More than a Recession

A bit of history. In the 1930s the U.S. economy shrank by 30 percent, the unemployment rate rose from 3 percent to 25 percent, and prices fell at an annual rate of 10 percent during the early part of the decade. Since World War II we have lived through ten expansions, averaging four years in length, and ten recessions, with an average length of one year. The two longest recessions (1969/1970 and 1973/1974) lasted for five quarters. And recorded declines were modest by the standards of the Great Depression. Which should provide a bit of comfort to those who are worrying that recessions typically collapse into a 1930s style depression.

That is not to say that the current recession is a mirror image of those we have experienced since WWII. It has many similarities to those setbacks, of course. Unemployment is rising, consumer confidence is fading, output is shrinking (although not as yet at an alarming rate), many investors are getting burned, some firms are being driven to the wall by declines in demand for their products, and a closing of credit markets.

Sigmund Freud is alleged to have said, “Sometimes a cigar is only a cigar.” And sometimes a recession is only a recession, with the consequences described above. The one in which we are stuck is different from those we have seen since World War II. The seizing up of credit markets, the ubiquity of bad IOUs on the books of financial institutions, the massive indebtedness of consumers, the rattling of the banks’ credit bowls at the doors of the Treasury and the Federal Reserve Board–a clamor made louder by auto companies, and insurance companies, construction companies, and U.S. subsidiaries of foreign banks–are relatively new features. Yes, we have had bailouts in the past–most notably of Chrysler during the Carter years, and Long Term Capital in the early days of Alan Greenspan’s tenure as chairman of the Fed–but we did not see the government buying shares in banks, or guaranteeing money funds, or opening the Fed “window” to collateral that, to put it politely, is not of the highest quality.

But note a common thread: All of these moves are generally correct policy responses to what some call the worst financial crisis ever, a veritable “tsunami”. In the Depression the Fed got it wrong, and tightened when it should have been loosening credit. In the Depression, the government almost got it wrong. Franklin Roosevelt thought part of the solution was a cut in spending to balance the budget, and so promised to do just that. Fortunately, that was a promise that he quite wisely decided not to keep, even before John Maynard Keynes provided the theoretical basis for deficit spending in a recession.

Now, after some stumbles, the most important being Treasury Hank Paulson’s decisions to let Lehman Brothers go down (he says he had no choice, since Lehman had no decent collateral he and the Fed could have accepted in return for bailout cash) the authorities are getting it right.

Ben Bernanke, a keen student of the Great Depression, learned from his predecessors’ mistakes, and even added some innovative loosening measures to a series of rate cuts, culminating in this week’s reduction to 1 percent. The recapitalization of the banks is underway on a huge scale, putting them in a position to begin lending again. The extension of government deposit guarantees calmed the panic that threatened to create queues at the withdrawal windows of the world’s banks. Measures to improve banks’ willingness to lend to each other seem to be taking hold, although that problem is proving the most resistant to government measures. There are tentative signs that the steps taken to thaw the frozen commercial paper market are working, so that businesses can cover short-term cash needs. All is not yet well in credit markets, and more shocks are in store, but the trajectory seems rather more encouraging than it was a few short weeks ago.

It is important to note that few of these measures have had time to work any magic they might contain. Interest rate cuts have an effect only after an 18-month lag. It was only last week that some of Hank Paulson’s $700 billion began to find its way onto banks’ balance sheets. And all of the talk in Europe about leading the way to recovery has yet to be followed by the injection of cash in quantities that match the EU president’s words (Sarkozy is the incumbent in that rotating post).

Those words might prove to be the most important result of the current financial trauma. In the 1930s, when the United States was in a deep depression, the U.S. model of free-market capitalism was challenged by Hitler’s National Socialism and Lenin’s Communism. Such as America’s ambassador to Britain, Joe Kennedy, and aviation hero Charles Lindberg professed to see National Socialism as the eventual winner over the U.S. model, while more than a few woolly-minded liberals went to the Soviet Union and proclaimed that they had seen the future, and it works. In the end, neither model survived its internal contradictions, while Roosevelt pushed through the reforms capitalism needed to make its markets function better, and enable the reformed American model to go on to produce a staggering increase in living standards.

Now Nicolas Sarkozy and Gordon Brown are posing still another challenge, a new, competing model, replete with new regulations and matching bureaucracies to staff augmented international organizations. Sarkozy would add a return to protectionism that will prevent foreigners from acquiring important EU firms and, if he can pull it off, something approximating the fixed exchange rate regime that emerged from the post-World War II Bretton Woods conference. France has been waiting almost since World War II to replace the American model with its state-run variant of capitalism–only some dare call it socialism–and believes a President Obama will prove more tractable than the reviled George W. Bush. Why he thinks that Obama would cap his arduous fight for the White House by ceding substantial control over the U.S. economy is unexplained.

There is more. America’s weakened economic condition has encouraged its European allies to attempt to reduce Uncle Sam’s military reach by shifting power from NATO to a European army. John Hutton, Britain’s new defense minister, is on board, and labels opponents of the new 60,000-man army “pathetic”. Of course, no European country has any intention of reducing spending on its welfare state in order to fund this new army, and most of these countries are refusing to put their troops in harm’s way in Afghanistan. It seems that the Europeans plan to borrow U.S.-paid-for helicopters and other “assets” when needed, rather than stump up their own hard cash. And their diplomats are pressing ours to urge the new president not to make any demands for more troops or funds that the Europeans will most assuredly turn down. If you ask, we will say “no”, so don’t embarrass us or yourself by asking, even though we recognize that the decades-long battle against the Taliban is as much in our interest as in yours.

So, unlike Freud’s cigar that is only a cigar, this recession is not only a recession. It is about more than the usual economic phenomena. Instead, it is providing the opening for a serious battle between rival visions of how the world’s domestic economies, and the international economy should be organized. And it has given the Europeans an opportunity to challenge America’s leadership of the western democracies.

Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).