COMMENTARY: What economists have learned from the Great Depression

The following is excerpted from “Lords Of Finance, The Bankers Who Broke The world” by Liaquat Ahamed, Penguin Press, 2009. It sheds light on the emphasis on maintaining liquidity and credit availability that the Bush and Obama administrations and Congress have pursued over the past year. The foot note (*) will come as a revelation to many students of the period.

As it had been during the 1920s, the United States was a major haven for gold flows. Far more damaging than the effect of the protectionist Smoot-Hawley Act was the collapse in capital flows. After a brief revival early in the 1930, U.S. foreign investment into Europe suddenly dried to a trickle. American bankers became risk averse and cautious and, claiming that it was hard to find creditworthy borrowers, pulled in their horns. With American capital bottled up at home and U.S. demand for European goods shrinking—a result of the weak U.S. economy and of higher import tariffs imposed in June 1930 by the Smoot-Hawley Act—Europe could only pay for its imports and service its debts in gold. During 1930, a total of $300 million in bullion was shipped across the Atlantic into the vaults of the Federal Reserve system.*

*Many popular accounts of the Great Depression attribute a large weight to the protectionist Smoot-Hawley Act as a cause of the economic collapse. Tariffs shift demand for imports to domestic goods, so if anything, it should have had an expansionary effect. Retaliation by foreigners did hurt the U.S. economy, but exports were a small percentage of Gross Domestic Product—less than 4 percent—so the total effect would have been small. Changes in capital flows dwarfed the impact of trade.