APRIL 23, 2015
WHY DID THE GLOBAL financial crisis of 2007–2008 — so similar in its root causes, initial phases, and global spread to the upheavals of 1929–1931 — result in the stubborn and dispiriting economic stagnation of the Great Recession, whereas the interwar crisis led to the epochal catastrophe that was the Great Depression? A common view, and one with much merit, attributes the difference to learning: our awareness of the appalling mismanagement of the earlier crisis informed better policies this time. Then, the dismal, deflationary policies of the United States Federal Reserve made a bad situation much worse; this time, the chairman of the Fed, Ben Bernanke, had made his academic reputation studying those blunders and was determined not to repeat them.
But a closer look paints a much more complex story. Along with similarities and parallels, there are also important differences between the two crises. In addition, the Great Depression offered many more vital lessons than the ones that were “learned” — and selective and self-serving attentiveness to those lessons has contributed mightily to our current troubles. Clearly, more than hand-waving invocation of the Great Depression analogy is necessary, and Hall of Mirrors rises to that challenge.
Barry Eichengreen is an ideal scholar to reflect upon both crises, together and separately. One of the world’s foremost experts on the Great Depression — his 1992 book Golden Fetters: The Gold Standard and the Great Depression, 1919–1939 is a landmark study — the prolific Eichengreen has also written highly regarded and in some cases the standard treatments of financial crises, the European monetary union, and postwar European economic history more generally. On equally firm footing discussing events in Europe and the United States and ranging effortlessly, expertly, and impressively across decades and continents, Hall of Mirrors earns a prominent place among the first rank of the many books that have been written in the wake of the global financial crisis of 2007–2008.
History buffs will be richly rewarded by this book — perhaps too well rewarded. Eichengreen knows too much, and at times it shows. The parallel structure — a few chapters on then, a few chapters on now — has a sound intellectual logic but doesn’t come off without a hitch; plunging into the details of the interwar depths and then suddenly returning to the surface of the present can leave the reader a little lightheaded. Perhaps the press (or the author) felt the need to emphasize Hall of Mirrors’ comparative advantage in order to distinguish the book in a crowded field. They need not have worried — Hall of Mirrors works through the current crisis with dexterity and acumen. If anything, the book is more riveting, and even more convincing, when engaging the current crisis.
Eichengreen’s main point is well taken: we ought to stop patting ourselves on the back and take a much harder look at what we got wrong. Yes, we stopped a great depression, and back then they did not; our better response was indeed shaped by the lessons on the path. Nevertheless, “this happy narrative is too easy.” If we’re so smart, then why did we so easily sleepwalk into a catastrophic crisis, the roots of which are actually not that mysterious and so obviously paralleled by the causes of the earlier disaster? And why have we done such a shameful job — worse, in many respects, than our much-maligned ancestors of the 1930s — in restoring economic growth and, especially, in putting in place measures that would prevent another crisis from taking place?
This is a three-part story: before, during, and after the crisis; reading this book as a report card, it looks like Professor Eichengreen awards a B+ for the immediate crisis response (he is a bit of a tough grader here, given how hard the assignment was), and Ds and Fs for the public policy choices made in the years before and after (and these grades are hard to dispute). A “naïve belief” that the Great Moderation and aptly managed monetary policy had tamed the business cycle led to a reckless insouciance about the plainly obvious dangers brewing in the financial system. The misguided, premature “hard right turn” toward austerity after the initial crisis was contained snuffed out nascent prospects for recovery and depressed economic growth.
Revisiting the Great Depression, Eichengreen relates the cringe-inducing similarities between the financial follies of the 1920s and the decade leading up to the 2007–2008 crisis — here lessons were very much not learned, or, more accurately, forgotten or superciliously set aside. Ponzi’s schemes become Madoff scandals, but other than that, it looks pretty much the same: real estate bubbles, financial excess, loose and indifferent regulation, an overly accommodating Federal Reserve, and the euphoric expectation that good times would forever and effortlessly roll. Hall of Mirrors is, not surprisingly, smart and sure-handed in its treatment of the depression, digging up some obscure gems, identifying and clarifying some productive parallels between then and now, and, especially of value, debunking some myths and offering some correctives to folk wisdoms. Simple monetary explanations for the depression only go so far. The Fed knew to engage in open-market operations and provide liquidity in response to the stock market crash, but it lacked a theoretical framework to combat the deflation and depression that followed, and its prompt return to orthodoxy did make a bad situation much worse. President Franklin D. Roosevelt (FDR) was indeed a heroic figure, but as an improviser, some of his measures misfired, and he made his share of mistakes as well, most notably the (politically influenced) drive to balance the budget in 1936.
Under pressure to breathe life into familiar material, Eichengreen occasionally overreaches. Striking a contrarian pose, he suggests that the effects of the United States’ notorious Smoot–Hawley tariff, which elicited reprisals from abroad and contributed to the downward spiral of international trade, have been overstated. It is true that trade only accounted for a modest contribution to the overall United States economy. But in general, the collapse of the global economy, rooted in a failure of international cooperation, foreclosed opportunities for economic recovery and tightened the straightjacket of the depression. Hall of Mirrors also duly notes, but marginalizes, the extent to which bitter and intense interwar political rivalries nudged countries towards counterproductive attitudes and inhibited the international cooperation that might have made things better. (Conversely, the relatively benign great power security environment was crucially permissive in this regard during the current crisis.) Most notably, international political squabbling undermined the response to the Creditanstalt crisis of 1931. The failure of the giant Austrian bank, uncontained, spread across the continent, upended German finances, knocked Britain off the gold standard, and emitted deleterious shock waves felt in the United States and Japan, and after which the teetering global economy completely cratered. Politics was always present, and at the center of this; as Eichengreen notes, President Hoover thought that France’s redemption of gold for dollars was “payback” for Hoover’s moratorium on the payment of German reparations.
Finally, leaning against the cult of FDR, Eichengreen is quick to note the flaws in his policies. In so doing, he underestimates the benefits brought about simply when the new president brought to an end Hoover’s catastrophic stewardship of the crisis, which prioritized balanced budgets, belt-tightening, and the orthodoxy of the gold standard. Hall of Mirrors does emphasize, repeatedly, properly and pointedly, the importance of the fundamental economic reforms and attendant financial regulations associated with the New Deal, even if FDR’s stimulus policies lacked sufficient oomph. Indeed, one of the key themes of the book is that FDR was weak on “recovery” but outstanding on “reform” — the inverse of the Obama Administration.
On the causes of the global financial crisis, Eichengreen does not break much new ground — but at this point it would be hardly possible to do so. Nevertheless, he tells the story clearly, vividly, and with remarkable efficiency. In one deep breath: the deregulatory trend in finance, dating back to the 1970s but culminating in the late 1990s with the repeal of the (depression-era) Glass–Steagall Act and the derivatives-unleashing Commodity Futures Modernization Act, combined with fading memories of the 1930s, new and widespread belief in the efficient markets hypothesis, and the Clinton-Democrats embrace of Wall Street, resulted in an environment that encouraged a “massive increase in the size, complexity, and leverage of US financial institutions.” As “time dampened awareness that financial markets are unstable,” oversight agencies like the Securities and Exchange Commission were increasingly outflanked by financial innovations and inadequately attentive to the dangers inherent in metastasizing shadow banking activity. (Nonbank financial institutions engaged in undertakings once the purview of traditional banks.) Starved of resources, regulators were seen as clumsy, inefficient, and vestigial. What followed was a carnival of highly-leveraged debt-financed risk-taking involving complex and novel financial instruments, including collateralized debt obligations (CDOs), and, ominously, “synthetic CDOs,” which were backed not by assets but by credit default swaps (CDSs): insurance arrangements based on promises to pay. How many promises were made? It was hard to say. In 2005 one estimate put the face value of outstanding CDOs at $1.5 trillion; another guessed it was closer $17 trillion. “But no one knew for sure.”
As Eichengreen shows, there is plenty of blame to go around for paving the road that led to the global financial crisis, including but not limited to ratings agencies riddled with conflicts of interest, investors who should have known better, the Fed’s overly accommodating monetary policy, Fed Chair Alan Greenspan’s faith-based overconfidence in the ability of financial markets to police themselves, failures to understand the true nature of the crisis brewing in the sub-prime mortgage market, and, commonly, questionable business practices. (With cheeky understatement, players like Goldman Sachs are described as “not overly burdened by scruples.”)
Hall of Mirrors also effectively dismisses the revisionist, politically motivated trope that somehow the crisis was caused by the government forcing reluctant banks to issue sub-prime mortgages to poor people — a relatively modest sideshow in the broader context of an unsupervised, profligate, and engorged financial system, recklessly managed, morally compromised, its giant firms incomprehensibly enmeshed and irresponsibly churning trillions of dollars of securitized derivative assets, the value of which was opaque at best to even the most savvy market actors and investors. That such a system would generate massive and growing systemic risk was inevitable. Yet in the years leading up to the crisis the very concept of systemic risk — that even individually rational behaviors in the financial sector, which is characterized by interdependent and leveraged obligations, generate risks for the system as a whole — was ridiculed by the very chummy elites traversing the gold-plated revolving door between Washington and Wall Street.
As the din of political noise becomes deafening, it is helpful to remember that it doesn’t take a rocket scientist to understand the basic causes of the crisis — a little rudimentary macroeconomic competence is all that is required. Former Federal Reserve vice Chair Alan Blinder’s fine book on the crisis, After the Music Stopped, runs over 500 pages of analysis. But Professor Blinder, famous for bringing a globe into his graduate macroeconomics class so students would always remember that the purpose of complex, abstract theory is to better understand the real world, is ultimately trenchant and succinct: “It was shameful business practices, coupled with regulatory neglect, that got us into this mess.”
And quite a mess it was. In two concise, gripping chapters, Eichengreen walks through the heat of the battle: the sluggishness of overly cautious central bankers to recognize the gathering storm; the Bear Stearns crisis, which forced the Fed to draw on its obscure (and, again, depression-era) “unusual and exigent circumstances” power to intervene; the subsequent decision not to rescue Lehman Brothers, which triggered “nothing less than a full-fledged run on the shadow banking system.” And from there, things got even worse, as the massive insurance company AIG, with trillions in outstanding obligations (dwarfing even Lehman’s massive exposure), was on the brink of failure, threatening a collapse that would pull down many of its key counterparties. The problem was, in Eichengreen’s words, “someone inside AIG apparently believed its experience in commercial and industrial insurance qualified it to sell protection against the failure of collateralized debt obligations” — a belief the company ran with aggressively, parlaying its coveted AAA rating and complex European booking schemes to place itself at the epicenter of the market.
As Bush Treasury Secretary Henry Paulson recounted, when the president, incredulous, wanted to know why the financial system would collapse if AIG — an insurance company — was allowed to fail, Bernanke explained that AIG wasn’t so much an insurance company; it had become “more like a hedge fund sitting on top of an insurance company.” Moreover, he observed, in the new, frenzied world of unchecked finance, there was “no oversight” of its financial products division, which “made huge numbers of irresponsible bets.”
And so the United States did what it had to do. A massive bailout of the failed financial system (in Bernanke’s estimation, 12 of the 13 “most important financial institutions in the United States […] were at risk of failure within a period of a week or two”), the provision of essentially unlimited liquidity, and initial fiscal stimulus saved the day; in addition, this time around a much more robust social safety net and automatic fiscal stabilizers did their Keynesian job. Unfortunately — and this is the principal theme of Hall of Mirrors, hammered home, again and again — “following this initial push […] the debate and with it the policy response began to shift.” For a “brief period in 2008–09” policymakers, determined to prevent another great depression, threw everything they had into stabilizing the economy. But once the worst was avoided, despite an economy still wounded and woefully anemic, policy was increasingly guided by concerns about budget deficits and the risk of inflation. “Rather than avoiding the mistakes of the 1930s, policymakers seemed intent on repeating them.”
The moment it appeared safe to climb out of their Keynesian foxholes, guardians of the satisfied status quo quickly regathered, and roared. Eichengreen quotes the open letter directed at the Federal Reserve published in The Wall Street Journal in November 2010, signed by 23 conservative public figures (including economists, business leaders, and pundits such as the preternaturally overconfident Niall Ferguson), opposing “quantitative easing” which would “risk currency debasement and inflation.” It is hard to think of an example of a bigger swing and miss in the history of policy advocacy, though some of the same figures clamoring for orthodoxy had been prominent Iraq war boosters. Nevertheless, as Eichengreen notes, “increasingly these arguments reshaped policy even if the dangers to which they pointed were largely illusory.”
Flashing an economist’s frustration with the way that politics and posturing prevent the adoption of optimal economic policies, Eichengreen bemoans the too-modest-by-half Obama stimulus, and the growth-inhibiting budget cutting and sequestration that followed. Incisively cutting through the claims of the austerity and orthodoxy crowd, he notes that the idea of government deficit spending “crowding out” private investment simply does not hold in an environment of very low interest rates, and in economic conditions that were “still far from normal,” monetary expansion would not, and did not, fuel inflation.
In Europe, public policy choices were even worse. The global financial crisis exposed the flaws and inconsistencies of the “still incomplete” Euro system, two of which are still proving stubborn and monumental. First, economic integration ran far ahead of political integration, and the enduring identity politics of “us versus them” conceptualizations — most commonly across a North–South divide — paralyzed policy responses. Second, by adopting the common currency, participants abdicated most of the policy levers that would normally be deployed to meet economic crisis. And with the Euro system in some ways recreating the pathologies of the interwar gold standard, “the only available response was austerity.”
The European commitment to inflation-fighting (even as its economy flirted with deflation) and fiscal caution meant that attempts on the continent to encourage economic expansion were even less ambitious than in America, and the shift from stimulus to austerity more swift. Hall of Mirrors notes the dispiriting track record of austerity in Europe — snuffing out nascent economic growth, visiting economic distress on Southern economies to a much greater extent than anticipated by its proponents, and serving the bitter portions of “economic pain and political turmoil” that yielded little hope or progress in return. These outcomes ought not surprise; Mark Blyth’s recent book Austerity: The History of a Dangerous Idea is similarly compelling on the inevitably self-defeating nature of such efforts.
What is particularly frustrating to those with an eye for history, and which Hall of Mirrors ably recounts, is that although the Great Depression offered lessons that helped prevent the worst this time around, other interwar lessons, just as plain, have been willfully ignored. We have been here before — with similar results. The momentum of emerging United States recovery in the mid-1930s was cut short by FDR’s election-year-inflected emphasis on balanced budgets and more restrictive monetary policy, which helped send the American economy plunging back into recession in 1937.
And as for the broader issue of stimulus and liquidity versus orthodoxy and austerity, this experiment had already been run — definitively. In the 1930s, France met its portion of the Great Depression with a zealous commitment to pious austerity unlikely to be rivaled. Obsessed with monetary orthodoxy and budget cuts, and clinging devoutly to the weighty albatross of the gold standard as if it was a life raft, French policy makers first tried deflation, and, when that failed, “super-deflation.” But no matter how much they cut the budget, the economy still contracted, reducing tax revenues — the economy chased its tail spiraling downwards. Recovery would not be possible until France finally cut its ties with gold in 1936.
In contrast, Japan, which initially suffered through its own bouts of self-defeating austerity and deflation (following a logic articulated by, inevitably, the director of the Mitsubishi bank: “adjustment could not be achieved without great hardships; good medicine is bitter to the taste”), more quickly chose the opposite path. Under the guidance of Finance Minister Korekiyo Takahashi in 1932 (see Richard Smethurst’s From Foot Soldier to Finance Minister: Takahashi Korekiyo, Japan’s Keynes, for more on this remarkable life), Japan broke with orthodoxy, abandoned austerity, and recovered rapidly. As Eichengreen notes, “Japan’s experience thus illustrates what concerted monetary expansion, backed by fiscal stimulus, could do.”
Another area where Hall of Mirrors emphasizes how contemporary policymakers have come up woefully short is with regard to the measures taken (that is, not taken), to prevent another crisis. Eichengreen is critical of the timidity of FDR’s stimulus measures, but gives Roosevelt high marks for his transformative reforms that remade the American economy and established the framework of oversight and control of the financial sector that ushered in an unprecedented half century of financial stability. This time, however, only modest reforms followed the catastrophe. Fighting upstream into the formidable fury of Wall Street lobbyists, although some “modestly useful measures” were introduced, ultimately, “little was done to make the world a safer financial place,” and the underlying factors that contributed to the global financial crisis remain unchecked. (With regard to “too-big-to-fail” firms, for example, the six largest financial institutions in the United States were over 35 percent larger in 2013 than they were in 2008.)
Ironically, by preventing the worst this time, the imperative for reform seemed less urgent, and the resistance to it more formidable. The Great Depression was an “implosion so complete” the political mandate for fundamental reform overwhelmed the opposition of the (then somewhat smaller) financial sector, still smoking in ruins. In the current crisis, elites in Europe and the United States did “just enough to ward off” another great depression, but “their very success encouraged second thoughts,” and “weakened the incentive to think deeply about causes.”
What we have not had, as a society, is a national conversation about “what kind of financial system was needed to best support the growth of the non-financial economy and how to structure regulation to produce it.” This matters, because, as Financial Times columnist Martin Wolf concluded in his book on the crisis, The Shifts and the Shocks, the current system is “irretrievably unstable,” and it is “grotesquely dangerous” to allow “the pre-crisis way of running the world economy and the financial system to continue.” With Hall of Mirrors, Barry Eichengreen adds his voice to the chorus of eminent authorities who share these concerns, and through the lens of economic history, illuminates all-too-harrowingly the stakes on the table.