What Economic Historians Think About the Meltdown

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Corporate debt. Housing markets. Foreclosures. Contracted liquidity. These terms are synonymous with one that has been flooding headlines and creating unrest for anyone with a bank account: the subprime mortgage crisis. What began as rapacious arrangements between financial institutions and under-banked borrowers led to global economies being dragged into the daunting direction that some believe could spell depression. Are we repeating history? Or is this a new breed of greed?

“The United States is in the midst of a serious financial crisis, probably the worst since the 1930s,” explains Professor Jon Cohen, an economic historian from the University of Toronto. “In addition, unemployment is up, factory orders are down, and consumers are tightening their belts.  It may not yet be official but it is fairly safe to say that the country is in recession.”

Berkeley Professor Jan de Vries opines that the United States is facing a credit crisis. “This began,” she says, “with a major under assessment of risk in mortgage lending, but extended via securitized mortgage debt instruments to the rest of the financial sector here and abroad.”

New York University Professor of Economics, Robert E. Wright concurs: “Many new types of mortgages were made on the expectation that rising home prices would cover over any problems related to lending to 'subprime' borrowers. When home prices began to fall, an unexpectedly high percentage of homeowners began to default. That caused major problems throughout the global financial system because of the widespread practice of 'securitizing' mortgages, of lumping them together, slicing them into risk-adjusted pieces called 'tranches,' and selling them to investors throughout the world.”

"It is important to note" says Cohen, "that the value of these asset-backed securities depended on the value of the underlying assets.  If the mortgagees paid their mortgages in a timely fashion, everything was fine.  If they fell behind on their payments, if, god forbid, they defaulted and foreclosure ensued, things were not so fine.  It became clear in 2007 – to many, it was clear much earlier – that things were not so fine in the asset-backed securities market. Firms with large positions in these securities saw their asset and capital base collapse and, with it, their solvency." de Vries lends a different perspective: "The proximate cause is the housing bubble, fueled by federal government policy [namely the] encouragement of  home ownership; guidance to banks to loan to marginal borrowers; [and the Federal] low-interest policy after 9-11."  

Nancy Koehn, James E. Robison Professor of Business Administration at the Harvard Business School, says there is plenty of blame to go around. "Clearly," she notes, "there was a failure of governance on the part of leaders in financial firms—executives, managers, traders, boards of directors. And in the United States, it seems the rating agencies have much to answer for in their assessment of the debt that is now so questionable. Fannie and Freddie and the political winds behind these institutions swept lending standards (and common sense) aside in a rush to promote home buying, even among households who simply could not afford to buy a home."

Professor de Vries agrees: "There are many guilty parties," she says. "The leaders of the financial institutions bear the brunt of the blame, since they either steered with open eyes into the new high-leverage environment, or they did not understand the techniques their institutions were relying on to make their high profits. More generally, " she adds, " 'deregulation' seems to be a minor player, most evident in retrospect, in this process."

Cohen doesn't believe anyone is to blame. "At least not in the conventional sense," he says. "It is argued by many that deregulation played a central role in the debacle but it is probably more accurate to say that poor and uncoordinated regulations were more responsible. In any case, by 2006, housing prices in many areas made no economic sense, access to mortgages was too easy, and huge amounts of leveraged money had gone into assets whose riskiness was, at best, difficult to assess."

Koehn believes that there is at least another factor at work here, "an overall suspension of responsibility on the part of executives who played too fast and loose with fiduciary obligations (and then took home ridiculous pay packages after destroying enormous value), on the part of consumers who have been buying more than they can afford for years (against better judgment) and on the part of  public officials who have generally been afraid to look hard and long at what was happening to the casino of capitalism and what this meant above and beyond short-term political considerations and the lobbyists' market that helps shapes these."

In short, "The financial system in the United States is in terrible shape," Cohen summarizes. Wright, who shares this belief, says that he would not go so far as to say that circumstances would lead to another Great Depression. "A recession, however, is well-nigh inevitable because our major trade partners are already in recession and the U.S. economy has stayed out of recession this year due solely to increased exports, which were largely a function of the greatly weakened dollar." Professor de Vries expands on this: "Whether it is very serious in terms of  financial and employment losses to the public at large, a depression is not entirely clear. What we do in the next months could still have an influence on this outcome."

So if not the Great Depression, what past crisis in the Unites States or elsewhere could the subprime mortgage crisis be compared against? "Mark Twain once said that history does not repeat itself but sometimes it does rhyme," Koehn says. "The panic of 1907 certainly 'rhymes' with this moment." Professor de Vries notes that although the Crash of 1929 and the subsequent Great Depression is a comparison that come readily to mind, it may be more relevant to compare it to more purely financial panics, such as 1907.

"All major panics," explains Wright, "follow the same basic outline: asset bubble, massive leverage (borrowing to buy the rising asset), bursting bubble (asset price declines rapidly), defaults on loans, asymmetric information and uncertainty, reduced lending, declining economic activity, unemployment, more defaults. In 1792, 1987, 1997-98, and 2001, the government was able to stop panics in their tracks. In 1819, 1837-39, 1857, 1873, 1884, 1893-95, 1907, and 1929-33, it either did nothing or failed to stop the panics from spreading and deepening before they severely damaged the economy."

Wright believes the mortgage crisis will be an important part of history and will be presented as the final culmination of the success of modern central banking if everything turns out okay and doesn't get any worse. Although she is sure the crisis will be taken up in future economic histories of the US and of the international economy, de Vries questions just how significant it will be. "It is possible that timely corrective policies (monetary, fiscal, and institutional) all suggested by analogy with the 1930s will prevent the worst from happening,' she says. "But, since history does not really repeat itself in such a convenient way, the odds of such a happy ending are probably not very great.  A surprising outcome will make our current situation more important historically."

"The great fear of everyone is that this is the Great Depression Redux," concludes Cohen. "It is not. We may experience a recession, but the probability of this turning into a long period of negative growth with very high rates of unemployment is close to zero. The Great Depression was, largely, a product of bad economic policies and inadequate institutions.  We have the institutions and we know what needs to be done."   

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Michael P. Shipley - 12/17/2009

Ok, its December 2009 and you guys were so wrong its not even funny. You thought you had it all figured out. Probably spent years getting brainwashed by the Keynesian professors paid for by the feds. How does it feel now knowing you don't know JACK about real economics?

The Fed caused the credit bubble during the roaring twenties, remember that by any chance? When the fed popped the bubble by finally raising interest rates it causes the stock market crash and a run on the banks.

Without the fed there would of been no crash and no run! The fed CAUSED the crash! Nevertheless, the banking system would of fixed itself within a year, but no, Hoover and Roosevelt just had to "fix" it. THAT caused the depression.

You say the recession became a depression because the fed didn't bail out the banks in 1929? You mean like right now with that idiot Bernanke? All he's done is set the stage for a much bigger crisis, a currency crisis.

What do think of Obama now? He's leading us into the biggest hyper-inflationary depression the world has EVER seen. God help us all.

Raul A Garcia - 10/30/2008

I remember when the internet value bubble burst some sage observers noted that many of the internet "gurus" were in their thirties and had no historical thinking....this present bubble period appears to be more of mismanagement and greed. Action must be taken because the market by itself will not establish true solvency. Economics is many times sorcery and wishful conjuring and confidence must be restored in all sectors and the new admin better hit the floor running and "get it done" and not wait for some self-help bestseller.

Lawrence Brooks Hughes - 10/20/2008

There is no defense against the madness of crowds. When conditions progress to the panic stage it doesn't matter what medicine is administered. Accordingly, it is prudent to acquire a boodle of gold coins at this time--not at all insane. A permanent overthrow of the Constitution could be at hand. Let's hope not, but it has never looked more likely.

Robert E. Wright - 10/20/2008

I can understand why S Steinberg does not want to settle for glib denials so here is a denial rooted in historical fact and theory:

During the GD (1929-1933), the U.S. was on the gold standard, which limited the ability of the Fed to expand the money supply or reduce interest rates.

The Trilemma or Impossible Trinity of international monetary relations is that no country can simultaneously have more than 2 of the following: fixed exchange rates; free capital flows; discretionary domestic monetary policy. Under the gold standard, the U.S. solved the trilemma, so to speak, by allowing free capital flows (gold and financial instruments) and remaining on fixed exchange rates (gold), rendering the Fed impotent to fight the Depression by forcing it to keep interest rates high (to retain gold). Today, we solve the trilemma by allowing free capital flows and allowing domestic monetary policy discretion, for which we have given up fixed exchange rates (the dollar has floated in world currency markets since the end of Bretton Woods in the early 1970s). So the system IS structurally different now. None of this means that bad things can't happen but Prof. Cohen is right that we now have the institutions and knowledge to prevent another Depression.

S Steinberg - 10/19/2008

For the first couple of years the contemporary view of the Great Depression was that it was a liquidity problem. The collapsing housing market, down over 15% in 1929, was seen as a minor, transient issue. We are in late 1929 today, so it is easy to ignore the housing market, the layoffs, the acres of for sale signs, the drop in NYC hotel prices and so on, but I am not much reassured by glib denials.

The underlying problem is the gap between productivity and wages. Workers are producing too much and they aren't being paid enough to afford to buy enough of it. This is global. The U.S. has been the consumer of last resort for decades, but the U.S. consumer is getting tapped out. Each recovery since the wage peak has been weaker than the last. This gap has to be fixed for an effective recovery.

Another problem is that we are in a demographic phase that amplifies crises. The baby boomers are getting on, so most of them are past their peak earnings. The latest generation is just entering the workforce well before their peak earnings. In a better demographic phase there would have been more workforce traction to fight the downturn.

One good thing is that we are in an election year. We won't have a three or four year wait for a new administration to come in. If Obama is elected there is a chance he can cut the depth of the collapse. As noted, there are things that can be done to get the economy moving again. Of course, McCain is unlikely to bother.