Depression offers lessons for dealing with new crisis
Posted on Sunday, October 5, 2008
They are the stories that Americans heard from their grandparents and the pictures seen in history books — bread lines stretching around street corners, shantytowns sheltering the unemployed, smalltown banks with darkened windows.
Today’s financial crisis is hardly that grim, though it does share some similarities with the economic collapse of the 1930 s — both were preceded by a housing boom, a long period of cheap credit and a falling stock market. But those similarities may offer some reassurance.
What was then economic calamity is today a history lesson. This time, America has been through it before, and there’s a guide, at least for mistakes to be avoided as the nation’s leaders try to prevent another catastrophe.
Economists have spent decades dissecting the Great Depression. Their findings demonstrate the crippling effect fear has on economic decisions, the tremendous cost of not acting quickly and the risk of damaging the larger economy in efforts to make individuals pay for financially irresponsible investments.
“The number of people with personal memory of the Great Depression is fast-shrinking with the years,” one noted expert said in 2004 in a speech at Washington and Lee University. “However, although the Depression was long ago... its influence is still very much with us.”
That expert was Ben Bernanke, a former Princeton University professor and an expert on causes of the Depression. He’s now the chairman of the Federal Reserve.
Today economists partly blame the Fed for the Depression because it raised interest rates even as the economy was slowing in the late 1920 s. Then when banks began to fail, it took a hands-off approach.
But if those policymakers were able to speak up now, they could offer at least one defense of their actions: How were they supposed to know ?
“In the Great Depression, what the Fed did at the beginning was to tighten interest rates. It took a long time to essentially recognize the magnitude of the problem, but of course it was a problem we had not had before,” said Robert Aliber, a University of Chicago professor emeritus who’s written on financial panics.
Today’s policymakers and lawmakers know better, or at least they should. They’ve had the benefit of studying not just the Great Depression, but numerous other financial crises, in the United States and abroad.
During the 1920 s, stock prices had more than quadrupled. But on Oct. 28, 1929, the Dow Jones average fell 13 percent in a single day, another 12 percent the next and 10 percent more a few days later. In comparison, Monday’s disturbing Dow Jones industrial average drop of 778 points was just short of 7 percent.
Stocks bottomed out in 1932 — down 80 percent from the peak. That’s more than three times the percentage that the Dow has fallen since setting a record last October.
Millions of people lost their jobs, with unemployment reaching 25 percent in 1933.
Consumers and businesses who had relied on cheap credit were struggling. The prices of the goods they made and sold were dropping, and many began to default on their loans. Scores of banks went bust.
Andrew Mellon, treasury secretary during the Hoover administration, advocated allowing the free market to punish reckless investors. To cure excesses of easy credit, he said, “the rottenness should be purged out of the system.”
In trying to make sure that people paid for their mistakes, the Fed allowed the financial system to deteriorate. The belief that government should keep its hand out of the market was echoed this week in Washington.
“When you hear what people in the House of Representatives are saying, it sounds to me like a voice of the past,” Elmus Wicker, a retired Indiana University professor and expert on banking panics of the Great Depression, said last week. “All of those people... saying it’s better to do nothing sounds to me exactly like Herbert Hoover.”
Today’s economy “is much more developed than we were then. We are many times richer. We have a very good safety net in place. They had none,” said Michael Bordo, a professor of economics at Rutgers University who’s an expert in financial crises.
There’s a danger in citing the Great Depression now because you don’t want to scare people, Bordo said. The current crisis is probably more comparable to what happened in Japan in the 1990 s, when a huge real estate bubble burst, and it took a decade of economic stagnation for the government to address the problem.
“We are not about to repeat the mistakes of the Great Depression,” said Peter Temin, an economic historian at the Massachusetts Institute of Technology.
The past also reminds us of a time when worries about banks rattled deposit holders. Within days of being sworn in as president in early 1933, Roosevelt responded by ordering a bank holiday. Every bank was closed for a week, and an army of examiners was dispatched to scrutinize their books.
One of every six banks never reopened. But the clean bill of health awarded to the many others helped restore confidence in banks.
Economists still debate just what steps ended the Depression, and whether it was Roosevelt’s New Deal policies or World War II spending that revived the economy.
The controversial plan debated the past couple of weeks in Congress follows a similar principle: trying to assure the solvency of Wall Street firms by taking all the toxic debt off of their books.
“The solvency problem drives the fear, and the fear leads to the seizing up,” Bordo said.
Critics attacked the plan pushed by President Bush, arguing that it would unfairly reward Wall Street companies largely responsible for the current mess.
“The problem is because the financial system is the lifeblood of the whole economy, and if the financial system is paralyzed, then everybody is paralyzed,” Bordo said. “That’s the reason we have to treat them differently.”
FEEDBACK:
Something to say about this topic? Submit a Letter to the Editor online
