But with the slow menace of a glacier, depression came on. No one had any measure of its progress; no one had any plan for stopping it. Everyone tried to get out of its way.
— FRANCES PERKINS (1880–1965),
U.S. SECRETARY OF LABOR , 1933–1945
Simply put, discussing the topics of economic depression and recession is painful at any time. It is, well, depressing emotionally. More so at this writing, since the entire world is not recovering from the last recession caused by the housing bubble, and it seems constantly poised to begin another plunge. There are many definitions of a recession and of a depression. Most involve the size of the gross domestic product (GDP), which is an esoteric economic term that means the value of just about everything that is made, bought, or done in a nation. Perhaps the simplest and most obvious way to define a recession is when this GDP, the total wealth of the nation, “recedes”—when the total amount of wealth, money, and the value of everything else in the nation becomes smaller. Negative growth affects everything, from jobs to interest rates. And if the recession continues for too long, the cumulative negative effects of a loss in wealth create a “depression.” Some say two years of recession defines a depression. Politicians, many of whose policies create the problems, try hard not to use either word.
It is good to remember that even when the economy remains unchanged, it is already losing ground. Every day, more people are born and more enter the workplace needing a job. The number of people is growing, and if the amount of wealth does not expand to match this population growth, then the result is, quite simply, that there is less for each person to live on. So when there is a recession and the amount of wealth decreases, that smaller amount of wealth is also constantly being divided by more and more people, a double whammy. Economic growth is needed in every country of the world just to stay even. As in Lewis Carroll’s Red Queen’s race, “it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” In a recession, the entire structure of jobs, business, manufacturing, and banking is losing the race with population growth. In a depression, it keeps losing ground for a long time.
In the short run not everyone loses when the economy stalls. There will always be those who benefit from the financial ruin of others. During the Panic of 1907, depositors with failing banks had to stand in line to get their money out of the banks before those banks ran out of money. It was a “first come, first served” kind of mentality. Some exhausted depositors, who had stood in line for days on end, paid people $10 a day to stand in line for them. And in 2011, as the economic recovery began to stall, alcohol sales in the United States shot up. While mortgage lenders, real estate agents, and construction workers scramble to make a living while living through what is still a housing depression, attorneys specializing in bankruptcies and foreclosures are making a fortune off the misfortune of others.
Recessions come from many causes, some of which have been discussed in other parts of this book. But when you look at them, the real cause is abuse and greed. The actions of some affect the entire economy enough that everyone pays. This may be the government, which can both cause and extend the misery. Another group can be those companies that handle the key parts of the economy. Unfortunately, both are in such a position of power that they may cause the recession but tend to suffer less than the average person from it.
The question is, then, have we learned economic honesty from the recent high price everyone is paying for the actions of Wall Street and the banks? Arguably the most powerful investment firm in the world, U.S. brokerage house Goldman Sachs (yes, the same firm that was a major player in the packaging of toxic mortgages that plunged our country into the worst recession since the Great Depression) did some creative accounting and a complex derivatives deal back in 2002. This was done to help the free-spending and -borrowing Greek government mask the extent of its debt so it could join the European Union. Goldman Sachs arranged agreements relating to the exchange of interest payments and principal denominated in two different currencies that are now maturing, swelling the Greek deficit and plunging that country into bankruptcy. Because of the deal brokered, Greece handed over its public assets to the International Monetary Fund (IMF; the organization that backs up the banks and even national treasuries), while Goldman Sachs got a sizable cut from the Greek government for managing to “legally” get the debt-ridden country into the EU even though it violated the 60 percent deficit limit. Now the euro is in trouble, but Goldman Sachs got its money and is doing fine. The real losers are the Greek people, who did enjoy their government spending all that borrowed money on them, but now are facing unprecedented levels of austerity and taxation. Because the disastrous condition of the Greek economy was exposed, the IMF now “owns” the Acropolis of Athens and other prime Greek real estate. Of course the Acropolis might need updating—after all, it is 2,500 years old. Maybe the United States could lend them some unemployed American construction workers; there certainly are enough of them available since the housing bubble burst in 2008 from all those toxic mortgages Goldman Sachs and others prettied up, then repackaged and sent down the road—or even across the Atlantic—again, after taking their hefty brokerage fees.
There is a running joke among economists that when your neighbor loses his job it’s a recession, and when you lose your job it’s a depression. There is no single agreed-upon definition for either of these terms, but the standard definition for a recession is a decline in the GDP for at least two consecutive quarters. Many economists don’t like this definition because it doesn’t consider things like consumer confidence or changes in the unemployment levels—two variables that certainly contribute to the collective pain felt by Americans during an economic downturn. It also makes it difficult to determine start and end dates, and using that traditional definition may ignore short recessions altogether.
Some economists feel that the Business Cycle Dating Committee at the National Bureau of Economic Research (NBER; the federal government’s source for hopefully unbiased monetary research) provides a more comprehensive and accurate definition. They say that a recession occurs when business activity has reached its peak and then begins to decline until it bottoms out. When it starts to pick up again that is called an “expansionary period.” Business activity includes the employment levels, industrial production, and wholesale-retail sales. Under NBER’s definition, the average recession lasts about a year.
Most Americans think all this number crunching is bogus. Two-plus years into the “recovery” from the Great Recession, more than 80 percent of Americans surveyed in an August 2011 poll said they believed the country was currently in a recession. Thirty-three percent of those surveyed felt it was “severe.” And why wouldn’t they? The August 2011 job report showed zero, zip, nada job growth. Since then it has run from 250,000 jobs per month to again almost none. The last time zero job growth was recorded for nonfarm jobs was in February of 1945. And Americans have every right to be depressed about the prospect of the United States tipping into a full-blown depression. After all, the latest news has been nothing but depressing. In August 2011, for the first time ever, the credit rating of the United States was downgraded. This means even the United States, once a safe haven for foreign money, now has to pay extra to borrow it.
Before the Great Depression in the 1930s, all periods of economic downturn were called recessions. But after the Great Depression, there needed to be a way to distinguish the severity of these periods of economic decline. A depression is now thought of as any period where the GDP declines by more than 10 percent. As of 2011, the last depression in the United States was in 1937–1938, when the GDP declined by a staggering 18.2 percent. However, that number pales in comparison to the period of the Great Depression, just a few years earlier, when the GDP declined at a horrific 33 percent. It’s significant to note that many economists feel that the Great Depression lasted from the 1929 crash until we entered World War II in late 1941. There was only a gradual recovery over those twelve years, and even that was partially reversed by the 1937–1938 decline that was caused by FDR deciding he could raise taxes. Then even after twelve years of government programs that outright hired millions of workers, it basically took the full employment and massive spending of a world war to end it. So history gives not the best of signs for a government-driven recovery.
This is not to say that all actions by the government are ineffective. Certainly President Hoover showed that by doing nothing as a policy, thinking the economy could heal itself. Things just got worse, and FDR won the 1932 election by a landslide. Having learned from this history lesson when the subprime mortgage industry collapsed in the fall of 2008 and the United States seemed poised for the first depression since the late 1930s, the federal and state governments acted. Through a series of drastic actions, the economy was pulled back from the brink, but we still ended up with the most severe recession in history. The Great Recession of 2008–2009 was seen as a huge relief compared to what many economists believed we were headed for: an epic depression that could have struck the global economy with the force of a tsunami, washing away entire countries and causing the complete collapse of the world’s economic superpower. Or perhaps history is repeating itself. Certainly if you ask average Americans whether they think we are headed toward another recession, they overwhelmingly respond that they don’t think we are out of the first one yet. The hope is that we have learned enough that this one lasts less than a dozen years, and a less drastic ending can be found.
A Long History
Since 1790, there have been about forty-seven recessions in the United States alone (depending on the definitions used). The more recent U.S. recessions have caused global economic downturns, since we are now more economically entwined with foreign countries than at any time in the past. What we are experiencing now, as fallout from the Great Recession, is plummeting consumer confidence levels—another factor triggering economic downturns. This jargon translates as: people aren’t buying because they are afraid of another recession or job loss, but if they don’t buy, their fears become self-fulfilling prophecies because there is less sold, so fewer jobs are needed and the recession worsens.
Let’s take a look at a select group of recessions and depressions in the past. How they ended can give some insight into solutions available today.
Panic of 1797
This was the first recession recorded in the United States. There was extensive land speculation during the 1790s. The Bank of England was experiencing severe deflationary pressures from its involvement in a war with France. England was still heavily tied to the new American economy, and the deflation wreaked havoc on the real estate market in the United States. Numerous businessmen, congressmen, and even a Supreme Court justice found themselves pursued mercilessly by creditors. In fact, Justice Wilson left Pennsylvania and fled to Maryland to hide from creditors. Eventually, he was found and spent time in a debtor’s prison.
After the panic, there was political pressure to pass some laws protecting debtors—particularly when some of the most notable ones were those who made or interpreted those laws. In 1800 the first bankruptcy act was passed, primarily because of huge debts incurred as a result of the land speculation on the western frontier. The act was repealed in 1803, mainly because of abuses from high-rolling debtors who used it to discharge their debts only to then turn around and start all over, knowing they could discharge the new debts almost as soon as those debts were incurred.
1821 Depression
In 1791, Congress created the First Bank of the United States. It was responsible for about 20 percent of the country’s money. It acted like a modern central bank, and it was created to help manage and finance the country’s needs. The bank’s charter lapsed in 1811, but it was soon replaced by the Second Bank of the United States.
In order to finance the War of 1812, the government borrowed heavily. After the war ended in March of 1815, inflation began to skyrocket. Panic ensued when banknotes plummeted in value because of that inflation. This excessive borrowing caused a strain on the bank’s reserve specie (gold and silver).
In 1814, the federal government stopped the specie payment. During that time, the U.S. government did not honor the obligations to their depositors. Not only did this cause economic instability, but it triggered a surge of new banks and the expansion of banknotes—paper money. When the printing presses started working overtime, monetary inflation soon followed. With all that excess currency—basically, easy money—risky investments soared. The government did it again in 1819, refusing to pay their depositors and creditors in gold and silver. This caused widespread panic and a deepening of the depression that had been going on for the past four years. By this time, hundreds of thousands of people were thrust into unemployment. In large cities like Philadelphia, unemployment reached 75 percent. Tent cities were set up in urban areas all across the country. Real estate prices plummeted and banks began to fail. Sound familiar?
Panic of 1837
Andrew Jackson was elected president in 1829. He opposed the Second Bank of the United States, calling it unconstitutional, corrupt, and dangerous. He kept the bank’s charter, which was due to expire in March of 1836, from being renewed. This caused the number of state and wildcat banks to explode. Money was readily available and investors borrowed heavily in order to fund their cheap public-land purchases. Small farmers, manufacturers, traders, and merchants all borrowed lots and lots of money. And rather than paying off their debts as they were incurred and then financing new projects, businesses kept borrowing more money to invest in speculative purchases. They all assumed that they would make a lot more money that way than if they paid their debts off first.
But it wasn’t just cheap public land that was being gobbled up by investors; the value of private land in urban areas began to skyrocket. One speculator from Hartford, Connecticut, related that he was making 75 percent annually on his initial $1,000 purchase in Michigan. The property values in New York City increased by 50 percent within five years. But the land bubble was about to burst.
Jackson believed that the government should be paid in gold and silver currency only—no paper money. He and his supporters thought that the paper money was the cause of the high inflation gripping the young nation. He watched with growing concern as the paper money, not backed by anything, was printed to aid speculators. The country’s first recession in 1797, which occurred mainly through funding excessive land speculation, was long forgotten by this time.
In the early 1830s, the economy grew rapidly, primarily because of the construction of new railroads and canals. Land speculation proceeded at a manic pace, and the government sold millions of acres of public land to feverish buyers, who were counting on that land to go up in value as new settlers moved into the areas near these railroads and canals. A new tariff was passed in 1833 that encouraged massive amounts of foreign imports to flood the economy. This tariff eventually caused a huge trade imbalance, as imports far exceeded exports. This imbalance resulted in a loss of specie for the states. Initially, however, all the land sales and the tariff caused the U.S. treasury to have a huge surplus. By 1835, the federal government was able to pay off the national debt. Jackson was thrilled, and most modern politicians would also be ecstatic over retiring the national debt on their watch.
But Congress was under pressure (lobbying apparently never goes out of style) to give the state banks some of that surplus so that the states could fund projects such as more new railroads and canals. Most of those states preferred to hoard their gold and silver and pay their debts off using state banknotes. Jackson was worried about all the federal land being purchased with paper money, so he had the treasury secretary issue an order called the Specie Circular. This order, which occurred right before Jackson left office, mandated that the Treasury no longer accept paper banknotes (or “rag” money) as payment for the land sales. The purchases had to be paid for in gold or silver after August 15, 1836.
A huge financial crisis was brewing in early 1837 for the incoming president, Martin Van Buren. Banks began limiting credit, and depositors started making a run on those banks, trying to get their money out. State banks, now forced to pay in gold and silver instead of paper money, didn’t have enough specie to pay their debts. With the loans drying up, construction companies were unable to pay their obligations, so numerous canal and railroad projects failed. All those land speculators, who were counting on that construction to raise the price of the land they had already purchased, could not sell the land for anywhere close to what they had paid for it, much less sell it at a hefty profit. The banks began calling in their loans. Unemployment became rampant, and there were riots over food in several major cities. Eight states went bankrupt in addition to thousands of individuals. The banking system collapsed.
Out of 850 banks, 343 failed and 62 closed partially. The state banks never fully recovered.
Van Buren was opposed to direct government action to alleviate the crisis, which is the likely reason he was not reelected in 1840. President Obama had his reelection hanging in the balance primarily because of the awful economic situation. But while Van Buren was seen as not doing enough, some accuse Obama of doing too much fiscal experimentation and too much spending to try to fix the economy. It’s that “damned if you do, damned if you don’t” mentality, which persists today.
Panic of 1857
It was the year of the Dred Scott decision and the Crimean War was raging. The depression of 1857 was caused primarily by the declining international economy and an overexpansion of the domestic economy. Foreign investors, who were heavily leveraged because they had bought on margin in the domestic railroad industry, became worried about the overbuilt industry and the solvency of banks in the United States. Any serious drop in their stock’s value would be ruinous. Many British investors sold out and took their money to Britain. But simultaneous events seemed to cause the initial panic. First there was embezzlement discovered at the Ohio Life Insurance and Trust Company. On the same day the Ohio company ceased operations, the Central America, a merchant marine ship carrying fifteen tons of gold, sank. News could travel quickly with the widespread use of the telegraph. American investors on the New York Stock Exchange panicked, as did British investors, who quickly began pulling their remaining money out of the market. This was an early taste of what could go wrong in a global economy. News in one part of the world, San Francisco, triggered an immediate reaction in London that crashed the American Stock Exchange. This depression quickly spread to Central and South America, whose economies were highly dependent on trade with the United States and Britain.
More than five thousand businesses failed during the first year of the panic. Some of these were railroads—the tech stock of its day—and many of the railroads, the ones that had been built to sell stock rather than to fulfill a transportation need, failed. Massive protests were held in urban areas over unemployment. There were several attempts to rectify the crisis, including creating a bank holiday in October of 1857. The secretary of the treasury also suggested selling bonds and lowering the tariff. By 1859 the country was starting to recover, although the effects lasted until the Civil War began. This war started a period of bank panics and runs on those banks because depositors feared they would lose everything. There was no deposit insurance and if your bank had invested poorly, your savings could be lost. In fact, the Second Bank of the United States did fail, not only destroying tens of thousands of depositors, but leaving the United States without a national bank at the start of the Civil War.
Recovery from the 1857 depression was slow, with the cotton-exporting southern states recovering more quickly than the manufacturing North. This caused the federal government to try to tax exports—especially cotton—more heavily. This increased tensions between the two groups of states and contributed to the split that culminated in the Civil War. The war itself, and the wartime economy, brought an end to the depression.
1873 and the Long Depression
This depression is important because it has many parallels to today’s extended and jobless recovery. The year was 1873: the first postcard ever had just been released, and in Canada the North West Mounted Police force was formed. Eight years after the end of the Civil War, growth had returned with a vengeance, particularly in the railroad industry. Railroad stocks became the investment of choice, and in the pattern of bubbles and bursts the stock values quickly became unrelated to the actual profits or even the track owned by the railroad itself. Then the collapse came in 1873 and again banks failed, businesses saw sales cut in half, and unemployment soared. There are many parallels between this depression and that of 2008. Both were tied to a stock bubble—railroads in 1873 and a more general market increase including tech stocks in 2009. A major component was real estate loans going bad. In 1873 the attitude was very similar to 2008 in that those who bought land or buildings did so after over a decade of increasing values. In both cases this raised values to beyond what the real market could bear, with speculation driving up the prices. In 2008 this was complicated by government intervention in the market, forcing the creation of bad housing loans. In both periods the banks bought and sold mortgages, and when the value of the property behind the mortgage collapsed, the banks suffered. Another parallel is that Europe was having severe problems and this spilled over onto the U.S. economy.
The panic began when the largest bank in the United States, Jay Cooke and Company, failed because the foreign money it was dependent on disappeared. Not only was Cooke the top investment banking firm in the United States, it was also the main backer of Northern Pacific Railway and a significant investor in several other major railroad lines. It had invested a disproportionate amount of its depositors’ money in the railroads. But most importantly, Cooke handled the majority of the government’s wartime loans. The failure of Cooke was a devastating blow to the economy. Of course, if Jay Cooke had been around in 2008, a bank of that size and importance would have been deemed “too big to fail” by the U.S. government, and taxpayers would have bailed it out.
This Cooke bank failure burst yet another speculation bubble that had inflated after the Civil War. The New York Stock Exchange was shut down for ten days after Cooke’s collapse to prevent panic selling. Market stops that freeze trading, both in the form of general stops and ones placed only on certain stocks, have been used since. (They were used again in the collapse of 2008, when trading was suspended on a number of bank stocks.) Credit disappeared and factories began closing. Within two years of Cooke’s failure, more than eighteen thousand businesses were lost, while a third of the country’s railroads went bankrupt. One effect of the high unemployment rate was wage cuts of up to 45 percent. This wage loss, combined with abusive practices and the high unemployment rate, gave impetus to the rise of labor unions.
The government did intervene, and by the time Grover Cleveland became president the nation’s reserve had dropped below what most considered a minimum safe level of $100 million. One measure to restore confidence was a return to the gold standard. This helped stabilize stagflation, but did not end the unemployment or credit crunch. The Panic of 1873 caused a severe six-year depression in both Europe and the United States. Even then, jobs did not return and workingmen saw little improvement. In some ways, historians think, the country didn’t pull out of this slump until 1897.
Panic of 1893 and Panic of 1896
By 1893 the World’s Columbian Exposition, featuring Edison’s electric lights, had opened in Chicago. It was the year ice cream cones were invented. Houdini was the greatest entertainer, and the Mormon temple in Salt Lake City was dedicated. It was also the year that saw the beginning of another depression, or possibly the resurgence of one that had not really ended. Like the Panic of 1873, the economic depression that followed in 1893 was triggered by the overbuilding of the railroad industry. The financing of all this railroad building was shaky as well, and a series of bank failures soon followed. Many of the railroads bought up their smaller competitors, compromising their own financial stability. When the mammoth Reading Railroad failed, European investors fled, causing the stock market and the banking industry to collapse.
In addition to the feverish speculation in railroads, the Sherman Silver Purchase Act of 1890 did its share to hurt the economy. In the west, there was overbuilding of the mines and overproduction of silver, so the new law required that the U.S. Treasury buy silver with notes that were backed by gold. The gold reserves fell to very low levels. Wall Street banker J. P. Morgan lent President Grover Cleveland $65 million in gold so that the country could maintain the gold standard. But like President Obama today, Cleveland was blamed for the depression. And so was the Democratic Party. In the 1894 elections, it was all about the economy—wow, that’s a familiar refrain—and the Republicans swept the elections in the largest GOP gain in history.
The period between the 1893 Panic and the 1896 Panic was mostly an economic depression with a very brief period of growth right after the first panic. During this time, production shrank with the United States producing less in its factories than it had a decade earlier. Deflation was the order of the day. The economy slowly began to recover in 1897, and it experienced a sizable gold rush in both the western states and Alaska and had ten years of growth before the Panic of 1907 reared its ugly head.
Panic of 1907
The year 1907 began with an exciting change when the rules committee for football legalized the forward pass. At sea, the first modern battleship, the HMS Dreadnought, was launched, starting a naval building competition that did not end until World War I. By the summer of 1907, the New York Stock Exchange had already plummeted 50 percent from the previous year’s high, and a severe economic downturn ensued. That October, one unscrupulous investor, F. Augustus Heinze, ingratiated himself with the bankers and came close to causing the entire banking industry to collapse when his attempt to corner the copper market failed. In some ways, the October Panic of 1907 was eerily similar to the lead-up to the subprime mortgage industry collapse in the fall of 2008. But in 2008, there was the Federal Reserve Bank to help prevent widespread financial devastation. (Some have argued that occurred anyway.) While they didn’t have the Fed in 1907, Wall Street did have financier J. P. Morgan. Yes, Morgan had already come to the rescue during the last panic by lending massive amounts of gold to the U.S. government as mentioned above. But this time, with literally only twelve minutes to spare, he managed to raise enough money to keep the stock market from a cataclysmic crash.
Although the Panic of 1907 wasn’t as severe as some of the ones preceding it, a very important change came about in its wake, which we’ll get to in a minute. It certainly is obvious from reading about the economic history of the United States during the nineteenth and early twentieth centuries that financial panics and bank runs had become commonplace. Just one important speculator who fell on hard times could cause widespread panic, as investors pulled their money out in an attempt to cut their losses. Remember, there was no federal deposit insurance at the time. To make matters worse, many speculators were also banking officials. So they were the first to know if one of their own was in trouble, and they would immediately pull their money out of any bank that was doing business with that troubled speculator. If a struggling bank had a run on its depositors’ money and you didn’t make it to the head of the line, you were out of luck. Huge personal fortunes were often lost in a matter of hours, if not minutes. Not only was there no way of getting your lost money back, but there were also no government safety nets at the time. Overnight, you and your family could be out on the streets, begging for food. So it is certainly understandable that during that time there were nervous investors and agitated bank customers.
The Panic of 1907 was a very important event in the financial history of the United States. To reduce or eliminate the panics and bank runs, which seemed to be occurring on a regular basis, the Federal Reserve System was created in 1913.
Recession of 1920–1921
Things happened in 1920 that later changed history. The Nazi Party began, known then as the German Workers’ Party. Edsel Ford took over the family business, not knowing his name would later be connected to the worst auto marketing fiasco in history, the Edsel of 1958. The League of Nations had its first meeting in February with great expectations but later failed miserably to prevent World War II or accomplish about anything else. The triggers for the 1920–1921 recession included the massive shift from wartime to a peacetime economy. This recession was only eighteen months long, but it was very steep. The year 1920 was the most deflationary year on record, at around 18 percent. This was more severe than any single year during the Great Depression. To make the pain even worse, wholesale prices dropped 36.8 percent—the largest drop since the American Revolution.
The causes of these two post–World War I recessions involved more than just adjusting to a peacetime economy. First of all, labor unions were powerful during the war because the government’s need for goods, services, and workers was high. Also, with so many men in combat, the year began with a labor shortage, and unions took advantage of it. About 1.2 million workers had been on strike in 1918. But by 1919, four million workers had gone on strike. However, when the war ended, the unemployment rates shot up, and relations between labor and industry quickly improved. Not surprisingly, wages fell while productivity increased.
The brand-new Federal Reserve Bank of New York made novice policy mistakes. At the end of the war, it started raising interest rates, at first by a quarter of a point, and then, a month later, by 1 percent. Six months after that, it was raised to 7 percent. This is the highest interest rate of any period in American history, except for the rates of the 1970s and early 1980s—but those were almost loan-shark rates. Once the rates rose to those new highs, credit dried up for all borrowers—businesses, consumers, and even other banks were unable to get loans.
The 1920–1921 recession ended when the New York Fed dropped the interest rate from 7 percent in July 1921 to 4.5 percent by November. The American economy bounced back with a strong recovery during this era, known as the Roaring Twenties.
1929, the Great Depression
If you were anyone but a farmer, 1929 started well. Farmers were already feeling the financial pressures that would soon bring down the U.S. economy. Many current economists think that we narrowly averted a Second Great Depression in 2008, but thus far no economic downturn in American history has even come close to the scope and size of the 1929 crisis.
Up until the Great Depression, the view of monetary policy held by most economists was that the Federal Reserve had the power and ability to achieve most any economic goal. So when the Great Depression hit and the economy collapsed, most economists were shocked at this catastrophe that they just hadn’t seen coming. The depression was so severe and so unexpected that an entire generation of economists was forced to rethink existing theories and develop new ones. The U.S. government created new polices as a result of that new economic thought that helped the economy evolve throughout the twentieth century. As we shall see, this rapid shift in thought and policies also occurred after the recent Great Recession. These new policies are still being debated and evolving throughout the recovery period.
Although most historians agree on the effects of the Great Depression, not all of them agree on all of the causes. Some of the more common theories are discussed next.
On October 29, 1929, the stock market crashed. This date is invariably linked with the start of the Great Depression, although the economy had been in decline for at least six months prior. Yet many greedy bankers on Wall Street refused to acknowledge the warning signs. They continued to borrow money and invest in risky stocks. Eventually, reality hit the stock market and company valuations began to fall. During October, there was intense panic selling and the markets went out of control. Within a matter of days, Wall Street had officially collapsed. It took twenty-seven years for the stock market to recover its losses and return to precrash numbers.
Even though many people think that the crash caused the Great Depression, only 16 percent of Americans had investments in the stock market at the time. Although the crash terrified investors and caused widespread panic, most economists believe that it was neither the sole nor the primary reason for the depression. It appears that it was a combination of several factors, with the bursting of the bubble where business and investors could get easy credit starting the collapse.
Farmers, as already mentioned, were suffering hard times even as the rest of the nation remained almost euphoric. Having enjoyed a booming economy during the 1920s, America had been overproducing goods for which there was a lessening demand. As demand declined, it triggered a slowdown in agriculture and factory production, which caused millions of people to lose their jobs. As people lost jobs, they began to curtail their purchases, which caused demand for those goods and services to decline even further. So production slowed and more jobs got eliminated. The cycle then continued, and as the unemployment rate soared, people who had jobs began to fear losing them, so they also cut back on their spending. If that sounds familiar, it’s because that cycle happens with every economic downturn. This lack of consumer confidence is a major reason why economists today are worried that another recession, or perhaps even a depression, is inevitable in the very near future.
By 1933, eleven thousand out of twenty-five thousand banks in the United States had failed. As mentioned above, although the Federal Reserve was created after the 1907 Panic, deposits were still uninsured. Just as in past panics, if the depositor wasn’t at the head of the line, he often lost his entire life’s savings. As banks began to worry about their own day-to-day survival, they stopped lending as readily. So there was significantly less credit available for investments and purchases.
In 1930, the Smoot-Hawley Tariff was passed in response to the alarming number of business failures during that time. The tariff created a high tax on imports and hurt trade with Europe. This meant we imported much less from them. In retaliation, they raised their tariffs on American goods. Those living in European countries reacted to the higher costs by curtailing their purchases of American-made products. This tariff battle accelerated the economic decline on both sides of the Atlantic because with no place to sell goods overseas, the workers who had made them were let go. Instead of protecting each country’s workers, these tariffs destroyed jobs in large numbers.
Though it was not a primary reason for the depression, a severe drought from 1931 to 1936 in the Mississippi Delta devastated countless farmers. In the Great Plains, millions of acres of land became worthless in the “Dust Bowl,” as the drought there lasted until the fall of 1939. Families were forced to sell their farms to pay taxes and other debts, losing their livelihoods and their homes in the process. John Steinbeck penned his famous novel The Grapes of Wrath about this catastrophic event.
The effects of the Great Depression cannot be understated. As all of this was going on, President Hoover decided to not “interfere” with the market, believing that the recession would end on its own. Hoover was blamed not for causing the depression, but for not acting decisively to end it (which could explain why President Obama acted quickly, if expensively, at the start of the current crisis). He was demolished in the next election by Franklin D. Roosevelt. By 1933, shantytowns, also called Hoovervilles, were cropping up across the country, housing the growing number of homeless. Americans built these makeshift “homes” with scraps of metal, pieces of wood, and cardboard boxes. In 1934, the Federal Deposit Insurance Corporation (FDIC) was created to insure bank deposits and restore depositors’ faith in American banks.
At its peak, in 1933, unemployment was at 25 percent. President Roosevelt’s New Deal policies were created. Some of them, or their successors, are still in place today, including the Federal Housing Administration, the Farm Security Administration, the National Labor Relations Act, and the U.S. Securities and Exchange Commission. Numerous parks, bridges, and highways were built during the next several years.
1937 Roosevelt Recession
The Great Depression waned, and the economy had recovered substantially by May of 1937. But the recovery was not really complete, and unemployment remained high (as it has after the 2008 recession). By late August of 1937, the economy began to falter again, due mostly to changes in federal policy. By early fall, it was in rapid decline. That is why this later period is sometimes called a “depression within a depression.”
The stock market quickly lost a third of its value, and by the spring of 1938, unemployment surged to 1931 levels. The unemployment rate was 19 percent, and corporate profits were down 80 percent from their 1936 levels. Production in industry dropped a dramatic 40 percent, and requests for public assistance in hard-hit places like Detroit quadrupled from those requests made before 1937.
There are several reasons commonly given for the cause of this severe recession. The first is that Roosevelt decided the worst was over and attempted to balance the budget. To do that he had to significantly curtail public works projects. Those projects had provided the economy with over $4 billion in tax receipts by giving hundreds of thousands of people a paycheck and increasing economic growth. Many historians believe that the decision to reduce the public works projects was premature, because the economy had not sufficiently recovered from the Great Depression. Roosevelt blamed businesses for the recession and called it a “capital strike” against his New Deal policies. There was a backlash in the next election, and Democrats lost a large number of House and Senate seats in the congressional elections of 1938.
The Federal Reserve got spooked by inflation worries, so it tightened the money supply. Additionally, declining business profits led to reduced investments. Like today, businesses were unsure as to what new regulations or taxes might be imposed by FDR and this discouraged investment and expansion. More regulations and the threat of new taxes made investors pull back. Finally, the Social Security Act of 1935 had pulled two billion dollars’ worth of tax receipts out of the economy. Payments back into the system didn’t begin until 1940.
When the country entered World War II in December of 1941, it was still in deep economic trouble. But the war effort proved to be good for the economy. Manufacturing planes, ships, tanks, and other military necessities got the economy growing again. Employment went to near 100 percent as millions of men left the workforce to enlist and everyone else was needed to take up the slack in the factories. Anyone making anything for the war, from auto companies to canning factories, boomed with business as the nation worked three shifts a day to meet the needs of our soldiers and those of our allied countries as well.
After the end of World War II, the American economy had long periods of expansion and, for the most part, less severe recessions than in the past. That held true until 2008.
2008–2009: The Long Recession Begins
The 2001 “tech bubble” and the 9/11 terrorist attacks shook investor confidence and caused a severe emotional trauma to the American psyche. People not only lost faith in the stock market as an investment, but also questioned the future, asking if America was in economic decline. Since 2001 the Federal Reserve has regularly lowered interest rates in an attempt to stimulate the economy. This set a low rate for loans of all sorts, making them more appealing to both businesses and home buyers. Many banks took advantage of these lower rates and the credit began to flow freely.
There was also massive overbuilding during the period leading up to the Great Recession. Like the overbuilding of the railroads in the past and the overproduction of goods in the Roaring Twenties, the housing market became overbuilt. Real estate speculation—as in the lead-up to many of the panics beforehand—was rampant as investors and developers snatched up cheap land. At the height of the housing boom, investors were flipping homes like pancakes—buying cheap, doing a few repairs and some cosmetic work, and then selling for two, three, or four times what they had paid for them.
Everyone and anyone who wanted one could get a mortgage. Credit was easy, easy, easy. The mortgage companies began giving very low introductory rates, even to those buyers who they knew, at their current income, couldn’t make the larger payments when the rates increased after a few years.
The adjustable-rate mortgage (ARM) gives a borrower an initial lower interest rate and lower payments because the rate is not set for the entire period of the loan. Instead, the interest rate can increase, or decrease, when the Federal Reserve Rate changes. In 2007 the interest rate increased as credit tightened. When the rates on many of those ARMs started to increase, a lot of buyers lost their homes. The housing crisis began to spiral out of control, unemployment skyrocketed, and the stock market began to collapse. Panicked banks began holding on to their money, and credit for businesses and consumers (even those with good credit) dried up, just like during the Panic of 1907 and the Great Depression.
As the credit crunch put pressure on banks to run their day-to-day business, unemployment rates rose even further, and people with clean credit histories began struggling to repay their mortgages. In 2008, the global stock markets reacted by plummeting around 40 percent.
During the Great Depression there were many bankers and economists who ignored the warning signs only to be stunned when the market collapsed. Free-market proponents argue that the subprime crisis was a direct result of the U.S. government’s intervention in the mortgage market and not unbridled capitalism.
In 1990 the Cranston-Gonzalez National Affordable Housing Act was passed so that low-income Americans could have an opportunity to buy homes. These buyers would not have qualified for a mortgage without the passage of the act, based on the credit standards used in the private sector arena at the time. So U.S. banks were basically forced to grant these subprime mortgages. There seems to be a valid argument that the federal act contributed to the subprime mortgage crisis in the sense that there may have been compliance pressure resulting in credit being made too easy. Just as in the years leading up to the Great Depression when anyone could borrow money to buy stock, no matter what the value of the stock, so, too, at the beginning of the twenty-first century, anyone could borrow money to own a home.
We have discussed how, starting in 2002, Goldman Sachs created derivatives to sell that, while technically legal, were so complicated that they could not really be valued. By doing this, Goldman Sachs enabled the Greek government to hide most of the debt that collapsed their economy and threatened the existence of the euro in 2012. Among the derivatives created, which other financial houses quickly traded, were credit default swaps based on toxic mortgages. These were so impenetrable that most rating houses gave them a good score anyhow, encouraged to do so by a system that rewarded them for giving any derivative a good rating.
Derivatives were an unregulated way for the finance industry to make these riskier loans and get them insured. The credit default swaps masked the truth about the financial solvency and creditworthiness of the mortgage’s insured borrowers. Once the initial toxic mortgages were in place, the banks could then sell them off to buyers and insurers who were unaware of the extent of financial risk they were taking on. Tens of thousands of Americans have lost their homes—which are now owned by the banks and the government. Greece has lost its 2,500-year-old real estate to the world’s bank, the IMF.
The Great Recession, measured by the standard definition of declining gross GDP, lasted eighteen months . . . which is to say it is technically over by the government’s definition. That still makes it a longer recession than any other that has occurred since World War II (when the average length of a recession was eleven months). This past recession was also the most severe since that war, with the GDP falling 6.1 percent from its peak right before the downturn began. That compares well with the more than 26 percent drop in 1929, but is worse the 5 percent drop in the 1973–1975 depression, which was the next highest GDP loss until 2008.
The recovery as of 2012 was the slowest and weakest since 1933. The United States hasn’t come close to regaining that lost ground with regard to the GDP level. Businesses are recovering more slowly, new business creation is slower, and unlike in other recoveries, the real unemployment remains so high that this “recovery” is often described as being “jobless.”
If you examine the past two recessions before this one, some disturbing differences emerge. When the 2001 recession ended, unemployment was measuring 5.5 percent. And after the 1991 recession ended, unemployment was at 6.8 percent. At this point, most Americans would be ecstatic with an unemployment rate that “low.”
Even if the current economic indicators don’t fall neatly under the definition of a recession, with more than 80 percent of Americans believing we are currently in one, then at a minimum, the country is mired in a psychological recession. It is a strange thing about depressions and recessions: they are self-fulfilling prophecies. If people and businesses believe times are hard and going to get worse, they spend less. If they spend and hire less, the economy does get worse. Simply, when the economy feels painful, people hold off from spending money. When consumers don’t spend money, the economy contracts further. The decline begins to create a feedback loop in which the mere fact that things are getting worse and people know it causes the economy to become even worse. The self-fulfilling prophecy can by itself cause the economy to spiral out of control.
So what do we do about it? Well, the psychologically and financially based recession we are in won’t end until the unemployed get jobs, the government stops stimulating the economy, the housing values start to recover, and consumers begin spending again. That’s a tall order. In the following chapter, we will examine a wide range of political, social, and fiscal policies used throughout history to try to cure ailing economies. Maybe, if we take the best ideas from the past, we won’t have the same old economic problems in the future.