One of the chief ways financial market participants make sense of events is by drawing parallels with the past. The subprime crisis, when it first erupted, was widely perceived as the most dangerous financial crisis since the 1930s. The implication was that it was critical to avoid the policy mistakes that transformed that earlier crisis into a macroeconomic disaster. The lesson drawn was that it was important to avoid an excessively tight monetary policy.
Now, with inflation rising, the popular parallel is not the deflationary 1930s but the stagflationary 1970s. Again the implication is that it is important for policymakers to avoid past mistakes. In this case past mistakes mean a monetary policy that allows inflation expectations to become unanchored.
In fact both analogies are misleading, precisely because market participants and policymakers are aware of this history. Their awareness means that financial history never repeats itself in the same way. Biochemists can replicate their experiments because molecules do not learn. Central bankers lack this luxury.
In the 1930s the critical mistake was the Federal Reserve’s failure to recognise its lender-of-last-resort responsibilities. The result was not just financial distress but the collapse of the US price level, which fell by 21 per cent between 1929 and 1932. Since demand for commodities, including food and oil, was inelastic, their prices fell even faster than the overall price level, causing distress among primary producers.
And since other currencies were linked to the dollar by the fixed exchange rates of the gold standard, US deflation caused foreign deflation. As US demand weakened, other countries saw their currencies become overvalued. They were forced to raise interest rates in the teeth of a deflationary crisis. By raising interest rates, foreign countries transmitted deflation back to the US. Only when they delinked from the dollar and allowed their currencies to depreciate did deflation subside.
The difference now is that the Fed knows this history. Indeed Ben Bernanke, the Fed chairman, wrote the book on the subject. Seeing the analogy, his Fed has responded to the subprime crisis with aggressive lender-of-last-resort operations. If anything, it may have been too impressed by the analogy. Its mistake was to cut interest rates so dramatically at the same time that it extended its credit facilities. It would have been better to lend freely at a penalty rate. Higher interest rates would have made its emergency credit more costly and led to better-targeted lending and less inflation.
The Fed’s response has forced other central banks that manage their exchange rates against the dollar, mainly in Asia, to import inflation rather than deflation. Their currencies have become undervalued rather than overvalued. As their real interest rates have fallen, these countries are now exporting inflation back to the US. Where global deflation led to the collapse of commodity prices in the 1930s – devastating those countries dependent on exporting commodities – our current inflation is having the opposite effect. This time, primary producers are the biggest beneficiaries.
What is the solution? Emerging markets need to tighten their monetary policy further to damp down inflation. They need to revalue against the dollar to fend off inflationary pressures coming from the US, just as they needed to devalue in the 1930s to protect themselves against US deflation. We have seen small steps in the right direction, such as the interest rate rises recently agreed by the Bank of Korea and Bank Indonesia, but more needs to be done.
The Fed’s position is harder. If it now tightens, it risks compounding the recession. If it fails to do so, it risks undermining confidence and precipitating a dollar crash – which could still happen, in spite of the recent relief rally. Here the historical analogy is direct. In the 1930s the US needed expansionary policies to counter the depression but worried that moving too aggressively would demoralise markets and destabilise the dollar. Franklin Delano Roosevelt personally oversaw the process, setting the new dollar exchange rate each morning while taking breakfast in bed. In hindsight, his judgment looks sound.
One hopes that history will judge the Fed as favourably. James Bryce, the historian, had it right when he wrote that the chief practical use of history is to deliver us from plausible but superficial historical analogies. Or as Mark Twain more prosaically put it, the past may not repeat itself, but it rhymes.
The writer is professor of economics and political science at the University of California, Berkeley