A new Great Depression? It’s different this time
Dysfunctional capital markets, frantic central banks, stressed-out consumers, fear and uncertainty -- all are alarming echoes of the global economic cataclysm of the 1930s.
Which raises the inevitable question: Could another Great Depression be lurking over the horizon?
TV news programs show grainy footage of Depression-era bankers as reporters tick off grim economic statistics. The Federal Reserve invokes powers it hasn’t used since the 1930s. Critics of President Bush’s economic policies are emboldened to use the H-word: “Hoover.”
On the surface, there are disquieting parallels between economic conditions in the early 1930s and those of today. There is the popping of enormous asset bubbles -- stocks then, housing now.
And, as in the Great Depression, the financial system is in disarray. It was symbolized back then by the failure of thousands of banks, mostly small, local outfits -- 2,300 in 1931 alone.The parallel today is the crippling ofonetime giantssuch as Bear Stearns Cos., Countrywide Financial Corp. and Ameriquest Mortgage Co.
Many economists believe that the U.S. will find it almost impossible to avert a recession, if one has not started already. Housing remains mired in a deep slump,with some analysts projecting that Southern California home values could plunge 40% from their peaks last year.The Commerce Department reported this week that new residential building permits nationwide plummeted 36.5% in February from a year earlier.
Then, like now, stock prices were highly volatile. The S&P 500 index, which fell more than 56% from 1928 through 1940, nevertheless recorded four up years in that span, including a 46.5% gain in 1933.
The shadow of the ‘30s looms over every economic downturn or crisis, no matter how modest. Pundits were quick to invoke the Depression as a cautionary model during the stock market crash of 1987, the bailout of the giant hedge fund Long-Term Capital Management in 1998 and the dot-com meltdown of 2000 and 2001.
But there are vast differences between the 1930s and today. U.S. unemployment reached 25% during the Depression; last month it was reported at 4.8%. The international industrial economy was a shambles in the ‘30s. Today it is coming off a global boom.
“I’ve been asked many times whether we will have another Great Depression,” said David M. Kennedy, a Stanford University history professor and the author of “Freedom From Fear,” a Pulitzer Prize-winning history of the Depression and World War II. “My standard answer is that we won’t have that one again -- I’d be surprised to have one of that seriousness and duration. But that doesn’t mean we wouldn’t have a catastrophe we haven’t seen before.”
Economists and historians say the most important difference between today’s economic environment and the old days is the government’s role.
“There’s a perception now that you don’t stand around at the central bank and whack people with a ruler for making bad decisions,” said Robert Brusca, chief economist at New York-based Fact and Opinion Economics. “Instead, you do something.”
Nothing demonstrates that as vividly as the Fed’s orchestration of the takeover of Bear Stearns by JPMorgan Chase & Co. over the weekend. The deal staved off a possible Bear bankruptcy, which the central bank feared might traumatize financial systems worldwide.
The resolution drew a stark contrast with the Fed’s role in the 1930 collapse of the Bank of the United States, a New York institution largely serving Jewish immigrants. The failure was then the largest in U.S. history, and the Fed’s inability to arrange a rescue by Wall Street banks -- including J.P. Morgan & Co., the predecessor to the “white knight” in the Bear Stearns case -- caused a cataclysmic loss of confidence in the entire national banking system. That fueled a panic that historians regard as a key cause of the Depression.
The Fed’s relative powerlessness in 1930 led directly to New Deal reforms that vastly expanded its authority. Some of the agency’s new powers, such as its ability to lend directly to brokers and investment banks, were seldom or never used until the current crisis.
Fed Chairman Ben S. Bernanke, an expert in the central bank’s Depression-era history, is also knowledgeable about the instruments at its disposal in a crisis.
In a 2002 speech -- he was then a member of the central bank’s Board of Governors under Alan Greenspan -- he outlined a number of drastic steps the Fed could take in extreme conditions and still remain within its legal authority.
Among them were buying up foreign government debt to influence dollar exchange rates, and even lending, if indirectly, against private assets. The subject of Bernanke’s speech was how to combat deflation, a broad decline in consumer prices that is not currently a problem on the Fed’s agenda. Still, the powers he described could apply in a wide range of dire scenarios.
But as Fed Vice Chairman Donald L. Kohn conceded in testimony before a Senate committee this month, the most serious challenges generally arise not from scenarios that can be forecast but from the unforeseen.
Alluding, in effect, to the tendency of regulated industries to burst at their weakest seams, Kohn blamed “the most sophisticated banks” for allowing credit rating agencies such as Moody’s and Standard & Poor’s to paper over the unsoundness of mortgage securities on their books.
The agencies bestowed lofty AAA ratings on some extremely complex mortgage bundles even though their inherent risks were not understood. The banks and firms that packaged the securities and hawked them to clients simply accepted the rating agencies’ conclusions, which were often favorable to the packagers. The dubious valuations of many of these securities are at the core of the credit crisis roiling the financial markets today.
Brusca, the economist, says the most dangerous behavior often occurs just beyond regulators’ reach -- in the exotic strategies of the hedge fund industry, to use a contemporary example. “We have a far more extensive regulatory network now,” he said, “but it’s always the unregulated sector that pushes change.”
Does it make sense to require banks to maintain adequate capital relative to their obligations, Brusca added, “but let them have an unregulated hedge fund?”
There are also limits to what monetary policy -- the Fed’s responsibility -- can achieve on its own to forestall a drastic economic downturn. The Franklin D. Roosevelt administration not only reformed the Fed but also experimented with stimulative fiscal policy, such as unemployment relief.
New Deal programs aimed at staving off a wave of home foreclosures may be especially relevant today. Among the most important was the Home Owners Loan Corp., or HOLC, which is one of several models for homeowner relief being considered by Congress.
HOLC took over 1 million mortgages in default starting in 1933, worked to keep the owners in their homes and made new loans to strapped mortgage holders. When the agency was finally liquidated in 1951, it even returned a small profit to the U.S. Treasury.
The Fed’s recent actions were “a temporary palliative” to the fundamental problem in the economy, which is the rapid fall in home prices and its ripple effect on mortgage bonds and other securities, said Barry Eichengreen, a professor of economics and political science at UC Berkeley. “You have to reorganize the system, but the discussion about that has only begun.”
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