The 1930s all over again?

Posted by on March 13, 2009 @ 8:30 am in Economy & markets

Is it the 1930s all over again? If that were true, it would be one very good reason to panic, sell everything, and put your money in a mattress. But it turns out that the comparisons between today and the Great Depression are (mostly) bunk.

You should know by now (if you’ve been reading the papers or the blogs) that the stock market crash of 1929 did not cause the Great Depression. Instead, the Depression came about because of a flawed economic response in Washington. As the economy cooled in the early 1930s, rising bank failures led to sharp contraction in credit. Congress balanced the budget and imposed trade tariffs. The result was a downward spiral in the economy and massive unemployment. The economic collapse led to the failure of the financial system—notably, a surge in bank failures and collapsing stock prices.

Today’s situation is different.

In 2000, as we all know, the stock market fell by 50% after the Internet bubble burst. The Federal Reserve flooded the economy with cheap money to offset the effects of a downturn. In a few years, the economy recovered, as did the stock market. So far, so good.

But then policymakers made a mistake—a different mistake than in the ’30s. Money was kept too cheap for too long. It fueled a massive increase in credit card and mortgage debt. Commercial and investment banks made boatloads facilitating this expansion. And everyone—banks, households, credit rating agencies, regulators—looked the other way and didn’t inquire as to the ability of borrowers to repay. Once it seemed obvious that the binge went too far, it was too late: The losses began to cascade.

So, today’s situation is exactly the reverse of the 1930s. In the 1930s an economic tailspin caused the banks to fail. Today, a crisis in the banking system, built on a debt bubble, is restricting credit and threatening the real economy. The encouraging sign is that the government is doing everything in its power to insulate the real economy from the financial sector’s losses. But we could be in for a prolonged slump—because the banking system isn’t working properly, and the economy can’t grow if the financial sector is bleeding red ink.

So, breathe easier: The next depression is almost certainly not around the corner.

But that said, it is true that today’s situation does share something in common with the Great Depression. That common element is systemic financial risk; ours is truly the first systemic financial crisis since the ’30s. Back then, the systemic risk was caused by the reverberations from an economic slump—panicked depositors demanding their cash back from banks. Today’s systemic risk arose from a willingness of the financial system to encourage debt and overlook credit quality.

Which leads us to the question of the day: How did we learn to box in systemic risk through the institutions of the Great Depression—only to have it resurface, 70 years later, in the new millennium?

Note: We invite your comments on this Vanguard Blog entry. Comments will be monitored and published at Vanguard’s discretion. Comments received prior to July 7, 2009 will not be published.

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