The Federal Reserve’s response to the economic turmoil of the COVID-19 pandemic has been unprecedented. Interest rates were slashed to near zero, and trillions of dollars were pumped into the financial system. A historical perspective, particularly examining past policy missteps, can offer valuable insights as we navigate this uncertain economic landscape.

This article delves into two periods of questionable interest rate policy: the 1920s and 1930s in the United States and the 1980s and 1990s in Japan. We will explore the parallels between these situations and the current state of the US economy, drawing on insights from Edward Chancellor’s “The Price of Time” and Milton Friedman and Anna Schwartz’s seminal work, “A Monetary History of the United States.” We will then analyze the US response to the pandemic and its potential long-term consequences, drawing comparisons with the bank failures of the Great Depression and the recent wave of bank failures in 2023.

The Roaring Twenties and the Great Depression: A Cautionary Tale

The 1920s in the US were a time of booming economic growth, fueled by easy credit and lax regulations. The Federal Reserve, a relatively new institution at the time, kept interest rates artificially low. According to “A Monetary History of the United States,” the federal funds rate remained below 4% for the entire decade [1]. This easy money policy fueled a surge in stock market speculation, culminating in the infamous crash of 1929.

The subsequent crash and the ensuing deflationary spiral were devastating. In 1929, the US inflation rate was -0.3%, and it continued to plummet, reaching a low of -10.7% in 1933 [2]. This deflationary environment discouraged investment and spending, worsening the economic depression. The Federal Reserve, criticized for its role in creating the bubble, remained hesitant to intervene.

Japan: The Asset Bubble and the Lost Decade

Japan’s economic story in the 1980s presents a chilling parallel. Riding a wave of export-driven growth, the Bank of Japan kept interest rates low throughout the decade. According to “The Price of Time,” the discount rate hovered around 3.5% [3]. This, combined with deregulation in the financial sector, led to a massive asset bubble in stocks and real estate.

The Bank of Japan’s initial response was to raise interest rates in the late 1980s to combat inflation. However, this move proved to be a case of “too little, too late.” The bubble burst in 1990, plunging Japan into a period of economic stagnation known as the “Lost Decade.” Asset deflation, similar to the US in the 1930s, took hold. Despite repeated stimulus packages, the Japanese economy remained mired in low growth and deflation for over two decades.

The US Response to COVID-19: A Necessary Gamble?

The Federal Reserve’s response to the COVID-19 pandemic was swift and decisive. In March 2020, the federal funds rate was slashed to near zero. Additionally, large-scale quantitative easing programs were implemented, injecting trillions of dollars into the financial system.

This unprecedented intervention undoubtedly prevented an immediate financial meltdown. However, concerns are growing regarding the long-term consequences. The Federal Reserve has raised interest rates to over 5%, but the question remains: can these measures curb inflation without triggering a recession? So far, the odds have tilted in favor of a soft landing, but only time will tell if inflation resumes its downward trend and the Fed can keep it down to around 2% over the longer-term.

The Looming Shadow: Bank Failures and a Fragile Recovery

The specter of bank failures adds another layer of worry. While the 2023 bank failures were nowhere near the scale of the Great Depression, they serve as a stark reminder of the potential fragility of the financial system. According to the Federal Deposit Insurance Corporation (FDIC), five banks failed in 2023, the most since 2010 [5]. This raises concerns about the stability of the banking sector, particularly if the current economic slowdown deepens.

A Crossroads: Learning from the Past

The parallels between the historical periods examined and the current situation in the US are undeniable. Easy money policies fueled asset bubbles in the 1920s and 1980s, eventually leading to painful crashes and economic stagnation. While the US response to the pandemic was necessary, the long-term effects of unprecedented money printing and historically low interest rates remain to be seen. Here are some key points to consider:

• The Debt Burden: Both the 1920s and 1980s witnessed a significant rise in national debt. The US national debt-to-GDP ratio in the 1920s climbed to over 25%, a substantial increase from pre-war levels [6]. Similarly, Japan’s debt-to-GDP ratio ballooned to over 60% by the late 1980s [7]. Today, the US national debt-to-GDP ratio exceeds 100%, a record high, raising concerns about the government’s ability to manage future economic shocks [8]. High debt levels can limit the ability of governments to stimulate the economy during downturns.

• The Zombie Economy: Easy money policies can create a phenomenon known as the “zombie economy.” Low interest rates allow poorly performing companies to stay afloat with cheap debt, hindering productivity growth and innovation. This raises concerns about the long-term health of the US economy, particularly if interest rates stay higher for longer.

• The Global Financial Interdependence: The world is now far more financially interconnected than it was in the 1920s or 1930s. A crisis in one country can quickly spill over into others. This creates an additional layer of complexity and risk for the US economy.

Navigating the Uncertainty: A Call for Caution

The historical examples explored offer valuable lessons. The Federal Reserve faces a delicate balancing act – controlling inflation without triggering a recession. A gradual and well-communicated approach to raising interest rates is crucial. Additionally, policymakers must be mindful of the potential for asset bubbles in specific sectors, like housing or technology.

Furthermore, addressing the national debt issue should be a priority. Reducing the deficit and stabilizing the debt-to-GDP ratio will provide greater flexibility in managing future economic challenges.

The current situation demands a nuanced approach that acknowledges both the successes and failures of past policy decisions. Learning from history is critical in avoiding a repeat of past economic calamities. The road ahead is uncertain, but by adopting a cautious and forward-thinking approach, the US can navigate its way through this complex economic landscape.

All my best,

Brandon VanLandingham CFA, CMT, CFP®

Bibliography

• Friedman, Milton, and Anna Schwartz. A Monetary History of the United States, 1867-1960. Princeton University Press, 2008.
• Chancellor, Edward. The Price of Time: The Real Story of Inflation and Deflation. Penguin Books, 2009.
• Board of Governors of the Federal Reserve System. https://www.federalreserve.gov/
• Bureau of Labor Statistics, U.S. Department of Labor. https://www.bls.gov/cpi/
• Federal Deposit Insurance Corporation. https://www.fdic.gov/resources/resolutions/bank-failures/in-brief/index.html
• The World Bank. https://www.worldbank.org/en/programs/debt-statistics

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