Fed Chair Ben Bernanke always likes to remind us that he is a scholar of the Great Depression. But I am not sure he has drawn the right lessons from it based on his actions. As Mark Twain said, history doesn't repeat itself but sometimes it rhymes. There are certain rhymes between the Great Depression and the current circumstance. Income inequality and negative savings rates leading up to the current circumstance are the same as they were in 1929. In both situations, high levels of borrowing and lack of transparency were key contributors.
But things are also different now. For example, securitization is at the core of the current catastrophe and so is the globally-interconnected nature of the financial system. There are $13 trillion worth of mortgage backed securities (MBS) and collateralized debt obligations (CDOs) alone and there is perhaps $340 billion worth of capital on the books of leading financial institutions (FIs).
And due to the global interconnections, banks in Germany were wiped out since they bought too much of this financial toxic waste. And this does not even take into account the $54 trillion credit default swap market – which did not exist in 1929.
The current responses are consciously the opposite of what happened in the 1930s in many respects. So far the Fed and Treasury have thrown trillions of dollars at the problem – during the 1930s, the Fed tightened. Also, now banks around the world are trying to coordinate their responses while in the 1930s, different countries raised trade barriers and tried to protect themselves at the expense of other countries.
The Feds should be fighting the problem of banks not lending to each other or to businesses and consumers. They should also be getting at the root cause of the problem, which is that the amount of mortgage debt is beginning to exceed the value of the housing stock. The underwater and defaulted mortgages are slashing the value of the MBSs and CDOs which are sinking the capital of the FIs that own them.
The problem we face now is fear of insolvency which leads to capital hoarding. In other words, FIs do not know whether it is safe to do business with other FIs because the others might be insolvent. I suspect that part of the problem is that many FIs do not know whether they, themselves, are solvent and therefore they doubt that their peers are. If they could be confident that they were solvent, then they would lend to each other because they would be missing out on profit opportunities.
My conclusion is that history is rhyming. We must be careful not to drive by looking in the rear view mirror. The current financial crisis is not the same as the Great Depression. Therefore, doing the opposite of what policymakers did back then will not solve the current financial crisis.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.
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Reader Comments (Page 1 of 1)
10-17-2008 @ 2:35PM
JCH said...
Look at real GDP growth from 1933 onward.
10-17-2008 @ 6:53PM
winslow said...
I saw this tsunami coming years ago. Sometimes when individuals reach a certian level of power and prestige, they become blind to the obvious. Everyone in the administration was blinded. This is what happens when there is group speak.
10-17-2008 @ 3:45PM
Iridium said...
Look at the value of mortage securites and credit default swaps. It exceeds world GDP.
World business may not be able to do enough business to pay for the debt it has created.
I'm not really sure but I think that once the world overextends itself there really isn't anywhere else to go.
10-18-2008 @ 4:32PM
Thomas Paine said...
The house of cards has some structural damage and even if the foundation were to be repaired "good as new", some sections will continue to collapse.
"After we found out that they are worthless, it is really hard to pretend that we don't know that."
Derivitives, CDSs, et al will continue to be ticking time bombs. Period. The confidence game that comprises the majority of Wall Street transactions has a naked king.
"The financial world REALLY liked the return on these pie-in-the-sky investments; real manufacturers of real, tangible products are not as 'sexy' and certainly not as lucrative an investment."
It is truly doubtful that enough capital can be pumped into the system to put clothes on the king. Before the fallout, the king wore only a pair of briefs - make that a thong.
The original intrinsic value - the thong - are the actual, physical properties represented by the MBS. This would be a lower level of that house-of-cards - a difference between REAL and PONZI.
The economic crisis is blamed upon the housing glut and defaults on mortgages, both of which share a common, underlying problem. People could no LONGER afford them.
For years, those same people had paid their mortgage and bought new homes, without LIAR loans. Even the people that just *barely* could afford their mortgage, still made their payments.
JOBS. Decent-wage paying jobs. That is what has been in decline for the past several years. This has been affecting people all over America, but it seems to be a lost idea among the financial elite.
Anyone reading this know a person that lost his 20-year job in a factory (that moved to Mexico), to end up as a Walmart Greeter? If not, you most likely cannot grasp the notion of what constitutes the very Foundation of our economy.
Bretton Woods II, is a wash. To the question - how long can a country be solvent when all it manufactures are consumers, investments, credit and debt? - the answer appears to be 8 years.