Can we learn lessons from history on the source of economic crises?

There are storms gathering over the global economy: geopolitical risks in the War on Terror, large trade imbalances between the major trading nations and threatening demographic change in the developed world and some developing nations such as China. However, there is no clear consensus on when shocks such as a commodity shortage or a stock market reversal will be translated into a crisis. As a result, Desmond Lachman has argued that each economic crisis is uniquely dysfunctional, in Tolstoy’s words, “every unhappy family is unhappy in its own way” and that the lessons we can learn from how past crises have unfolded are limited. I would beg to differ: there are important lessons to be learnt from past crises about how the next crisis might unfold.

A more traditional approach is the Galbraithian view, that capitalism tends to crisis thanks to the greed and irrationality the economic system is based upon. However, there is a third option: that economic crisis is caused not by the economic system’s inherent instability but by institutions designed to manage this instability that cannot adapt to new conditions and wind up turning instability into a crisis.

Galbraith pioneered the classic account of irrational excess as the cause of the Great Depression. The greedy, irrational actors who populate the economic system saw an opportunity to get rich quick in the ever rising stock market and built it up to such a level that a crash was inevitable when their greed turned to fear. This approach has received some empirical support from modern studies by DeLong and Shleifer and Rappoport and White but for various reasons these studies are far from convincing. Studies from McGrattan and Prescott, Sirkin, Nicholas and have all confirmed the view of Irving Fisher before the crash that the 1929 stock market was not, a priori, overvalued and the Friedman and Schwartz analysis that the Depression was caused by Fed policy exacerbating the minor setback of a relatively moderate initial stock market fall. However, the refinement offered more recently is that the reason policy failed in this way was the constraint imposed by the Gold Standard. Ben Bernanke, the new chairman of the Federal Reserve, did an empirical study showing that the sooner a country left the Gold Standard the sooner it recovered from the depression. A rule that had played its part in the stability of the 19th century created a mess in the first half of the 20th.

The other crises of the 20th century had much in common with this story of institutional rigidity. It is impossible to separate the crisis following the 1970s oil shock from the collapse of Bretton Woods. The early 1990s recession in the UK can be connected to the ERM and the collapse of that attempt to fix interest rates. Finally, the Asian Financial Crisis can be related to an outmoded institution of a different kind. Krugman’s analysis of ‘crony capitalism’ is too simplistic. The East Asian economies use of relation based contracting was successful in earlier years when formal rules were costly to enforce. However, the close knit business relationships were a source of bias in the investment decision and created a financial instability that would be exposed with liberalisation of financial markets that was necessary as the East Asian economies developed.

The common thread running through the origins of all these crises is institutions past their sell by date. These institutions are attempts to control the instability that comes with free markets which can have new products or dramatic changes in costs thanks to technology or suffer shortages thanks to political or physical changes. The volatility that emerges from these changes in expectations of the future state of the economy is put down to speculators, to a greed for filthy lucre and is seen as dangerous. Such attempts at control can appear successful. The Gold Standard presided over the long stability of the pre-WWI economy. Fixed exchange rates set under the Bretton Woods system watched over the European Golden Age. However, the source of stability can usually be found elsewhere and the institutions play a supporting role at best: free trade, technological advance and political stability in the case of the 19th century and liberalisation of trade and sensible policy choices encouraged by the Marshall Plan in the European Golden Age. The instability these institutions create in their death is not matched by stability created during their life.

Attempting to form institutions to defend the stability of the global economy often fatally underestimates the ability of the capitalist system to adjust to external shocks. This underestimation can cause wise men of great experience and solid temperament with state power to be far more dangerous to economic stability than any ignorant fool trying to get rich quick but with only the funds he possesses himself or can borrow. It is institutions, whether the Euro or East Asian Currency manipulation, which try to work against rather than with the corrective forces of the market that should be watched for signs of the next economic crisis rather than the more brutally obvious danger of geopolitical stand offs with Iran.