Expecting Worse

Lessons from the Great Depression, Peter Temin, 1991.

Black and Violet, Wassily Kandinsky, 1923.

Change is afoot. It seems that every day I see another brilliant economist put out some poorly-considered AI post, and I suspect there is already a plethora of blogs where the new copilot has been handed the controls, if perhaps in more subtle form. So, I felt I needed to put my cards on the table. I wrote this for my ‘about’ page (and posted it on notes), but given few of you would see it there, I thought I might nail it to this door as well.

Given the flood of AI-assisted writing (and even more insidiously, AI-assisted thinking, transcribed by human hands) now thrust upon us, I am compelled to declare that nothing published on this blog has or will involve the use of AI tools at any stage: not to summarise, review, edit, brainstorm, or write. For this I apologise: I am sure my pieces would be better-researched, and my sentences less clunky, if I used them. I am also no AI-sceptic. I think AI coding tools are fantastic, and if all jobs in finance, consulting, etc are to disappear, trust that I will be amongst the first out on the streets celebrating (although I am sceptical that they are). In truth, my rationale is purely selfish: this blog has always been my tool for reading, thinking and writing better. Any use of AI would undermine this. What’s in it for you? My hope is, at least, that my pieces are very different (if surely more imperfect) to what you would receive if you asked your frontier-LLM-of-choice about the books that I review.

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How would you argue in 1991 that there was anything to learn from the Great Depression? In the post-2008 world we inhabit it seems easy enough to show the relevance of the 1930s, but in the 90s, surely not so much. The end of the Cold War, the ‘Great Moderation’, Alan Greenspan, and the memory of the 70s dominated, I can only imagine, the intellectual geography. Why dwell on what happened then, and what surely would, likely, never happen again?

But arguing this is the task that Peter Temin sets himself in his Lionel Robbins lectures, delivered in 1989 and published as Lessons from the Great Depression in 1991. The three lectures are short (the book is under 150 pages) but cover in remarkable detail the three phases of the Depression — the cause, the spread, and the recovery. Furthermore, perhaps because they are lectures, Temin has no qualms intermittently bouncing back-and-forth on a number of tangential themes — his disagreements with economists, from Friedman to Kindleberger to Bernanke; Reagan, Thatcher, and the impact of their policies; the dynamics of capitalism and socialism; and the role of economics within history and vice versa.

That last theme is worth mentioning. What I have always valued about Temin, whether he is writing about Rome, the Industrial Revolution, or the Great Depression, is his considered perspective on the strengths and limitations of both historical and economic modes-of-analysis. While this is usually implicit in his work, Temin here makes it explicit: “the intellectual framework for this story combines history and economics… even technical decisions by expert monetary and fiscal authorities… are part of a unified historical process determining individual and national destinies”.

This is epitomised in Temin’s focus on the distinction between policy actions and policy regimes. Invoking Robert Lucas and Thomas Sargent, Temin mixes up a cocktail of historical sensibility with macroeconomic theory. On the one hand, he argues rational investors largely do not react to actions taken inside the convention of a policy regime: they have already anticipated them. Those actions which are unanticipated are interpreted as noise. But Temin suggests that this rationality is not omniscient: it is bounded by the policy regime, and change in the policy regime is a political, fundamentally historical process.

Thus Temin’s theory of the Depression is rooted in the historical contingency of expectations. The policy regime — the gold standard and the holy doctrine of sound finance — set expectations, causing and propagating the Depression while also blunting the effect of conventionally inflationary action, deliberate or otherwise. Likewise, only when the gold standard was abandoned, not just in practice but in principle, was recovery finally made possible.

The cause of the Great Depression, Temin believes, was the strain on the gold standard induced by the First World War; the ur-shock that reverberated well after the guns fell silent. The war created asymmetry and imbalance, but gold standard ideology dictated this be met with deflation not devaluation, and, in Temin’s words, “deflation causes depression” (I should say that Temin justifies all his theoretical pronouncements with a number of IS-LM extensions inside a short appendix — a little more about this in the supplemental).

In claiming this, Temin positions himself against the explanations of the Great Depression advanced by Friedman and Schwartz and Charles Kindleberger. In regards to the former, Temin ridicules their notion that “small events at times have large consequences”, and that such a butterfly-effect due to the death of Fed governor Benjamin Strong in 1928 caused the Depression. Strong was just as trapped in the “gold-standard train of thought” as anyone else and besides, “the Great Depression was the result of a much larger deflationary impulse”.

Temin views Kindleberger as no less delusional. The idea that the Depression resulted from a hegemonic void — a product of the transition of international financial preeminence from the British Empire to the United States — ignores the fact that, even if there were a “single hegemonic central bank”, there is no reason to expect that its actions would have differed. Lender of last resort or not, it would have been relentless in the pursuit of deflation. The particulars which constitute global power, just like the idiosyncrasies of central bankers, are mere footnotes to the policy regime.

The propagation and continuation of the Depression was, similarly, caused by policy-determined expectations. Temin does not believe, I should clarify, that from the moment conditions started to deteriorate in the late 1920s, markets expected that a long and bitter deflation would ensue. In fact, his view is that until Europe’s banking crisis in 1931 most participants predicted an imminent recovery, and reasonably so. Once deflationary expectations began to settle, however, what Temin calls the “second phase” of the Depression was ushered it. In this phase, the deflationary expectations cycle — the so-called Mundell effect — interacted with a policy regime which reinforced it, causing banking panic and spreading Depression across the globe.

A point to note here is that Temin believes that the financial crises of the era (1930 in the US, and 1931 in Europe and the US) were not causes of the spread of the Depression but just consequences, putting him at odds with Friedman and Schwartz as well as Ben Bernanke. He expends a lot of effort arguing that the banking crises did not have much effect, whether you think they reduced the money supply (like Friedman and Schwartz), or produced credit rationing (like Bernanke). Temin is uncompromising: deflationary expectations are the true driver of economic depression. Everything else is window dressing.

Temin’s theory is compellingly parsimonious. By avoiding the need to theorise about bank failure and the webs of international finance he is able to produce an explanation more elegant than many other approaches. But the cost of this is a reliance on claims about expectations which are devilishly difficult to find unambiguous evidence for. His core claim, for example, about the appearance of deflationary expectations only in 1930 relies on little more than “reading of the business press”. On another note, I also suspect Temin is overzealous with his dismissal of financial instability/crisis. His claim that the German banking system was not destabilised à la Hyman Minsky by the exuberant late 20s and was only pushed into the 1931 crisis by “three years of deflation” strikes me as too strong by half. It is arguable that Temin does not take finance seriously, an unsurprising weakness for a macroeconomic historian in the 1980s, a time when international macroeconomics was more financially illiterate than it is today.¹

The recovery is the subject of Temin’s third and final lecture, and his theory is as one would expect — that shifts, not only in policy but in policy regime after 1932, finally lifted the deflationary expectations which had crippled the global economy. This was not the triumph of Keynesianism (as Temin reminds us, Keynes was only one of many ‘expansionists’ in the 1930s) but of a broad push towards “socialism”. The New Deal and the shift to an expansionary monetary policy in the US is one example; as another, Temin controversially claims that “Nazi policies still retained a socialist bent” as well. Of course, whatever your opinions on these specific cases, Temin’s broader point holds when one looks at Blum’s France, and later, Atlee’s Britain.

The rise of ‘socialism’ stimulated the economy because it shifted expectations. Falling wages from 1929-32 did not stimulate employment because they were expected to continue falling — a consequence of the deflationary spiral. From 1933, however, a new policy regime inducing inflationary expectations meant that low wages genuinely did stimulate recovery. In Temin’s view, an economy dominated by expectations is, at its core, an economy dominated by politics.

On a higher level, however, it is the recovery era in which we observe Temin’s most world-historical lesson from the Great Depression — a distillation of the historical dynamic between capitalism and socialism. Temin suggests that the Depression reveals how:

“Capitalism thrives during economic stability. It wilts in depression. Socialism appears to be the reverse. It fades during stability from the lack of nourishment supplied by technical change. But it flowers in depression with its support of economic planning and distribution of the social dividend”.

This grand narrative also brings Temin to the note with which I kicked off this review: how to make the Great Depression relevant to an audience of the late 1980s? His answer is that the world (and the United States in particular), circa 1989, was nearing the end of such an oscillation, with the (partial) dismantling of US socialism under Reagan representing the latest step. His question is: are we due another depression? Temin is not pessimistic — he believes it unlikely that governments in his time would pursue the deflationary regime of Hoover and Brüning, a judgement that would be vindicated in 2008 and 2020.

But Temin would not let us be too self-satisfied. His concern is that the policy of the Great Depression was formulated in a wartime context — the middle of the Second Thirty Years’ War (1914-1945), as Temin rather anachronistically insists on calling the interwar period. Under ‘wartime conditions’, he writes,

“policies can be formulated for reasons that have little to do with macroeconomic stability… if we find ourselves a few years hence occupied with military rivalries or even diplomatic contests with military adventure as a threat in the background, then we should begin to worry also about the threat of a new depression”.

Are those echoes of 1929, audible to Temin in 1989, not deafening today?

1. Much of the important ‘modern’ business cycle research only takes off in the 90s (with Hodrick and Prescott, etc), and it is only really after 2008, and especially in the last decade, that macroeconomics really starts taking finance seriously.