The Globe and Mail

Sunday, September 28, 2008

The Great Depression haunts us still. During every financial crisis since that time, one of the first questions on people’s minds has been: Could it happen again?

Well, could it? Reading economist John Kenneth Galbraith’s The Great Crash, 1929 (Houghton Mifflin, 1954) is certainly a rather unsettling experience in light of recent events.

In his uniquely wry style, the Ontario-born Galbraith details many of the same follies of banks, investors and policy makers that we have just witnessed. During the bubble of the late 1920s — the overconfidence, the highly leveraged positions, the speculative excesses, the easy credit, the financial innovations and the official complacency — it was a time, in Galbraith’s words, when illusion replaced reality.

And then followed the sudden bursting of the bubble in October, 1929. The panic, the fear, the terrifying losses of financial fortunes when the house of cards came falling down, and the regulatory backlash.

The speed of the transformation of market euphoria to doom left a scarring memory for all those who lived through that period. Lest subsequent generations forget, Galbraith insists that the history needs constant retelling: As a protection against financial illusion or insanity, memory is far better than law.

The familiarity of late 1920s experience may be uncomfortable enough. But will today’s financial meltdown also be followed by the kind of rapid unravelling of the global economy that followed between 1929 and 1933?

A few short years ago, many people would have scoffed at the prospect of globalization being reversed. But Princeton historian Harold James’s The End of Globalization: Lessons from the Great Depression (Harvard University Press, 2001) should give them pause.

In his very readable history, James reminds us how every international economic order rests on political-institutional foundations. During the interwar period, these foundations proved more fragile than many thought.

The 1929 U.S. stock market crash exposed enormous international economic imbalances which had been papered over by large-scale international capital flows, especially those emanating from the United States, the world’s main creditor at the time. As their confidence collapsed, U.S. investors brought their money home, leaving deficit countries around the world in a mess.

The political reaction was swift: defaults on international loans, trade protectionism, exchange controls and currency instability. Given these volatile conditions, James describes how trade, capital and even migration flows contracted quickly. And the economic upheavals only gave further political strength to those with long-standing resentments and reactions against globalization.

Even when an economic recovery got under way, the Depression had left a legacy of the reassertion of state control over economic life that was no longer compatible with liberal visions of integrated global economic community. Not until the Bretton Woods conference of 1944 was a new framework worked out to try to reconcile the new state interventionism with an open multilateral international economic order.

How could things unravel globally so quickly? Economic historian Charles P. Kindleberger’s classic The World in Depression, 1929-1939 (University of California Press, 1973) provides probably the most famous political explanation for why it happened. At the core of Kindleberger’s story is a failure of leadership, U.S. leadership.

According to Kindleberger, the country that had done so much to promote the integrated liberal global economy in the 19th century, Britain, was no longer capable of leading in this way. And the United States, as the dominant new economic power, was not yet willing to assume the leadership mantle.

For Kindleberger, U.S. policy makers failed to perform three functions that were needed at that time of crisis: providing counter-cyclical long-term capital, maintaining a open market for distress goods from abroad, and acting as an international lender of last resort.

The current financial crisis has also taken place at a moment of massive global economic imbalances. How will the United States respond this time? Given its large external debt and trade deficits, does the country still have the capacity to lead, or is this crisis undermining its financial power, just as the Great Depression did for Britain? And what role will emerging financial powers, such as China, play?

There may be parallels to draw back to the era of the Great Depression, but there are also many differences. One of the most important is the simple fact that lessons have been learned from the 1930s.

By a strange twist of fate, the U.S. central bank is in fact today headed by a person, Ben Bernanke, who is one of the world’s leading experts on those very lessons and who has even described himself as a Great Depression buff, the way some people are Civil War buffs. The Great Depression, it appears, continues to cast its long shadow even in the very highest ranks of monetary policymaking.

About the Author

Eric Helleiner, former CIGI Chair in International Political Economy