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Is this crisis like the Depression? Yes and no

November 09, 2008|Adam Geller | Geller writes for the Associated Press.

NEW YORK — They are the stories we heard from our grandparents, the pictures we studied in history books -- bread lines stretching around street corners, shantytowns sheltering the unemployed, small-town banks with darkened windows.

Today's financial crisis is hardly that grim, though it does have similarities with the economic collapse of the 1930s: Both were preceded by a housing boom, a long period of cheap credit and a falling stock market. But the similarities also offer reassurance.

What was then economic calamity is today a history lesson. America has been through it before, and there's a guide, at least for mistakes to be avoided as the nation's leaders try to prevent another catastrophe.

Economists have spent decades dissecting the Depression. Their findings illustrate the crippling effect fear has on economic decisions, the cost of not acting quickly and the risk of damaging the larger economy in an effort to make individuals pay for financially irresponsible investments.

"The number of people with personal memory of the Great Depression is fast shrinking with the years," one expert said in 2004 in a speech at Washington and Lee University. "However, although the Depression was long ago . . . its influence is still very much with us."

That man was Ben Bernanke, a former Princeton professor and an expert on causes of the Depression. He's now Federal Reserve chairman.

Today economists partly blame the Fed for the Depression because it raised interest rates even as the economy was slowing in the late 1920s. Then when banks began to fail, it took a hands-off approach.

But if those policymakers were able to speak up now, they could offer at least one defense of their actions: How were they supposed to know?

"In the Great Depression, what the Fed did at the beginning was to tighten interest rates. It took a long time to essentially recognize the magnitude of the problem, but of course it was a problem we had not had before," said Robert Aliber, a University of Chicago professor emeritus who's written on financial panics.

Today's policymakers and lawmakers know better, or at least they should. They've had the benefit of studying not just the Great Depression, but numerous other financial crises, both in the U.S. and abroad.

They also have tighter regulation of financial markets, bank deposit insurance and other policies that were adopted to prevent history from repeating itself.

The current panic has pushed the economy to the edge of a cliff. In the Depression, it plunged over.

During the 1920s, stock prices more than quadrupled. But on Oct. 28, 1929, the Dow Jones industrial average fell 13% in a single day, another 12% the next and 10% more a few days later.

Stocks bottomed out in 1932 -- down 80% from their peak.

Millions of people lost their jobs, with unemployment reaching 25% in 1933.

The banking system went into convulsions. About 9,000 banks failed in panics from 1930 to 1933, and hundreds of others were closed by the Roosevelt administration in the first days of its term.

The nation's economic output plunged by a third.

The underlying causes were different than those at play today, but the two periods share important similarities.

America in the 1920s was swept up in a boom. In some respects, it was a bubble, one that was bound to pop.

The bubble was clearly evident in real estate, most notably in Florida. It was cheap to borrow, and investors plowed money that wasn't theirs into new cities fashioned out of swamps, hoping to take advantage of sharply rising housing prices. When land values began to fall, they couldn't make payments, and banks were squeezed.

Fed policymakers viewed the soaring stock prices of the 1920s as fueled by immoral speculation. They responded by raising interest rates in an effort to restrict the supply of cheap cash.

The Great Depression also was characterized by a growing sense of mistrust and fear among major players in the economy -- another phenomenon increasingly seen today.

Consumers and businesses that had relied on cheap credit were struggling. The prices of the goods they made and sold were dropping, and many began to default on their loans. Scores of banks went bust.

At that point, the 30-year home loan had not been developed. Most people had loans they needed to renew every five years. But with some banks out of business, they had nowhere to go. Banks still afloat called in loans to protect themselves. But that just made the situation worse, as the economy began to freeze up.

As the problems grew worse, policymakers were trapped by their own "liquidationist" viewpoint.

Andrew Mellon, Treasury secretary during the Hoover administration, advocated allowing the free market to punish reckless investors. To cure excesses of easy credit, he said, "the rottenness should be purged out of the system."

In trying to make sure that people paid for their mistakes, the Fed allowed the financial system to deteriorate.

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