Was 2008 the beginning of another Great Depression?

McClatchy NewspapersDecember 28, 2008 

In March, Treasury Secretary Henry Paulson unveiled the most sweeping overhaul of the financial regulatory system since the Great Depression.

CHUCK KENNEDY/ MCT

WASHINGTON — It wasn't 1929, but like that infamous year, 2008 is sure to be remembered by economic historians as one unlike any other.

"We had a much simpler financial system back then. The number of wild and crazy things that happened this year is completely without precedent in world history," said Alan Blinder, a Princeton University economics professor and a former vice chairman of the Federal Reserve.

Where to begin? In March, there was the overnight collapse of Wall Street titan Bear Stearns, in hindsight the first domino to fall in what would become a meltdown of the global financial markets.

Maybe July's record oil prices of $147 a barrel, which helped spark inflation and send food and commodities prices spiraling upward worldwide? That gave Americans gasoline at more than $4 a gallon, and everyone said that gas would never be cheap again. On Wednesday, however, crude oil prices fell to just more than $37 a barrel, and gasoline was down to a nationwide average of $1.66 a gallon, thanks in part to the global downturn.

Then there was September's government seizure of mortgage finance giants Fannie Mae and Freddie Mac, which own or back more than half of all U.S. mortgages. Washington, however, let investment giant Lehman Brothers collapse in a shock wave felt around the globe.

Unfortunately, that's not the half of it. In September, the Federal Reserve also took an ownership stake in insurance behemoth American International Group, followed by the $700 billion Wall Street rescue package that Congress grudgingly passed in October, with little supervision over how the money would be spent.

Then there were the record nationwide home foreclosures and the 13.2 percent year-over-year drop in median home prices nationwide through November, the biggest drop since, yes, the Great Depression.

Capping off the year, December brought the grim-faced chief executive officers of Detroit's Big Three automakers begging for a lifeline to avoid bankruptcy. Fed Chairman Ben Bernanke and his colleagues dropped a benchmark lending rate almost to zero — the lowest ever — in an attempt to thaw the deepest freeze ever seen in the credit markets.

Investors were so averse to risk late this year that the yield on short-term Treasury bonds briefly went negative twice. Yet investors were opting to lose money on them, perceiving Treasuries as the safest investment to have; better to lose a little than risk losing more elsewhere.

"I have been around awhile, and I have never seen the economy decline more rapidly than it has in the past few months," said Lyle Gramley, a Fed governor from 1980 to 1985 and an economic forecaster since 1964.

At 81, Gramley offers the long view. A child during the Great Depression, he remembers seeing able-bodied men reduced to begging.

"I remember men standing in a soup line that was three or four blocks long just for a bowl of soup," he recalled. "People don't remember how bad things can get."

Back then, federal cluelessness allowed the U.S. economy to slide into the Great Depression. That's a mistake that Bernanke, a scholar of the Depression, isn't repeating: He took unprecedented steps — many of them increasingly at odds with the Bush administration's laissez-faire economic philosophy — throughout the turbulent year.

In March, the Fed began emergency lending to investment banks that it didn't regulate, later expanding to a wider range of Wall Street players. In a failed bid to arrest declining home prices, the Fed also began buying the complex mortgage bonds that investors didn't want. No wonder: The bonds were backed by bundles of mortgages whose risk was impossible to assess.

When the broader credit market froze and banks stopped purchasing commercial paper — short-term promissory notes that major U.S. corporations issue to fund their cash-flow needs, such as payroll — the Fed stepped in and began buying them, too.

By doing all this, the Fed has increased its balance sheet from around $890 billion in assets in August to more than $2.2 trillion. That sum is sure to grow more early next year, when the Fed's role as the buyer of last resort will expand as it begins buying securities whose underlying collateral is made up of bundled car loans, student loans and credit card debt.

These are called asset-backed securities, and the bundling of loans for sale into a secondary market is called securitization. Securitization allowed for the rapid expansion of credit to Americans during the past 15 years. However, the market for virtually any securitized consumer or commercial debt has evaporated. By stepping in, the Fed hopes to lead institutional investors back into the marketplace.

Bernanke's aggressive actions are akin to printing money. Once the economy begins to recover, the Fed will face the daunting challenge of shrinking the money supply and raising interest rates — or risking the return of high inflation.

Nevertheless, Bernanke's Fed also is expected soon to allow GMAC, the finance arm of General Motors, to convert a bank it owns into a bank holding company, making it eligible for Wall Street rescue funds. This would allow carmakers to lend to consumers, since banks aren't. GM's November car sales were down 41.3 percent over November 2007.

"It does boggle the mind," Gramley said. "One thing I take a lot of comfort in is, if you were God right now and you could appoint anyone you want to be the Fed chairman to manage us through this crisis, the guy you would pick is Ben S. Bernanke. He is a student of the Depression."

Bernanke declined interview requests.

If 2008 was an ice age for banking and finance, millions of ordinary Americans will remember it for its utter destruction of their personal wealth, their hopes for retirement and even their children's college plans.

Home prices nationwide sank 7.5 percent on a year-over-year basis through October, and 8.8 percent since they peaked in April 2007, according to the Federal Housing Finance Agency. Through the third quarter, the annualized declines were much steeper in former boom states such as Florida, where they were down 16 percent, and California and Nevada, where they were down almost 21 percent.

Apart from seeing the equity in their homes evaporate, many Americans have seen their 401(k) retirement plans shrink by 30 percent or more as the stock market plunged. Many economists say that amounts to more than $2 trillion in lost retirement savings.

Through Christmas week, the 30 blue chip companies that constitute the Dow Jones Industrial Average had collectively lost 47 percent of their stock value during the past 12 months and 39 percent since the Dow's all-time peak close on Oct. 9, 2007.

In a Dec. 15 report, the Investment Company Institute, a trade group for the mutual fund industry, estimated that 47 percent of U.S. households have some exposure to stocks or bonds, down 10 percent since 2001. Both younger and older Americans are now less prone to take risks, the group said, following the bear market of 2000-02 and this year's nosedive.

It may be a hard sell to get ordinary investors back into the stock market anytime soon.

"We've just thrown people through two bear markets in eight years. They're going to decide, 'I can't risk the rest of my life on this,' " said Howard Simons, the president of Rosewood Trading, an economic research firm in Glenview, Ill.

The new Democratic-led Congress and President-elect Barack Obama have identified a regulatory crackdown on Wall Street as a top priority.

"We need to put rules into place that will give people some assurances," said Rep. Barney Frank, D-Mass., the chairman of the House Financial Services Committee, which will be drafting new Wall Street regulations.

To restore confidence in the broader economy, Obama and Congress must find a way to halt massive job losses. Employers had shed more than 2.5 million jobs through the end of November, and on Wednesday the Labor Department reported 586,000 new requests for jobless benefits in the week that ended Dec. 20, the highest level since 1982. Many economists think that the unemployment rate may peak as high as 9 percent next year, which would be the worst jobless rate since the 10.8 percent peak of 1981-82.

When the 111th Congress convenes on Jan. 6, lawmakers will quickly begin work on an economic stimulus plan that will be so large that its only parallel is the New Deal. The spending and state-aid plan is expected to range from $650 billion to $850 billion over two years, and could grow larger as lawmakers begin horse-trading.

Stimulus efforts can do only so much, however. For the economy to recover, many economists say, bolder steps are needed to reverse the slide in home prices and the epidemic of foreclosures.

The Obama team has signaled a more interventionist approach to finding ways to purchase distressed mortgages and perhaps refinance them with the taxpayer and lender sharing the loss.

"The public sector has to provide some response," Frank said.

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McClatchy Newspapers 2008

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