There is no doubt that the weeks we are living through now will be remembered and studied in the decades to come. In this post I compare and contrast our crisis with the great crisis of 1929 and thereafter.
After it initially appeared that financial hemorrhaging had been staunched, in rapid succession long-standing titans of American finance -- Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, AIG, and more likely than not Washington Mutual and Wachovia Bank -- all have failed in one way or another.
The stock indices have declined over 10% in the last 2 weeks. In just one day, gold shot up in price 10%. A ten year treasury bond on Monday fetched 3.30% interest -- the lowest save one week in 40 years. This afternoon a 3 month treasury bill fetched 0.06%, that is 6 cents for a $100 investment on an annual basis. Professor Paul Krugman had a chilling, two-word description: "Liquidity Trap."
The world's up and coming economic superpower, China, through its party organ, the People's Daily, openly called for a non-dollar based international economy.
Ordinary Americans looked at the retirement balances in their 401K plans and feared that they would never be able to stop working.
This may not be Economic Armageddon, but it certainly appears to be Financial Armageddon. In addition to Prof. Krugman, some excellent commentary has appeared from the ever-levelheaded Calculated Risk and Prof. Mark Thoma, both of which I highly recommend to you.
As somebody who almost two years ago began to write that the "diffused risk" of structured finance could easily transform into "systemic risk", and over a year ago described the period we have entered as an old fashioned "Panic" or "Bust" that would unfold in "s l o w m o t i o n", (for example, here, here, here, here, here, here, here, here, here, here, here, and here), describing it as a slow, grinding, multi-year destruction of debt to come, this week is certainly one of the particularly bad sudden periods that I knew had to be embedded within that traumatic event, an event that I believe still has 3-5 years to go before it is complete, and at the end of which both America and the world will seem quite different places. I wanted to share a "Big Picture" overview of how this Event is similar to and different from the Great Crash of 1929.
I knew the "bust" would occur in slow motion because so much momentum towards inflation was built into the system, that the deflationary forces of a credit collapse would only emerge after the old order was vanquished, kicking and screaming the whole way down. In fact I still suspect there will be a brief "respite" caused by lower inflation in gas and food by the end of this year, much as a drowning man might briefly bob to the surface and catch a breath of air before sinking again. After that, it is beginning to appear that the next chapter of the Slow Motion Panic will unfold in terrible earnest in 2009.
But let me step back and compare this period with the unfolding of the Great Depression, for what is happening now is in a number of significant ways quite different, and very susceptible I hope to competent and committed public action aimed at limiting the damage.
As I described earlier, what characterizes what I have called "The Panic of 2008" is (1) declining asset prices (in stocks and housing), (2) increased imported inflation, (3) wage stagnation, and (4) the liquidity trap that has just emerged today. At the same time, I have continually pointed out that, ex-housing, the "real" economy on Main Street America has not worsened very much at all in 2008. In this respect the "Panic of 2008" is fundamentally different from the Great Crash of 1929.
In 1929 and 1930, as I have described in several prior diaries, it was the Main Street economy which declined first, beginning in June 1929. In that month inflation gave way to deflation, and consumers began to slow their purchases of goods. Meanwhile the financial economy, typified by the stock market, continued to roar ahead until September. What collateralized housing loans were to the housing bubble of our decade, stocks were to the 1920s. Just as those housing loans were leveraged and continually re-sold at higher prices using loaned money, so stocks in the 1920s were bought on margin. In both cases, it was only after the real economy turned that the debt-laden instruments began to blow up in earnest.
The consumer slowdown of June 1929 inexorably spread and deepened, month by month by month, throughout the rest of 1929 and 1930, a vicious spiral of ever more layoffs, ever more wage cuts, and ever more price cuts, while accumulated debts became ever more unaffordable. It was Main Street leading, and the financial sector following, first via the Great Crash of October 1929, then the failed stock rally and subesequent stock collapse of spring and summer 1930, and finally the spreading financial catastrophe of runs on the banks beginning near the end of 1930.
In our Panic, however, while the housing bubble burst first, nevertheless it is the financial sector that is the epicenter, and Main Street is so far only peripherally giving way. Although housing has been faltering since 2006 (just as the 1920s real estate bubble peaked in 1926), other consumer areas have either not fallen or are just now falling to recessionary levels. Retail sales are still nominally positive, services and manufacturing in the real economy are not expanding, but not significantly declining either.
This is not to minimize the ongoing suffering of average Americans. During the last 7+ years of the Bush Administration, the working and middle classes have suffered greatly and never did participate in any of the real gains of the last economic expansion. Americans collectively have been living on credit cards and home equity loans, in other words, on fumes. Poverty now has little correlation to education levels, skills and age. As a result, the middle class looks like swiss cheese, as millions of people ever so gradually have been kicked out. The point is, whatever this suffering has been, it has not dramatically increased for Main Street America beyond gas and food prices in the last year or so, except for those who were caught in the housing bubble.
But first mortgage lenders, then hedge funds, and then investment houses and now giant government sponsored agencies and insurers have all imploded dramatically, causing the value of America's financial sector to be cut in half. In contrast, regular savings and commercial banks, aside from the very few that were heavily involved in "alternate" mortgage products, have been untouched. The "run" is on the unregulated "shadow banking system", not the plain vanilla corner regulated bank. It is as if one half of the body economic is rattling on its deathbed, and the other half is running a mild fever.
The crucial dynamic about the next portion of the "Slow Motion Panic" is whether Main Street comes down with pneumonia. "If Wall Street crashes, does Main Street follow? Not necessarily", says the Financial Times, recalling that the 1987 Wall Street stock crash left the Main Street economy almost completely unscathed. In our own present case, retail sales have declined slightly, and auto sales have crashed. Industrial production, chiefly centered around the auto industry, is also in decline, but not yet at levels equal to or greater than the relatively mild 2001 recession.
But the tools available to the Federal Reserve in 1987 -- cutting rates, getting stronger players to take over weaker brokerages, a vibrant underlying economy -- either don't exist now or have already been virtually exhausted. Moreover, as individuals feel the 25% losses in their retirement portfolios, it is realistic to expect that "fear itself" will finally take hold and consumer purchases will slow significantly. If so, this could begin another round of the vicious spiral as house prices fall further, leading to further writedowns in mortgage related collateral, leading to further financial calamities and further consumer fear.
It is hardly an exaggeration to say that trying to minimize the financial pandemic's infection of America's Main Street economy is the single most critical job that will await the new, hopefully Democratic, Administration and Congress on January 21, 2009.