And Now the Great Depression

A couple of months ago at lunch with a respected Fed watcher, I asked, “What are the odds are that U.S. unemployment will reach 10 per cent before the crisis is over?” “Zero,” he responded, in an admirable display of confidence. Watchers tending to internalize the outlook of the watched, I took this as reflecting opinion within the U.S. central bank. We may have been in the throes of the most serious credit crisis since the Great Depression, but nothing resembling the Depression itself, when U.S. unemployment topped out at 25 per cent, was even remotely possible. The Fed and Treasury were on the case. U.S. economic fundamentals were strong. Comparisons with the 1930s were overdrawn.

The events of the last week have shattered such complacency. The 3 month treasury yield has fallen to “virtual zero” for the first time since the flight to safety following the outbreak of World War II. The Ted Spread, the difference between borrowing for 3 months on the interbank market and holding three month treasuries, ballooned at one point to five full percentage points. Interbank lending is dead in its tracks. The entire U.S. investment banking industry has been vaporized.

And we are in for more turbulence. The Paulson Plan, whatever its final form, will not bring this upheaval to an early end. The consequences are clearly spreading from Wall Street to Main Street. The recent performance of nonfinancial stocks indicates that investors are well aware of the fact.

So comparisons with the Great Depression, which have been of academic interest but little practical relevance, take on new salience. Which ones have content, and which are mainly useful for headline writers?

First, the Fed now, like the Fed in the 1930s, is very much groping in the dark. Every financial crisis is different, and this one is no exception. It is hard to avoid concluding that the Fed erred disastrously when deciding that Lehman Bros. could safely be allowed to fail. It did not adequately understand the repercussions for other institutions of allowing a primary dealer to go under. It failed to fully appreciate the implications for AIG’s credit default swaps. It failed to understand that its own actions were bringing us to the brink of financial Armageddon.

If there is a defense, it has been offered Rick Mishkin, the former Fed governor, who has asserted that the current shock to the financial system is even more complex than that of the Great Depression. There is something to his point. In the 1930s the shock to the financial system came from the fall in the general price level by a third and the consequent collapse of economic activity. The solution was correspondingly straightforward. Stabilize the price level, as FDR did by pumping up the money supply, and it was possible to stabilize the economy, in turn righting the banking system.

Absorbing the shock is more difficult this time because it is internal to the financial system. Central to the problem are excessive leverage, opacity, and risk taking in the financial sector itself. There has been a housing-market collapse, but in contrast to the 1930s there has been no general collapse of prices and economic activity. Corporate defaults have remained relatively low, which has been a much-needed source of comfort to the financial system. But this also makes resolving the problem more difficult. Since there has been no collapse of prices and economic activity, we are not now going to be able to grow or inflate our way out of the crisis, as we did after 1933.

In addition, the progress of securitization complicates the process of unraveling the current mess. In the 1930s the Federal Home Owners Loan Corporation bought individual mortgages to cleanse bank balance sheets and provide home owners with relief. This time the federal agency responsible for cleaning up the financial system will have to buy residential mortgage backed securities, collateralized debt obligations, and all manner of sliced, diced and repackaged paper. Strengthening bank balance sheets and providing homeowners with relief will be infinitely more complex. Achieving the transparency needed to restore confidence in the system will be immensely more difficult.

That said, we are not going to see 25 per cent unemployment rates like those of the Great Depression. Then it took breathtaking negligence by the Fed, the Congress and the Hoover Administration to achieve them. This time the Fed will provide however much liquidity the economy needs. There will be no tax increases designed to balance the budget in the teeth of a downturn, like Hoover’s in 1930. Where last time it took the Congress three years to grasp the need to recapitalize the banking system and provide mortgage relief, this time it will take only perhaps half as long. Ben Bernanke, Hank Paulson and Barney Frank are all aware of that earlier history and anxious to avoid repeating it.

And what the contraction of the financial services industry taketh, the expansion of exports can give back, what with the continuing growth of the BRICs, no analog for which existed in the 1930s. The ongoing decline of the dollar will be the mechanism bringing about this reallocation of resources. But the U.S. economy, notwithstanding the admirable flexibility of its labor markets, is not going to be able to move unemployed investment bankers onto industrial assembly lines overnight. I suspect that I am now less likely to be regarded as a lunatic when I ask whether unemployment could reach 10 per cent.

Barry Eichengreen is George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley.

27 Responses to "And Now the Great Depression"

  1. Guest   September 23, 2008 at 3:20 pm

    You are not seeing the big picture. Massive bailouts are going to lead to default by the US government. We are going to need at least 5 trillion dollars to bailout the entire financial system, real estate market, and consumers. Think about it.

    • Guest   September 23, 2008 at 5:32 pm

      I agree the US Economy is doomed. We are going to see the huge behemoth like US go down on its knees. Paulson, Berknake and Bush all of them must pay for this.

      • Guest   September 24, 2008 at 8:22 am

        I like the French idea of guillotine.

    • Guest   September 29, 2008 at 12:29 am

      Plus the end of BWII will mean no more “free lunch” for the US.

  2. Guest   September 23, 2008 at 3:34 pm

    If a depression occurs it could have been avoided and was engineered by the Federal Reserve who fueled the bubble with low rates and chose to ignore what was happening. The Federal Reserve caused the depression of the 1930’s and will seek to cause it again. This is a private bank with private interests controlling the money supply of the country. This situation should cease to exist for the benefit of the american people and the world

    • Guest   September 28, 2008 at 10:30 pm

      And remember, this bubble was fueled by Alan Greenspace to ensure Bush’s re-election in the first place. But that’s because the federal reserve was in the hands of a hack.

  3. John H   September 23, 2008 at 4:07 pm

    Wow! Loads of confidence in the powers that be. Yes there will be a bail out and it will drive the value of the dollar into the ground.It won’t stop at 700 billion, in fact it won’t stop. Lending institutions now know that all they have to do is cry “crisis” and the fed will come to their aid.If you really want to stop the hemoraging don’t bail out anyone. Let the whole market deflate. Yes it will be painful and yes their will be a wake of destruction but it will end decisively and relatively quickly. Then we can begin to rebuild with the confidence that we have truly purged the system of it ills. The proposed bail out will only lengthen the inevitable and reward those who caused the problem.

  4. Gepay   September 23, 2008 at 5:43 pm

    What would the unemployment figure be today if it was measured the same way it was in the Depression of the 30s or vice versa? True, at this time we are no where near the misery of the depression. This is not to say that events can’t transpire much more quickly these days. History doesn’t repeat itself but it does rhyme as Mark twain said. He also said,”Sometimes I wonder whether the world is being run by smart people who are putting us on or by imbeciles who really mean it.”So did Paulson think we are idiots when he asked for financial dictatorial powers in his bailout plan?Treasury’s Paulson- subprime woes likely containedUS. Treasury Secretary Henry Paulson said on Friday the housing market correction appears to be at or near its bottom and that troubles in the subprime mortgage market will not likely spread throughout the economy.”We’ve clearly had a big correction in the housing market. Retail housing was growing for some time at a level that was not sustainable,” Paulson said in a speech to The Committee of 100, a business group in New York promoting better Chinese relations.”I don’t see (subprime mortgage market troubles) imposing a serious problem. I think it’s going to be largely contained,” he added.That was this year. And he wants total control of of revolving $700 billion line of credit.There was an article in RGE considering the possibility of financial terrorism as a factor.Not being conspiracy theorists, there was no consideration of whether the terrorism would have been an inside job.

  5. Guest   September 23, 2008 at 7:19 pm

    The thrust of technological advance and globalization has been to concentrate wealth and power in ever fewer hands, especially in the United States. The last 3 bubbles can be seen as a desperate attempt by politicians to ameliorate the associated social strain. They now have to admit failure. Unemployment is going to reach 30% or more. Add to that destruction of the environment and the resource base by overpopulation and you have Armageddon. Nor financial Armageddon, but the real thing.

  6. Anonymous   September 23, 2008 at 7:27 pm

    I have to agree with Guest, above. Eichengreen demonstrates a fundamental misunderstanding of the self-perpetuating nature of a depression. Consumers stop spending, companies lay off workers, prices come down. In spite of the government’s desperate attempts to re-flate the economy, we appear to be very near to credit growth zero hour, when debt is eschewed by all as too risky. The consumer is over-extended and the banks are seizing up. Hold on for the ride; it will not be boring.

  7. Anonymous   September 23, 2008 at 7:31 pm

    I thought we were already at 10% unemployment?

  8. Anonymous   September 23, 2008 at 10:48 pm

    The bailout plan does not address the fundamental problem facing the USA. The population is teeteringon the precipace of insolvency. The bailout serves to solidify the cash positions of the well to do while fueling the further financial collapse of the population at large. The population is, unfortunately, borrowed out. Good luck will be needed in trying to recoup enough capital to retirethe accrued new national debt with a service-based economy having its financial leg blown away through the loss of international trust and its industrial leg long amputated and shipped to Asia.Unemployment may top the ten percent figure during the coming travails.

  9. François   September 24, 2008 at 1:29 am

    Tend to agree on what you said.However, may I point out that quite easy to tarnish the policies once the times have passed.Easy to dump Hoover. Easy to discredit the Japanese government attitude. Rewriting economic history has been a full-time occupation for academics.We’ll see what comes out.I do not expect ANY miracle. No major crisis like this one can be dealt with properly with economic or political planning of any kind.It is out of reach. The full country has to react. Not the government. Any administration is powerless in front such an even.I just hope the Dems are given a chance to make the treatment more socially acceptable.Yes this is a social event. And this is at this level that government can make it smoother. And let the US be even more of a place to live. Peacefully.

  10. Guest   September 24, 2008 at 3:08 am

    The U.S. has lost it’s soul. Too many foreign & domestic interests in control plotting the total exploitation of the american people. The constitution of the U.S. is a mockery to most of those on Wall Street and Washington D.C.

  11. Guest   September 24, 2008 at 7:16 am

    Have the owners of the FED private bank put up the money for the bailout. They are all trillionaires

  12. Guest   September 24, 2008 at 8:00 am

    “This time the Fed will provide however much liquidity the economy needs. There will be no tax increases designed to balance the budget in the teeth of a downturn, like Hoover’s in 1930.”Japan, the second largest economy in the world, already has interest rates at virtually zero, and has a debt-to-GDP ratio of 100%. They have recognized that they no longer have a world class economy given the new competition, and have recognized that they can’t spend their way out of their current economic downturn because of their fiscal predicament. The demographics of their aging population is also more precarious than that of the U.S.SocGen issues China alert as fears mount on banksSociété Générale has advised clients to dump shares of banks exposed to the Far East.By Ambrose Evans-PritchardLast Updated: 10:35PM BST 23 Sep 2008″The collapse of emerging market economies will shake investors to the core. The great unwind has only just begun,” said Albert Edwards, the bank’s global strategist.”The big surprise in store is what could happen in China. The potential for a deep recession in the US is already on the radar screen, but people will be stunned if China’s economy contracts, as I believe it will. Investors could be massively caught out,” he said.”The consensus has a touching belief that emerging markets will prove resilient despite a deep downturn in developed economies. My view is that an outright contraction in global GDP is entirely possible next year.””The emerging market boom is totally tied up with a decade of ballooning current account deficits in the US. Put that into reverse and you’ll be surprised what pops out of the woodwork.”Mr Edwards said the vast accumulation of foreign exchange reserves – led by China with $1.8 trillion – had provided the “rocket fuel” of liquidity for frontier markets. This virtuous circle has now turned vicious as America tightens its belt. Countries in Asia and Latin America are intervening to prop up their currencies, causing reserves to fall.”We could see monthly trade surpluses in the US within a year. The emerging market liquidity squeeze will intensify ferociously, and assets linked to the region will become toxic waste. That includes previously resilient banks such as HSBC, Standard Chartered and Banco Santander,” he said.The gloomy forecast comes as Fitch Ratings warns of mounting distress for banks in China, where debt has been shunted off books to circumvent state limits on credit growth.

  13. John H   September 24, 2008 at 8:13 am

    Great comments everyone.I would like to add some interesting points that aren’t being discussed in these meetings.- What about this abyss they keep telling us is so terrible we ought not look at it? Lets look at it. What would happen if we didn’t bail out wallstreet? Not some esoteric analogy but what literally would happen. I don’t think its as bad as they make it out to be. Any power vaccum in a lack of lenders would be quickly filled.- What if we didn’t bail out wallstreet but we did bail out individual tax payers from any collateral damage cause by the wall street firms going under? I’ll bet it would be cheaper than $700 billion.- Isn’t it interesting that there is talk about limiting the price of golden parachutes for the wallstreet ceo’s? Wouldn’t common sense tell you that they have already gained substantially from corrupt practices. Shouldn’t the question be why aren’t these people being prosecuted?

  14. Dave P   September 24, 2008 at 8:30 am

    And what the contraction of the financial services industry taketh, the expansion of exports can give back,

    ?Anyone want to hold their breath over this one? University economists, you gotta love ’em.

  15. John H   September 24, 2008 at 8:56 am

    To Dave PThose who can’t do, teach. Or in this case hold government positions. Kind of weird. The idea of listening to the solutions proposed by the ones who got us into this mess.

  16. A different Guest   September 24, 2008 at 9:54 am

    Thanks for the China note above…it validates ALL of the Commenters above. Note how the Chinese Milk contamination scandal has been suppressed for so long – with devastating consequences. What if that attitude has been extended to how other issues causing all kinds of lumps under their carpets…?Eichengreen’s title seems apt, but he ends with a much tamer scenario. It does not take into account the fundamental lack of transparency issues in Chinese politicized economy.Getting very nervous here…

  17. K.M.Shravan Dharmaraj   September 26, 2008 at 4:07 am

    What needs to be blamed is the SEC regulatory system that permitted excessive leverage for the financial system.Too much credit is always bad and has perpetuated the dollar crisis whereby we are ultimately going towards total curtains on the greenback and emergence of a new currency standard altogether. Time will only tell when.

  18. Aristotle   September 27, 2008 at 8:14 pm

    Here is the basic human problem.A leveraged fiat money market is not free. It is adebt market. It is a slave market. Proofis the statement “One who borrows what isn’this’n must pay it back or go to prisn.”I believe the first three sentences are theOccam’s Razor of the cause of thecurrent crisis.I don’t see anything in world history orlong term economic history to disprove this.Of course one may argue that an economicslave market is a good and/or necessarystate. In my opinion this argument hasalways necessitated a state of war untillsettled. And then the cycle starts again,because resentment inhabits the laws ofdesire more intimately than the worm doesthe apple.Welcome to the new world disorder. I thinkI’ll watch “Judge Dredd” dvd tonight to getprepared.

  19. Guest   September 29, 2008 at 12:08 am

    All I can say is that I earned an MBA in Marketing at a leading University…My finance stream colleages were super righ brained and never seemed to have thought about the consquences of the their strategies…It was as all about the Returns…This was the Harvard way…There was no “responsibility factor” in the equations that we studied…Greed wa srampant and was a large motivation factors..I feel that the MBA education leads to immoral and irresponsible behaviour.. We should shutter MBA schools and retool their curriculums …

  20. Anonymous   September 30, 2008 at 6:27 am

    The solution is TRIVIAL.The problem is the finance system.So bypass the finance system. Set up a giant government bank which lends DIRECTLY to industry and commerce, skipping the private banks entirely.The financiers collapse, but the real economy continues getting credit. FDIC and similar programs bail out smallholders.Radical, simple, pretty much guaranteed to work (at least in terms of preventing the financial system from wrecking the real economy).

  21. Guest   October 3, 2008 at 4:11 pm

    It’s a bit early in the game for the author of this article to claim that housing prices haven’t collapsed like they did in the Great Depression. It took time for housing to collapse then, and it will take time for housing to collapse now. This is a situation that is going to spiral.The stock market and housing market turned into a giant Ponzi Scheme. People were buying stocks and investing not because of dividends, but because prices kept going up and up. People were buying houses at inflated prices because the prices kept going up and people worried that if they didn’t buy now they would never be able to afford it. Now the whole house of cards has fallen.If wages had kept up there might have been a chance for us.