Guided by ‘Ghosts’

Ryan Avent has a long post: “The meaning of Lehman”. I think these two passages provide a good summary:

It should have been clear from the beginning that big trouble was ahead. Economic history is history and is never perfectly straightforward. Yet the clear lesson from the Great Depression was that aggressively expansionary monetary policy was both necessary and sufficient to end the decline and restore rapid growth. In 2008 most of the rich world was poorly positioned to heed that lesson.

That was mostly the fault, or rather the pride, of a generation of inflation-fighting central bankers. Thanks in large part to the achievement of low and stable inflation, nominal interest rates edged slowly downwards from the late 1980s on. On the eve of the crisis the Fed’s preferred interest-rate tool—the federal funds rate—stood at just 2.0%, leaving the central bank almost no room to support the economy when financial disaster struck. 

Even so, inflation-obsessed central bankers were slow to react to the unfolding disaster thanks to distracting effect of high oil prices. As oil surged in early 2008 core inflation rose to 2.5% and headline inflation hit 5.6%. The Fed, which had begun lowering rates in late 2007 to buoy the economy amid a broad housing bust, paused in early 2008 despite continued deterioration in the economy. Remarkably, the Fed took no interest rate decision at a meeting on September 16—after the Lehman failure—because, “The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee.” That despite the fact that the price of oil had already dropped $50 a barrel from July and month-on-month CPI inflation was negative in August and September. The Fed needed more certainty that economic weakness would weaken inflationary pressure before acting. It soon got it.

Still the Fed remained woefully behind the curve. It acted quickly to prevent a freeze-up in money markets from paralysing the economy entirely. Yet it waited until December to bring rates all the way down to zero and until March of 2009 to properly start quantitative easing: a delay no doubt caused in part by uncertainty over how best to act once short-term rates are at zero. In the five years since the Fed has repeatedly dipped into its tool kit to prevent dangerous disinflation and to make sure the unemployment rate moves in the right direction, however slowly. But it has never found the nerve to do the one thing that might have generated a robust recovery.


The Depression was not, fundamentally, about the failure to understand the importance of demand and the way an economy could become stuck operating well below potential. It was about the tyranny of a bad idea: the gold standard. Or more honestly, it was about the set of institutions, cultural norms, and men who gave the idea its power.

There was an intellectual skeleton beneath the gold standard—and an era of prosperity on gold (the great period of globalisation from 1870 or so to 1914) to give the intellectual arguments teeth. Yet the extent of the devotion to the system, and the level of suffering governments were willing to impose on citizens on its behalf, goes well beyond the loyalty normally commanded by economic policy norms. Britain drove its economy into the muck in the 1920s trying to deflate enough to return to gold at the prewar parity. Governments suffering crippling levels of unemployment, bank runs, and social unrest squeezed their economies even harder with rising interest rates, simply to prevent a pile of gold in a vault from getting a bit smaller. In Germany the government of Chancellor Heinrich Brüning refused to expand the money supply even after effectively going off gold, in the process helping to bring the Weimar Republic to an end. 

Britain and Germany were forced off gold for lack of reserves. America had reserves galore but let gold orthodoxy squeeze its economy anyway—until Franklin Roosevelt ignored the concerns of his more sober-minded advisers. Even given the example of how effective reflation was at boosting the real economy the old ideas maintained their power. The choice to sterilise new gold inflows in 1937 to rein in inflation sank the American economy back into recession. Hard money was sensible, serious, responsible. Gold was what the sober men of the age knew to be the bedrock of sustainable economic expansion. And they were all horribly wrong.

One thought on “Guided by ‘Ghosts’

  1. Imagine the.misery then and now caused by the officious pompous pettifoggers and their peevish fixation on the stability of currencies or the sacred nature of gold.

    We are still not clear of these demented theomonetarists. Thr Fed still fears a truly aggressive growth policy. Incredibly monetary policy today is more concerned with rigid price stability than real growth.

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