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The End of Prosperity?
A noted historian looks at parallels between this financial crisis and 1929 and shows
what must be done to avoid Depression 2.0
By Niall Ferguson Thursday, Oct. 02, 2008
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Chicago, 1931
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Congress's initial rejection of the Bush Administration's $700 billion bailout plan calls to mind an
unhappy precedent. Back in 1930, the Senate passed the Smoot-Hawley Tariff Act, which raised
duties on some 20,000 imported goods. Historians define this as one of the critical steps that led to
the Great Depression--a tipping point when the world realized that partisan self-interest had
trumped global leadership on Capitol Hill.
It's fair to ask whether America's lawmakers could do it again. The bursting of the debt-fueled
property bubble and the crippling losses suffered by banks, together with the political dithering of
recent days, have set in motion a chain reaction that, in the worst-case scenario, could lead to
something like a 21st century version of the Depression--even if a bailout package does eventually get
approved.
The U.S.--not to mention Western Europe--is in the grip of a downward spiral that financial experts
call deleveraging. Having accumulated debts beyond what's sustainable, households and financial
institutions are being forced to reduce them. The pressure to do so results from a decline in the price
of the assets they bought with the money they borrowed. It's a vicious feedback loop. When families
and banks tip into bankruptcy, more assets get dumped on the market, driving prices down further
and necessitating more deleveraging. This process now has so much momentum that even $700
billion in taxpayers' money may not suffice to stop it.
In the case of households, debt rose from about 50% of GDP in 1980 to a peak of 100% in 2006. In
other words, households now owe as much as the entire U.S. economy can produce in a year. Much
of the increase in debt was used to invest in real estate. The result was a bubble; at its peak, average
U.S. house prices were rising at 20% a year. Then--as bubbles always do--it burst. The S&P CaseShiller index of house prices in 20 cities has been falling since February 2007. And the decline is
accelerating. In June prices were down 16% compared with a year earlier. In some cities--like
Phoenix and Miami--they have fallen by as much as a third from their peaks. The U.S. real estate
market hasn't faced anything like this since the Depression. And the pain is not over. Credit Suisse
predicts that 13% of U.S. homeowners with mortgages could end up losing their homes.
Banks and other financial institutions are in an even worse position: their debts are accumulating
even faster. By 2007 the financial sector's debt was equivalent to 116% of GDP, compared with a
mere 21% in 1980. And the assets the banks loaded up on have fallen even further in value than the
average home--by as much as 55% in the case of BBB-rated mortgage-backed securities.
To date, U.S. banks have admitted to $334 billion in losses and write-downs, and the final total will
almost certainly be much higher. To compensate, they have managed to raise $235 billion in new
capital. The trouble is that the net loss of $99 billion implies that they will need to shrink their
balance sheets by 10 times that figure--almost a trillion dollars--to maintain a constant ratio between
their assets and capital. That suggests a drastic reduction of credit, since a bank's assets are its loans.
Fewer loans mean tighter business conditions on Main Street. Your local car dealer won't be able to
get the credit he needs to maintain his inventory of automobiles. To survive, he'll have to lay off some
of his employees. Expect higher unemployment nationwide.
Anyone who doubts that the U.S. is heading for recession is living in denial. On an annualized basis,
real retail sales and industrial production are both declining. Unemployment is already at its highest
level in five years. The question is whether we're headed for a short, relatively mild recession like that
of 2001--or a latter-day version of what the world went through in the 1930s: Depression 2.0.
The Historical Parallels
We tend to think of the depression as having been triggered by the stock-market crash of 1929. The
Wall Street crash is conventionally said to have begun on "Black Thursday"--Oct. 24, 1929, when the
Dow Jones industrial average declined 2%--though in fact the market had been slipping since early
September. On "Black Monday" (Oct. 28), it plunged 13%, the next day a further 12%. Over the next
three years, the U.S. stock market declined a staggering 89%, reaching its nadir in July 1932. The
index did not regain its 1929 peak until 1954.
On Sept. 29 of this year, as investors and traders reacted to Congress's rejection of the bailout plan
presented by Treasury Secretary Hank Paulson, the stock market sell-off was dramatic: the Dow fell
nearly 7% that day, a one-day drop that has been matched only 17 times since the index's birth in
1896. From its peak last October, the Dow has fallen more than 25%.
Yet the underlying cause of the Great Depression--as Milton Friedman and Anna Jacobson Schwartz
argued in their seminal book A Monetary History of the United States: 1867-1960, published in 1963-was not the stock-market crash but a "great contraction" of credit due to an epidemic of bank
failures.
The credit crunch had surfaced several months before the stock-market crash, when commercial
banks with combined deposits of more than $80 million suspended payments. It reached critical
mass in late 1930, when 608 banks failed--among them the Bank of the United States, which
accounted for about a third of the total deposits lost. (The failure of merger talks that might have
saved the bank was another critical moment in the history of the Depression.)
As Friedman and Schwartz saw it, the Fed could have mitigated the crisis by cutting rates, making
loans and buying bonds (so-called open-market operations). Instead, it made a bad situation worse
by reducing its credit to the banking system. This forced more and more banks to sell assets in a
frantic dash for liquidity, driving down bond prices and making balance sheets look even worse. The
next wave of bank failures, between February and August 1931, saw commercial-bank deposits fall by
$2.7 billion--9% of the total. By January 1932, 1,860 banks had failed.
Only in April 1932, amid heavy political pressure, did the Fed attempt large-scale open-market
purchases--its first serious effort to counter the liquidity crisis. Even this did not suffice to avert a
final wave of bank failures in late 1932, which precipitated the first state "bank holidays" (temporary
statewide closures of all banks).
When rumors that the new Roosevelt Administration would devalue the dollar led to widespread
flight from dollars into gold, the Fed raised the discount rate, setting the scene for the nationwide
bank holiday proclaimed by President Franklin Roosevelt on March 6, 1933, two days after his
Inauguration--a "holiday" from which 2,500 banks never returned.
The obvious difference between then and now is that Fed Chairman Ben Bernanke has learned from
history--not surprising, given that he once studied the Great Depression intensively. Since the onset
of the credit crunch in August 2007, Bernanke has repeatedly cut the federal-funds rate from 5.25%
down to an effective rate at one point last week of about 0.25%. He has pumped money into the
financial system through a variety of channels: in all, about $1.1 trillion over the past 13 months.
The Treasury is also active in ways it wasn't during the Depression. Back then, conventional wisdom
held that the government should try to run a balanced budget in a crisis, even if that meant cutting
welfare spending and raising taxes. A generation of economists inspired by John Maynard Keynes
taught us that this is precisely the wrong thing to do. Government deficits in a recession are good, the
Keynesians argued, because they stimulate demand. The Bush Administration, which ran substantial
deficits in the boom years, looks set to run an even larger deficit now.
Indeed, even without the $700 billion bailout, Paulson has already written some big checks--to cover
the subsidized sale of Bear Stearns to JPMorgan, the nationalization of mortgage monsters Fannie
Mae and Freddie Mac, the bailout of insurance giant AIG and the sales of Washington Mutual to
JPMorgan and Wachovia to Citigroup. All of this will cost somewhere between $200 billion and
$300 billion.
Some say you can't solve a problem by throwing money at it. But that's what the Fed and the
Treasury are attempting. Faced with the potential debacle of Depression 2.0, they have tried to calm
the fears with up to $2 trillion of liquidity. Call it the Great Repression: a Depression denied.
Why Depression 2.0 Can Still Be Avoided
At the moment, a reworked bailout deal seems likely to pass. But the world may still be heading for a
severe downturn. Interbank lending remains stubbornly frozen, despite the Fed's liquidity fire hose.
With WaMu and Wachovia wiped out, the stampede out of bank stocks and bonds will surely claim
new victims. As the recession bites, Main Street firms will start going bust too. And the impact on the
$62 trillion market for credit-default swaps could be explosive.
What's more, this is no longer an exclusively American crisis. European banks are going under as
well. Growth rates in the euro zone and Japan have fallen further than in the U.S. Emerging markets
too are suffering. With the exception of Brazil, stock markets in the BRIC economies (Brazil, Russia,
India and China) are now down about 40% or more on the year.
The notion that Asia has somehow "decoupled" itself from the U.S. now seems fanciful. China and
America have come so close to merging financially that we can almost speak of "Chimerica." When
Fannie and Freddie were on the brink of collapse, many were surprised to learn that fully a fifth of
China's currency reserves was composed of their bonds. Small wonder. Having spent much of the
past decade intervening on currency markets to prevent the appreciation of its renminbi, China has
accumulated a huge hoard of dollar-denominated bonds. No foreign nation stands to lose more from
a U.S. financial collapse.
In the end, what made the Great Depression so greatly depressing was that it was global. The
combined output of the world's seven biggest economies declined nearly 20% from 1929 to 1932. The
unemployment rate soared in the U.S. and Germany to a peak above 33%. World trade collapsed by
two-thirds, not least because of retaliation to the Smoot-Hawley tariff.
But while we certainly face a global slowdown, we may yet avoid another depression. Now, unlike in
the Great Depression, central banks and finance ministries know it's better to run deficits and print
money than to suffer massive losses of output and jobs. And the introduction of U.S.-style deposit
insurance in many countries means banks are less vulnerable to runs by depositors than they once
were. Finally, the possibility still exists (though the odds are slimmer than they were a year ago) that
the Asian and Middle Eastern sovereign wealth funds could step in to recapitalize U.S. and European
banks before they succumb to another great contraction.
Given the immensity of the crisis, a Congress-approved bailout may be just a short-term fix. But a
short-term fix is better than no fix. If nothing else, it would signal to the world that--unlike in 1930-the U.S. is doing what it can to avoid financial calamity and sidestep Depression 2.0.
Ferguson is a history professor at Harvard. His latest book, The Ascent of Money: A Financial
History of the World, will be published this month