eichengreen conclusion misuse of history

The historical past is a rich repository of analogies that shape perceptions
and guide public policy decisions. Those analogies are especially
influential in crises, when there is no time for reflection. They are particularly
potent when so-called experts are unable to agree on a framework for careful
analytic reasoning. They carry the most weight when there is a close correspondence
between current events and an earlier historical episode. And they
resonate most powerfully when an episode is a defining moment for a country
and a society.
For President Harry S. Truman, in deciding whether to intervene in Korea,
that historical moment was Munich. For policy makers confronted in 2008–
09 with the most serious financial crisis in eighty years, that moment was
the Great Depression. Given the close correspondence between the events of
2008–09 and the 1930s, the earlier episode, or more precisely the lessons of the
episode as distilled by economists and historians, powerfully shaped perceptions
and reactions.
Policy makers, according to this distillation, should respond swiftly and
forcefully to incipient financial distress. This means injecting liquidity into
financial markets to prevent problems from spreading further. It means sorting
out insolvent banks from those that are illiquid, while continuing to
extend emergency liquidity to the latter but closing down or recapitalizing the
former, in this way restoring confidence and allowing the financial system to
start functioning again.
But even though this monetary and financial triage may prevent financial
distress from deepening, it will not undo the damage already done. Given
the disruption to financial markets, it will not be enough to prevent a serious

recession. It will not be enough to get the economy moving again if heightened
risk aversion creates a reluctance to borrow and lend. In such circumstances,
it will be necessary to increase public spending to offset the decline in private
spending. This emergency response should be forceful, but it should also be
temporary. It should be wound down when private spending recovers, in order
to prevent debts from spiraling out of control.
Help, in the form of extending the duration of unemployment benefits,
augmenting provision of food stamps and expanding access to social services,
should meanwhile be provided to the unemployed casualties of the crisis.
Helping these less fortunate members of society is fair and just insofar as their
suffering results from the malfunctioning of a system that operates disproportionately
to the benefit of others. But such help is also required to maintain
broad support for prevailing economic and political processes.
Last but not least, the flawed monetary, fiscal, financial, and social policies
that allowed the crisis to develop in the first place should be fixed through
comprehensive reforms put in place before the sense of urgency has passed.
Such were the lessons of the Great Depression as distilled by economic and
historical scholars. Milton Friedman and Anna Schwartz made the case for
forceful central bank action to prevent banking crises, deflation, and depression
in a book hailed as one of the most important works of twentieth-century
economic history. John Maynard Keynes made the case for public spending to
counter depressed economic conditions in one of the most influential books in
all of economics. Karl Polanyi made the case for social and regulatory reform
in a book published to great acclaim in 1944.1 Those making consequential
decisions in 2007–08 did not all have firsthand knowledge of these authors.
But they were aware of their arguments, given how their conclusions were
passed down through the generations and had come to constitute a standard
historical narrative.
Policy makers in the United States and other countries, their actions informed
by this narrative, responded quickly and forcefully to events. Central banks
cut interest rates and flooded financial markets with liquidity. Governments
unfurled front-loaded programs of fiscal stimulus. Although efforts to recapitalize
the banks were more tentative, they were enough. Collapse of the monetary
and financial system was averted. Support for democracy and the market
economy did not crumble. This at least was no Great Depression.
The paradox is that we failed to do better. Unemployment in the advanced
economies still rose to double-digit levels, not as high as in the Great Depression
but higher than in normal recessions, and higher than anticipated by those
taught to believe that economic science had cracked the problem of avoiding
a Depression-like slump. Financial distress was more acute than expected by

those taught to believe that central banks and regulators had learned how to
prevent a 1930s-style crisis. Recovery was marred by slow growth, high unemployment,
and a falling rate of labor force participation. It remained sluggish for
longer than could be explained by the need for firms and households to work
down excessive debts and banks to repair damaged balance sheets, alone.
It can be argued that high unemployment and deep recession are unavoidable
in the wake of a financial crisis, appropriate policy response or not. But
this observation, even if correct, only pushes the problem back another step.
The paradox then is that we failed to anticipate, much less prepare for, the
possibility of this crisis.
Ironically, the roots of this failure lay in the same progressive narrative of
the Great Depression. Entirely correctible flaws of collective decision making,
this narrative explained, were responsible for the inability of contemporaries
to appreciate the risks to stability in the 1920s, and then for their failure to
deal effectively with the consequences in the 1930s. Modern-day policy makers
learned from the mistakes of their predecessors. Scientific central banking
informed by a rigorous framework of inflation targeting reduced economic and
financial volatility and prevented serious imbalances. Advances in supervision
and regulation limited financial excesses. Deposit insurance eliminated bank
runs and financial panics. The dominant narrative of the Great Depression,
that it was caused by avoidable policy failures, was itself conducive to the belief
that those failures could be—and had been—corrected. It followed that no
comparable crisis was possible now.
This belief, we now know, was dreadfully wrong. The economic and
financial instability of the 1920s and 1930s may have been heavily associated
with inflation and deflation, problems that inflation targeting, the twentyfirst-
century version of Friedman and Schwartz’s stable money growth rule,
could plausibly claim to have solved. But this did not mean other risks to stability
were eliminated. To the contrary, the long period of economic stability,
the Great Moderation, encouraged investors to take on additional risk. The
eighty years since the advanced economies last experienced an equally serious
crisis allowed them to ignore the consequences. Time dampened awareness
that financial markets are unstable. Market participants are continuously innovating,
sometimes in the effort to better serve their customers but other times
to evade regulations put in place in response to earlier problems. The regulatory
bloodhounds are unable to keep pace with the well-fed private-sector
greyhounds. The result is a widening gap between actual regulation and what
appears, with hindsight, as best regulatory practice. All this suggests that the
longer the period of stability persists, the greater the risks. But this is not the
perception while the party is underway.


In addition, a long period of stability born of good policy or good luck
empowers those inclined to argue that regulation is too strict. A regulatory
response to the Great Depression, which produced a tightly cosseted financial
system and an extended period of stability, thus contained the seeds of its
own destruction. Financiers could argue that since they had learned to better
manage risk, capital and liquidity requirements for financial institutions could
be relaxed. Restrictions on cross-selling financial products could be removed.
The heavy hand laid on financial markets in the 1930s could give way to
light-touch regulation. The instability of financial markets and hence the dangers
of light-touch regulation should have been another lesson of the Great
Depression as distilled by economic and historical scholars. This view existed
as well, but it resided mainly on the fringes of economics.
Why it remained out of the mainstream is worth pondering further. If such
powerful lessons for how policy makers should respond to a crisis were remembered,
how could other equally powerful lessons about what could cause it be
forgotten?
Part of the answer is that historians always did a better job of describing
the fateful decisions that transformed the recession of 1929 into the Great
Depression of the 1930s than of understanding the origins of the recession
itself. Explanations of the onset of the crisis were the least systematic and satisfactory
part of the historical narrative. Lessons about what can cause a crisis
and how to avoid one were less powerful because the corresponding history was
less well developed and less effectively distilled.
In addition, recent experience reminds us that the causes of crises are not
so simple and, consequently, not so readily identified and avoided. Flawed conceptual
frameworks and wrongheaded policies there were in abundance, but
the Great Depression involved more. We now appreciate how policy makers
in the 1920s and 1930s were forced to take decisions on the basis of partial
information about the state of the economy, just as the Federal Reserve
didn’t know how rapidly conditions were deteriorating at the end of 2007 and
President Obama’s economists didn’t know how fast the economy was shrinking
in 2009. The problem wasn’t simply that they didn’t know how to react to
a certain set of conditions. It is that they didn’t know the conditions. A crisis
is a time when the pace of events seems to accelerate and when information is
especially incomplete. Having lived through such a moment in 2008–09, we
better appreciate how a similar moment must have felt in 1929.
This is just one example of how the Great Recession will change how we
understand the Great Depression. We now better appreciate the tendency to
take credit for an extended period of stability, extrapolate that stability into
the future, and let our guard down. We better understand the inclination to

offer ex post rationalizations for large and unsustainable lending flows. We
better understand the temptation to reduce the art of economic policy making
to a simple rule, whether it is that the central bank should focus on a rate
of inflation of 2 percent, as recommended by the tenets of inflation targeting,
or that it should provide only as much credit as is required by the legitimate
needs of business, following the dictates of the real bills doctrine. We better
understand the anger spawned by bailouts of fat-cat bankers and how this complicates
the extension of public support for troubled banks. We better appreciate
how viewing the future through the lens of the past can distort as well as
illuminate—how Europeans starting in 2010 could remain fixated on the risk
of 1920s-style inflation when deflation was the real and present danger, or how
US policy makers could remain preoccupied by excessive risk taking after 1929
when in fact a dearth of risk taking was holding back the economy. We better
understand the reluctance of central bankers, sensitive to political criticism, to
do more to promote recovery. And we better understand the instincts that led
governments in the midst of a crisis to cut spending prematurely.
Finally, we better appreciate that economic analysis and advice are not
enough. Policies still have to be implemented. And here deeply held political
ideologies and agendas stand in the way. These are by no means new themes in
histories of the Great Depression. But recent events will cast them in a more
prominent light.
The progressive narrative—that advances in risk management and regulation
had eliminated the danger of a 1930s-style financial crisis—similarly
rested on a particular, historically informed vision of the risks. The crisis of
the 1930s, in the standard narrative, resulted from runs on banks that governments
and central banks did too little to prevent and whose effects they did
too little to contain. But this focus on the banks caused twenty-first-century
policy makers to miss the growing importance of the nonbank financial sector
of hedge funds, money market funds, and special purpose vehicles. It caused
them to miss the importance of derivative securities and other nonbank financial
claims. This neglect was especially consequential in the United States,
where, by the early twenty-first century, nonbank sources had come to provide
more than two-thirds of credit to the nonfinancial private sector. But it was
more general.
This shift had profound if unappreciated consequences. Federal deposit
insurance did nothing to enhance confidence in money market mutual funds,
whose shareholders were now as prone to run as bank depositors in the 1930s.
Capital requirements for banks did nothing to deter excessive risk taking or
provide a buffer against losses when the risky assets were held by the offshore
arms of insurance companies, like AIG Financial Products. But the

bank-focused crisis of the 1930s and the enduring influence of that narrative
encouraged policy makers to overlook this change in the locus of risks.
In Europe, where the nonbank financial sector furnished only 30 percent of
credit to households and firms, the story was different. There it was still about
the banks. The financial system had long been more bank-based in Europe
than in the United States. Now, as memories of the banking crises of the
1930s faded and deregulationist forces gained traction, it was the banks that
benefited disproportionately in country after country. The Creditanstalt crisis,
in which the failure of a bank that supplied half of all credit to the Austrian
economy triggered the collapse of Central Europe’s financial system, might
have served as a cautionary tale. But not all European countries shared such
histories. And banking policy, in any case, now was made at the European
level. Even in countries that did share such a history, memories of it were
lost in the din, overwhelmed by arguments about the efficiency advantages of
megabanks and advances in scientific risk management.
In addition, some countries like Britain, fortunate to have been spared a
banking crisis in the 1930s, were less than alert to the need for the central
bank to act as a lender of last resort. Not having experienced a bank run in
150 years, they provided only limited deposit insurance. The result was the
first bank run in 150 years.
The single greatest failure to learn appropriate lessons from this earlier history
was surely the decision to adopt the euro. The 1920s and 1930s illustrated
nothing better than the dangers of tying a diverse set of countries to a single
monetary policy. Experience under the interwar gold standard highlighted the
tendency for large amounts of capital to flow from countries where interest
rates were low to where they were high, and the destabilizing consequences
that would follow when those flows came to a stop. It highlighted the economic
pain and political turmoil that would result when the only available
response was austerity. That history should have given European leaders pause
before moving ahead with the euro.
This failure is a reminder that there does not in general exist a single historical
narrative, but several. History is contested. One narrative portrayed
the fixed exchange rates of the 1920s gold standard as the problem; another
instead indicted the unstable exchange rates of the 1930s as a source of disruptive
beggar-thy-neighbor policies.2 This second interpretation resonated with
recent European experience, given how disruptive exchange rate changes, as
recently as 1992–93, had thrown a wrench into the gears of European integration.
Many will now argue that this was a questionable reading of the 1930s.
In the event, it led to the questionable decision to move to the euro, with
unquestionably disastrous consequences.

In the end, the Europeans did just enough to prevent the collapse of their
monetary system. Like the Americans, they did just enough to avoid another
Great Depression. But their very achievement weakened the incentive to do
more. The monetary and financial system not having collapsed as completely
as in the 1930s and the economic consequences being less dire, the urgency of
radical reform was less. Financial interests spared damage on the scale of the
1930s were better able to mobilize in opposition to radical reform. Creditor
countries were able to mobilize in opposition to proposals for pooling the debts
of the monetary union partners and moving forthwith to banking union. Social
policy reform was similarly less far-reaching because social distress was less.
Moreover, this policy success, such as it was, allowed governments and
central banks to heed the call to return to normal policies as soon as the emergency
passed. Unfortunately, the return to normal policies preceded the return
to normal conditions. Under normal conditions the expansion of central bank
balance sheets would have ignited inflation. The large budget deficits of the
American and British governments would have caused interest rates to spike.
That these consequences did not now follow should have made clear that economic
conditions were still far from normal. But this did nothing to diminish
the intensity of the call for governments to balance their budgets sooner rather
than later.
As governments scaled back their spending, central bankers, concerned by
the continued weakness of the economy, felt compelled to do more. But if
unelected technocrats with narrow mandates were one thing, unelected technocrats
with sweeping powers were another. Anxiety over their unprecedented
interventions was shared by the central bankers themselves. The policies were
unconventional, and central bankers are nothing if not conventional. Inflation
aversion, the most deeply held convention of all, rendered moot the idea of
raising the inflation target as a way of bringing down the cost of borrowing
in this exceptional slump. Historical memories of the 1970s, when inflation
had been allowed to run out of control, were more immediate for many of the
central bankers on the Federal Open Market Committee than distant memories
of deflation in the 1930s. Those more immediate memories caused them
to hesitate to turn to unconventional policies even when deflation became the
immediate threat.
Moreover, the longer unconventional policies persisted, the more political
criticism they invited. Central bankers concerned to protect their independence
grew more anxious still to return to conventional policies. The reluctance
of twenty-first-century central banks to do more brought to light another
lesson of the Great Depression, namely that central banks doing too little to
support economic growth can also see their independence compromised and be

stripped of their powers. But prior to recent experience, which highlighted this
risk, this observation was not part of the conventional narrative.
Then there was the worry that low interest rates were encouraging investors
to move into riskier assets. Policy, in this view, was only setting the stage
for another bubble and another crash. This was of course the same fear that
had prevented the authorities from responding more forcefully in the 1930s.
Viewing the world through a historical mirror, they were unable to recognize
that the problem in the 1930s was deflation rather than inflation. It was too
little risk taking, not too much. Five years after Lehman Brothers, it was not
hard to see the same funhouse mirror at work.
The concern with moral hazard was real, albeit more real for some policy
makers than others. They worried about the consequences of creating expectations
that everyone would be bailed out. But the concern was also political.
Bailouts were politically contentious. Criticism fed the desire to find a bank
that could be made an example, whether Lehman Brothers in 2008 or Union
Guardian Trust in 1933.
The European version of this moral hazard argument was that too much
central bank support for the prices of government bonds and even for economic
growth would weaken the pressure on governments. Politicians and their
constituents had to feel pain in order to appreciate the urgency of structural
reform and fiscal consolidation. This problem was one of moral hazard, but
also of moralism. The euro crisis, seen from Frankfurt and Berlin, was caused
by feckless Southern Europeans. The subprime crisis that rendered Europe so
vulnerable was caused by reckless Americans. The miscreants needed to suffer
in order to mend their ways. The instincts that informed Andrew Mellon’s
policies of liquidationism are easy to criticize, and they have come in for much
criticism from historical scholars. Our own experience suggests they are universal
human instincts. They are not easily suppressed.
This tendency to frame the crisis in moralistic terms did not make cooperation
in countering it any easier. The historical narrative that governments
and central banks, working at cross purposes, made things worse in the 1930s
inspired the effort in 2008–09 to coordinate monetary and fiscal policies
and shun protectionist responses. But once the emergency passed, sustaining
cooperation became harder. As fatigue set in, coordination gave way to finger
pointing. German Finance Minister Wolfgang Schäuble criticized the Federal
Reserve for pushing down the dollar, deriding its policies as “clueless.” US
President Obama cast not-so-veiled aspersions at the Europeans for not moving
faster to fix their banks. In this light, the failure of governments and central
banks to mount a cooperative response to the European financial crisis in 1931
and then to the global economic crisis in 1933 becomes easier to understand.

Nowhere was the finger pointing worse, this time, than in Europe, where
the Northern European narrative that set industrious Germans against spendthrift
Greeks had as its Southern European counterpart an account that set
ill-starred Greeks against unsympathetic Germans. This was not a framing
that made it easy to extend foreign assistance, or even to accept it. It was
not conducive to debt mutualization or debt forgiveness. A balanced analysis
would have observed that for every reckless borrower there is a reckless lender.
It would have acknowledged that it was easier for one country to export its
way out of trouble than for every Southern European country to do so. It was
easier to conjure up an export miracle with the support of an accommodating
monetary policy and a weak euro, as in Germany in the early 2000s, than now
that the opposite conditions prevailed. These same conclusions followed from
the contrast between the 1920s, when France, with an undervalued currency,
enjoyed an export boom, and the 1930s, when a depressed Europe was unable
to collectively export its way out of a slump. But given how the crisis was
framed, these implications were now lost on the French government and, more
importantly, the German.
This more balanced analysis would have also conceded that no country is
prepared to bail out a troubled neighbor without attaching conditions and
putting in place mechanisms to ensure it is repaid. But a moralistic framing
of the crisis that pitted the virtuous against the unprincipled was not conducive
to this balanced view. It did not incline the lenders to propose reasonable
conditions or borrowers to accept them. Successful countries could not resist
the conclusion that their success derived from their virtue and that, to succeed,
other countries only had to develop like-minded virtue. Unsuccessful countries
were led to believe that their more successful neighbors took satisfaction in
their plight.
Finally, that policy makers did just enough to prevent another Great
Depression weakened the incentive to think deeply about causes. Having
avoided financial collapse, it was still possible to defend America’s banking
and financial system and Europe’s monetary union as the worst alternatives
except for all the others (to paraphrase Winston Churchill on democracy). As
a result, there was little discussion of executive compensation practices, in the
financial sector and generally, and their implications for financial stability. In
the wake of the crisis, there was the short-lived Occupy Movement, which
questioned the merits of financialization and warned of growing inequality.
But there was no sustained discussion of the roots of these phenomena or their
consequences.3 Inequality reflected the failure of society to provide the majority
of its members with the education and training needed for a world of global
competition. It reflected technical change that made it easier to substitute

robots for workers. There was little willingness to address these problems or
to acknowledge that the disappointing recovery from the crisis reflected not
just headwinds from deleveraging but also a long period of underinvestment
in infrastructure, basic research, and education.
Addressing these problems would have required not a quick and temporary
stimulus but sustained national and international strategies for investing
in infrastructure, education, and research. It would have required mobilizing
the necessary resources. It would have required hard thinking about how to
ensure that the resources so mobilized were deployed productively. It would
have meant pondering what kind of financial sector was needed to best support
the growth of the nonfinancial economy and how to structure regulation
to produce it.
In many cases, addressing these problems would have required more government,
not less. This was the response to the Great Depression, but it was
not the response now. The irony was that policy makers, by preventing the
kind of depression that brought about the New Deal, discouraged hard thinking
on the role of government.
Finally, the fact that policy makers did just enough to prevent another
Great Depression meant that too little was done to make the world a safer
financial place. Although banks are now subject to modestly higher capital and
liquidity requirements, modestly is the operative word. Big banks are required
to write living wills, and the Dodd-Frank Act in the United States includes a
procedure for orderly liquidation of large financial institutions. But it is unclear
whether those wills and liquidation procedures are actually to be used, given
fears of exciting the markets. Little that is meaningful has been done about the
problem of too-big-to-fail. That another Great Depression was avoided weakened
the argument for more radical changes and allowed the banks to regroup.
Similarly, averting the worst allowed money market mutual funds and
insurance companies to mobilize the lobbyists. Insurance companies, other
than Prudential Financial and the now notorious AIG, were able to avoid being
designated as systemically important by the Financial Stability Oversight
Council. The credit-rating agencies, legislative handwaving aside, were able to
escape significant regulation and reform.
Likewise, although there is now a Volcker Rule to limit proprietary trading
by commercial banks, it is riddled with exceptions, given that the banks,
spared a 1930s-style crisis, were not inclined to divest their securities business.
Transactions in derivative securities have been moved into clearinghouses, but
this only concentrates risk rather than removing it. The Europeans, having
avoided their own Great Depression, find it hard to overcome the political
obstacles to creating a meaningful banking union. They find it hard to agree

on conditions under which their emergency rescue fund can lend and their central
bank can backstop financial markets. The crisis created a sense of urgency,
but not urgency sufficient to overcome these problems.
Thus, the very success with which policy makers limited the damage from
the worst financial crisis in eighty years means we are likely to see another such
crisis in less than eighty years.