pass legislation greatly expanding its financial responsibilities in the area of health care while imposing high taxes on an economy in deep recession.

It is not just macroeconomic theorists and econometricians that ignore economic history. It seems as though almost every person in the U.S., particularly the U.S. Congress, ignores economic history.