Published: March 16, 2009 08:38 am      

Lessons learned should guide us on what not to do

We have all read the headlines that the current financial problems are the worst since the Great Depression.

There are some similarities, but there are also many more differences.

In the 1920s, the U.S. was an emerging global powerhouse; wealth remained concentrated in a few hands with a growing but still small middle class. Between September 1926 and September 1929, the Dow Jones Industrial Average had climbed 133 percent. In the three years prior to October 2007, the Standard & Poor’s 500 had risen 39 percent. Home prices had increased in value significantly. As measured by the S&P/Case-Shiller Home Price Index, which tracks prices in 20 of the largest metro areas, they had increased by 71 percent from December 2001 to July 2006, and 46 percent in the three years before July 2006.

Within 18 months of the Dow’s peak in October 1929, the stock market declined 52 percent and then bottomed 16 months later for a total decline of 89 percent. Since October 2007 the S&P 500 has declined 50 percent, and any further similarities are yet to be seen. This is where the differences between the policy decisions today and those of the 1930s become important.

During times of financial problems, policymakers have four key areas they can use: Monetary policy, fiscal policy, banking regulation and foreign trade. Following 1929, policymakers took “pro-cyclical” steps that, today, are regarded as the opposite of what they should have done. The federal government attempted to balance the budget, dramatically raising marginal income tax rates from 25 percent to 63 percent. Confidence in the safety of bank deposits declined with the Treasury Department taking a wait-and-see attitude.

In an effort to protect domestic production, Congress passed the Smoot-Hawley Tariff Act of 1930, setting off global retaliation and causing exports to decline by 54 percent through 1933.

One of the most insidious differences of the Great Depression to other downturns was the 25 percent decline in the consumer price level from 1929 to 1933. This level of deflation distorts economic relationships, not the least between lenders and borrowers as the real value of debt rises. A significant reason for the price decline was U.S. adherence to the gold standard. This caused the money supply to contract, shrinking an estimated 32 percent by 1932. Under the gold standard, the federal government was virtually powerless to affect money supply or to take any actions that would reflate their economies. The shortage of money caused some governments and companies to resort to barter or issuing script.

Since the onset of the current financial problems, the government has generally pursued “counter-cyclical” policies. The Federal Reserve has cut the federal funds rate by 475 basis points to an historic low range of 0 percent to 0.25 percent, and is in the process of introducing a variety of programs to thaw the credit markets.

The Fed has increased its balance sheet to more than $2 trillion, at one point, to increase money supply. Washington has adopted a fiscal stimulative policy, including the $787 billion bill recently passed. The specific programs and line items can be debated, but, in comparison to the 1930s, these counter-cyclical policies should, at a minimum, help slow the pace of decline, rather than making the policy worse.

For the banking system, the Federal Reserve and FDIC (not in existence until after the 1929 crash), have moved to shore up the banks, forcing mergers of weaker institutions, implementing the $700 billion TARP program and increasing insured limits. There has been talk of a “Buy American” policy by raising tariffs and creating other trade barriers. Such a policy could trigger a trade war that could be even more damaging to the domestic economy than the 1930s due to the increased level of global integration of trade and economies.

Our current economic situation has some similarities to the Great Depression. The major and possibly most significant difference has been governmental response, in most of the key areas. There cannot be a guarantee that current responses will produce quick or even effective results. However, history has provided important lessons on what not to do.



David Helscher is a senior vice president and trust officer with Clinton National Bank.