An Economic Wake-Up Call

Wednesday, September 22, 2010
By Paul Martin

Simon Johnson
NYTimes.com
September 21, 2010

Before 1913, recessions in the United States were long (22 months on average) and painful (with little by way of social protection). They were often set off by financial crises, and the creation of the Federal Reserve in 1913 was intended — by both left and right — to at least reduce the probability that bank failures would lead to huge job losses.

Supporters of the Fed argue that the shorter duration (10 months on average) and reduced devastation of post-1945 recessions are due in part to the way monetary policy has operated — including “easing” interest rates when the economy is slowing down (known more recently as the “Greenspan put”; meaning that the Fed implicitly put a floor under asset prices). The moral hazard that this produced — in other words, you are not so careful about making bets when you feel that someone else will help protect you on the downside — was limited, Greenspan and others argued, by the natural functioning of self-interest and market mechanisms.

Remember, however, that until recently the financial sector was tightly controlled in the U.S. and generally well behaved, but those controls slipped away after the mid-1980s. To think about how our system operates today — with a large and largely uncontrolled financial system, plus the Federal Reserve trying to be helpful — think back to the interwar period, from 1918 to 1939.

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