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 Case-Shiller 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.