The Spread of Financial Panic


Note how the collapse of financial institutions and governments spread in two directions at once. While the Great Depression was generated by decisions and actions of economic and political actors in the developed industrial and financial world, its effects were most devastating in nations on the periphery that were nevertheless dependent on the health of these industrialized nations.

Beginning in May 1931, panic swept from Austria through Poland, Hungary, Czechoslovakia, and Romania and eventually to Germany, then to Switzerland, France, the United Kingdom, Turkey, and Egypt, Mexico, and the United States.

And matters today may be far worse, not because of the greater depth of the economic crisis, but because of the responsiveness and interconnectedness of world markets. Greece, Turkey, Spain, Ireland . . .

Note also however that with the reversal of the Glass-Steagle Act of 1932, Congress in effect recreated the very conditions that hastened the spread of the financial crisis.

“Where banks were tied to industry, as in much of central Europe, financial distress was quickly transmitted to the rest of the economy.”




Does Market Rigidity Respond to Market Forces? Should It?

Among the arguments leveled against Keynesians is that swift government intervention in response to recessions contributes to wage and price rigidity. Were flexibility rewarded by higher returns, so it is argued, then flexibility would quickly enter the market place. However, when governments intervene, easing the supply of money, decreasing its cost, or directly providing it to producers (e.g., defense, education, transportation or health industry contracts), then they contribute to the very rigidity that demands their intervention.

This raises the question whether government intervention is counterproductive. But even supposing that government intervention is counterproductive, how long should families be permitted to forgo food, clothing, housing, healthcare, transportation waiting for the market to shed its rigidity?

What Caused the Great Depression?

It is common today to fault government intervention for the Great Depression. Had the government simply let the economic cycle take its course, then the Great Depression would have remained a Great Recession.

But note that it was the unregulated markets that produced the bubble into which investors poured their capital. Note that it was the draconian reparations placed on Germany that set the cycle in motion. And note that it was the Democratic Socialists in Germany who successfully brought inflation under control with the help of the Dawes Plan.

This suggests that it was not government intervention that brought on the Great Depression, but the absence of government oversight of markets.

Why might the wisdom that did not work in 1929 bear bad news to a world economy that is following that wisdom today?

The Received Wisdom . . . Still

Why might J Frieden’s observation not instill confidence in the “received wisdom” of current lawmakers around the world?

Received wisdom and prewar experience said that the recession would correct itself. Once wages got low enough, capitalists would start hiring back workers; once prices fell far enough, consumers would start buying. As prices and wages dropped, demand would rise, until balance was restored.

What Happens When the Highest Return Makes Nothing?

Economists note that one of the precipitating factors leading to the Great Depression was the simple fact that investors could make a better return on their investment investing in the stock market than investing it anywhere else. Capital for the production of real things simply dried up. Corporations, which might have redirected such investments to productive ends, simply plowed these investments . . . back into the market. Money became more valuable than things.

As money flowed into the United States and the dollar, investors unloaded other currencies. European governments facing a sell-off on the foreign exchanges responded as usual, raising interest rates and imposing austerity.

One of the consequences of the financial instruments created in the 1980s was that investors could realize higher returns investing in financial institutions than in the production of goods. How might the current deregulated financial environment mirror economic circumstances that prevailed in the 1920s?

The Marvels of Debt

Once both Central Powers and Triple Entente nations were well along the path to economic recovery, thanks largely to the Dawes Plan, US investors came to be awash in debt. J.P. Morgan—the same investment house that had handled England’s huge wartime debt—also masterminded the huge debt relief package that brought Germany’s debt under control and enabled Germany to begin paying off its debt to France and England; which, in turn, enabled France and England to repay its war debts to US investors, with interest.

This made US the largest creditor nation and explains how the US came to succeed Great Britain as the world’s fourth hegemon (after Italy, Holland, and Great Britain); i.e., the primus inter pares without whose agreement international trade and commerce could not take place and whose laws and holdings therefore shape the global economy.

But, of course, US investors needed to find places to invest their riches and this, more than anything else helps to account for the seemingly contradictory turn inward by US politicians and turn outward by investors. Political Economy students will need to reflect more carefully on this potentially toxic combination. For it suggests that defense policy will increasingly follow instead of lead. American investors buy up huge chunks of territory and resources whose export, trade, exchange, or processing into finished goods fuels the health of the markets and and well-being of American citizens. But the protection and securing of these foreign investments in turn therefore come to be of interest to the Department of War (subsequently the Defense Department) which then has a vested interest in protecting these private investments.

How might free markets foster this unintended consequence?


In his book The Post-American World, Newsweek International Editor Farheed Zakaria justifies Paul Volker’s draconian anti-inflationary measures beginning in 1981 by suggesting that high inflation is much more dangerous than high unemployment because high inflation deprives individuals of what they have already earned, invested, or saved, while high unemployment deprives individuals only of their present and future earning capacity. Mr. Zakaria refers in this context to the repercussions that followed from hyperinflation in Europe, particularly among the former Central Powers and allies, following World War I.

Although in purely economic terms Mr. Zakaria is surely correct, may there be some value in reflecting, on the one hand, on the effects high unemployment has traditionally had on working families, and, on the other hand, on the alternatives leaders of the former Central Powers could reasonably choose in light of their destroyed industrial capacity and towering debt connected to the Versailles Treaty’s “war guilt” clause. Since Germans had neither the industrial capacity to raise sufficient capital to pay this debt nor sufficient reserves, and since it was only much later that Americans would lend to Germans at a reasonable interest rate, what were the alternatives open to such leaders?

Do economists or–in the case of Mr. Zakaria–public intellectuals have a responsibility to call attention to impact economic policies are likely to have on social and political events?

Merchants of Death?

No one disputes that US investors were huge beneficiaries of World War I. Nor does anyone dispute that historically private weapons manufacturers and financers have benefited from wars going far back into the Middle Ages. As we will see when we read G Arrighi later in the semester, since they are often guaranteed by governments or (in monarchies) governing families and since they appear at times of extreme need, wars are among the most profitable investments investors can make. But their benefits are not universal. Just as Italy and Spain were losers in the conflict between Spain and Holland (16th century), or just as Spain, Germany, and France were losers in the conflict between Spanish and England (17th century), so Germany and England were losers in the two conflicts that gutted Europe mid-twentieth century.

The truth is, so long as nations go to war, someone needs to put up the capital to finance those wars and someone needs to produce the weapons that belligerents purchase in order (they hope) to win those wars.

It is less often remarked how those who finance and supply warfare are politically and economically empowered by their readiness to lend capital and produce weapons, stealing much more of a share of the market and garnering much more political influence, relative to their competitors and relative to other sectors, than they would have in the absence of war.

As a very young JM Keynes commented in 1917:

The sums which this country [Great Britain] will require to borrow in the United States of America in the next six to nine months are so enormous, amounting to several times the national debt of that country, that it will be necessary to appeal to every class and section of the investing public. . . . It is hardly an exaggeration to say that in a few months’ time the American executive and the American public will be in a position to dictate to this country on matters that affect us more dearly than them.

Yet bankers and weapons manufacturers often feign indifference in the causes of war and peace, almost as though they are merely responding to popular political “demand” (and not the rational drive to maximize return on investment).

Considering the delegation that Woodrow Wilson brought with him to Europe following the war, composed largely, as J Frieden observes, of “representatives of Wall Street [such] as [J.P.] Morgan’s Thomas Lamont, Norman Davis, Bernard Baruch, and a young John Foster Dulles”—a pattern repeated in nearly every major previous conflict and every conflict since—it is easy to see why some might see war financiers and suppliers as “merchants of death.”

Do economists have a responsibility to consider the benefits bankers and weapons manufacturers gain from conflicts between nations?

How can Economics Capture Käthe Kollwitz’s Despair?

Economists often take on the Great Depression to show that their theories pass muster. JM Keynes wrote his General Theory in part to show that Classical Economic Theory only covered the special (and rare) case when an economy enjoyed full employment. M Friedman countered with a series of articles and books in the 1950s that showed how government intervention deepened and lengthened the Great Depression. Yet, how can economics—which attempts to recognize and formalize the aggregate decisions of delimited communities—adequately take into account Käthe Kollwitz’s despair? Why did J Frieden begin a chapter about the onset of the Great Depression with this story?

Economists are famous for dismissing—at the peril some argue of both their theories and their societies—the social and political consequences of economic events. Despair, such as that experienced by Ms. Kollwitz, often propels people to action and their actions often give rise to economic events that are entirely unanticipated by economists. Do economists have a responsibility to consider the effects of economic events on social and political forces?

The cascade of unanticipated events unleashed by World War I and its aftershocks is bewildering. But so too is economists’ naïveté over the possible repercussions of economic events leading up to that War. Imperialism, colonialism, and militarism are only the most obvious of the economic processes that gave rise to World War I. Even if economists are not responsible for controlling these processes, how might they account for them in their theories? And, if economists are not responsible for their failure to take these processes into account, then of what value can their economic theories be in helping us to understand the world or predict how economic policies and decisions will shape the world of tomorrow?

(To get us thinking about this, you might want to reflect on the costs and benefits of WWI, WWII, the Holocaust, the Rise of the Soviet Union, the Cold War, anti-imperial and anti-colonial conflicts, etc.)

Republican Tea Party’s Historical Precedent

As analysts and economists bewail the Republican Party’s utter incomprehension of the most fundamental macroeconomic principles, they seem completely oblivious to the historical precedent the Republican Party appears to be following. No doubt, the dock workers and laborers who donned costumes and tossed tea into the Boston Harbor all these many years ago were tired of paying for the British military occupation of their own country. And they were tired of the British taxing their second most favorite beverage. But, how many of those hoodlums were invited to the Constitutional Convention in Philadelphia fourteen years later?

None. That’s because one of the leading aims of the meeting in Philadelphia was to empower the federal government to tax citizens in all of the thirteen states, an aim none of the participants in the original tea party would have countenanced. In their view, a nation that restored the authority of the central government to tax the citizens of individual states would amount to nothing short of restoration of monarchy. And they said so explicitly.

It was the intransigence of these original tea partiers that provoked the Constitutional Convention. For, as Virginia’s Edmund Randolph put it when introducing his outline of the new Constitution:

The Confederation produced no security against foreign invasion; Congress not being permitted to prevent a war, nor to support it by their own authority. Of this [Randolph] cited many examples; most of which tended to show theft they could not cause infractions of treaties, or of the law of nations, to be punished; that particular states might, by their conduct, provoke war without control; and that, neither militia nor drafts being fit for defence on such occasions, enlistments only could be successful, and these could not be executed without money (Elliot’s Debates, May 29, 1787).

Then as now the tea partiers would rather have seen the ship of state scuttled than secure its financial integrity.

But they were, in effect, locked out of the meeting, leaving the fiscally responsible delegates from each of the states free “to form a more perfect union” as the Preamble puts it.

So, where does that place today’s successors to the original Tea Party? At the very least, they display a remarkable (or not so remarkable) lack of understanding of the most basic Constitutional principles. They want us to scrap the Constitution and start over. In effect, they are asking for a Constitutional re-do. Which is fine. Our Constitution and Bill of Rights make allowances for this possibility.

Unlike 1787, however, the fiscally responsible members of each party have no authority to lock these hoodlums out of our meetings. Their popular support is too strong, their Congressional delegation too large. Which is why “we the people” must do what Congress cannot. First, we need to use whatever means we have—which means our Constitutionally protected freedoms (press, speech, association, religion)—to disempower these enemies of the Constitution. Corporate campaign donors need to deprive them of their source of revenue. Individual donors need to send their money elsewhere. Second, we need to use these same means to get the Tea Party out of Congress and out of the Republican Party.

Finally, the Republican Party itself needs to recommit itself to “public things,” to res publica, and to the wealth we hold in common (hence the Commonwealth). Or they should have the guts to publically disavow their claim to republican values and institutions and change their name, perhaps to the Tea Party. In either case, the Republican Party should make clear either that their delegation continues to support the U.S. Constitution and the Federal Government’s right and responsibility to manage—yes, manage—the finances of their nation or Republican office holders should clearly and unmistakably disavow the Constitution and (no longer able to swear to uphold the Constitution) they should step down from office.