Did Geithner Save America from a Second Great Depression?

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Dean Baker
CNN Money, May 27, 2014

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Since the release of former U.S. Treasury Secretary Timothy Geithner's new book, Stress Test: Reflections of Financial Crises, accounts of his stint in the Obama administration have been getting considerable attention in Washington policy circles. One assumption that has gone virtually unquestioned is that Geithner and his colleagues at the U.S. Federal Reserve and the Treasury saved us from a Second Great Depression (SGD). However, it is long past time that this narrative get some serious scrutiny.

The basis of the SGD story is that the first Great Depression of the 1930s was the result of the failure of the Fed to come to the rescue of the banks in the middle of a series of bank runs. If the Fed had flooded the banks with liquidity and offered various guarantees to depositors and other creditors, it could have put an end to the bank runs.

The failure to do so led to a chain of collapses that destroyed much of the economy's wealth. This was a direct hit to the people who saw their life's savings disappear when their banks went into bankruptcy. The macroeconomic consequences were enormous, as people had to radically cut back their spending, forcing massive layoffs. In addition to the loss of demand, many businesses also saw their working capital disappear when their banks collapsed.

This was the disaster that Geithner and his colleagues were determined to prevent in the financial crisis in 2008-2009. But this is only part of the story. The Great Depression was not just the financial crisis that set it off; it was a prolonged period in which the economy operated well below its potential, leading to double-digit unemployment.

The recipe for countering these types of weaknesses in demand is simple: Spend money. This is something we have known since renowned economist John Maynard Keynes wrote The General Theory in 1937. It is also a proposition that we had the opportunity to test with the massive spending associated with the United States' entry into World War II in 1941. And events played out just as Keynes predicted. The economy surged and unemployment plunged.

There is nothing magic about the economic impact of military spending. If the U.S. government had spent massive amounts of money building up its infrastructure and its education and health care systems, and done this in 1931 rather than 1941, we would not have seen a decade of double-digit unemployment. The initial downturn from the financial panic would have been quickly reversed and the economy returned to near full-employment levels of output.

This is not just idle speculation, we had the opportunity to witness this set of events in Argentina in the last decade. In December of 2001, Argentina defaulted on its national debt and broke the link of its currency to the dollar. This led to the sort of meltdown that Geithner and company worked desperately to prevent. Banks couldn't repay depositors, and businesses couldn't get access to working capital. The country was overtaken by panic as the economy plummeted.

But the plunge proved to be short-lived. Government measures were able to stabilize the economy by the second quarter of 2002, and it was growing rapidly by the second half of the year. In fact, by the end of 2003, Argentina's economy had fully recovered the ground lost from the crisis. By the end of 2004, the economy was larger than it had been before it went into recession in 1998. The country maintained healthy growth until the world recession brought it to a halt in 2009. (There are questions about the integrity of the data toward the end of this period, but there is little dispute that the data through 2004 are largely accurate.)

In short, Argentina had a full-fledged financial crisis and meltdown of its banking system, but it didn't endure anything like the Great Depression. Its government and central bank were able to act aggressively to quickly get the country's economy back on its feet.

Given Argentina's experience, why would we think that U.S. policymakers would be paralyzed in the event of a financial meltdown? Would Congress lose the ability to vote spending measures and tax cuts that put money in people's pockets? Would the Fed be unable to conduct the expansionary monetary policy it has been pursuing for the last five and a half years?

There are obviously differences between Argentina and the United States. A collapse of the U.S. financial system would have far greater global consequences than Argentina's collapse. On the other hand, the U.S. would still be the world's dominant economy and the U.S. dollar the leading reserve currency even after a collapse.

The veracity of the SGD story matters hugely in how we think about Geithner and the performance of the Bush-Obama economic teams through the crisis. If we really had to fear a decade of double-digit unemployment then we should be very thankful, even though the economy remains weak and unemployment is still high at 6.3% as of May. However, if the SGD is just a scare story for the kids, then people should be very angry about the current state of the economy. And the evidence suggests they should be very angry.


Dean Baker is a macroeconomist and co-director of the Center for Economic and Policy Research in Washington, DC. He previously worked as a senior economist at the Economic Policy Institute and an assistant professor at Bucknell University.