Economic historians and theorists still have no universally accepted explanation for how we fell into the Great Depression of the 1930s and how much the stock market crash that started in 1929 had to do with it. Popular accounts usually say the stock market crash "heralded" the Depression, meaning it announced its coming.
It is harder to know how much the stock crash also helped cause the Depression by wiping out a great deal of personal wealth, leading people who owned stocks to cut back on their spending, causing firms to lay off workers for lack of demand and so on into a vicious downward spiral.
What is also unsettled is the extent to which perverse policies of the Hoover era added to this downward slide in the economy by tightening the government budget when it should have been easing, by maintaining high real interest rates and by adding to a trade war that closed our markets to foreign goods and their markets to our goods.
Are we in any danger of another depression this time? Shortly after the big stock market crash this October, a wise friend with deep experience in the stock market remarked that this time we may repeat 1929 but avoid 1930-33. His hope was that Wall Street had sent a message that would wake up Washington, and even Bonn and Tokyo. Policy changes that were long overdue would finally be made, and the U.S. and world economies would come out healthier and able to grow.
Of course, some people see the stock market as a predictor of the economy and so see economic disaster ahead whatever policy steps are now taken. But the market is a far from perfect predictor. It has anticipated the bad slumps of the economy, though with a highly variable lead time. But it has also fallen when no economic downturn followed.
The market decline of 1962 is the best postwar example of a crashing stock market that predicted the economy all wrong. Three years of strong growth, high profit and inflation-free expansion followed the 25% market decline in that year. So, on the record, we should not regard the economy's fate as sealed and unresponsive to policy steps from here on.
What should these policy steps be? Nobody should pretend to see the future too clearly or to have exactly the right prescription for our economic ills. On the other hand, this is not the time to lose sight of what we do understand about the present situation and about the direction in which policy should move so as to minimize the risk of a severe economic downturn and related financial problems.
In my view, the right policy package starts with a convincing program to reduce the U.S. budget deficit, starting right away and by increasing amounts over the next several years. What has come out of Washington thus far is a beginning on this front. The right package includes a response by governments in Europe and Japan to lower their interest rates--as West Germany, France and the Netherlands began to do last week--while we reduce our budget deficit.
Stock Market Support
Judging by past performance, we must wait and see how much they actually do, especially in Europe, where West Germany's obsession with inflation continues to dominate policy. And the right package includes a rejection of trade restrictions that could lead to a trade war. The latest reading of Washington suggests that protectionism is subdued.
What of the concern voiced by many economists that reducing the U.S. budget deficit at this time will cause a recession? The argument is that the stock market decline has already weakened consumer demand and that removing still more demand by tightening the budget would be overkill and repeat the mistake of Hoover's time. If interest rates were not still so high today, that would be a concern. But, in fact, there is enormous scope for lowering interest rates both here and abroad so as to compensate for a tighter U.S. budget. The weaker the outlook for the economy, the further they should fall.
Protection against a severe economic slump is not the only benefit available from lower interest rates. Lower rates are also desirable for the relief they would bring to less-developed-nation debtors, for the support they would provide the stock market and for the improvement they would produce in balance sheets throughout the financial system.
What of the exchange value of the dollar in all this? Although a weaker dollar is the economists' standard remedy for reducing today's foreign trade deficit, at this time there are risks to a policy that lets the dollar fall. With such a policy, foreign investors might dump their U.S. bonds and stocks in order to shift their funds into investments at home. And such foreign selling on a massive scale could produce a renewed bear market in bonds and stocks and even disrupt the world financial system. That is a risk we should try to avoid. If our trading partners lowered their interest rates and stepped up their own growth rates, I believe that the dollar could and should be kept near its present level.