Melt Down on Wall Street

During the early 1930’s, the output of the US economy dropped by nearly one-third, and about one in four people who would like to have been working were unemployed (with many more under-employed.) This event makes all subsequent recessions pale in comparison. The question of interest is whether it could happen again? One way to consider the question is to examine the causes of the Great Depression. I don’t think this is the right approach and may lead us to draw false conclusions. If the question is whether history could repeat itself because the causes of the Great Depression realigned in the present day, the answer is probably no. However, could the perfect conditions for a catastrophic collapse in economic output be created in an entirely new way? That remains to be seen, but should not be dismissed summarily.

A number of competing explanations have been offered as the cause of the Great Depression. Like any catastrophic event of that magnitude, it was probably formed in a perfect storm of multiple exacerbating factors. While many the proposed factors contributed to the magnitude of the economic decline, most were not individually sufficient to cause the problem. Factors such as a severe draught that devastated agricultural output and the Hawley-Smoot Tarriff Act that resulted in reduced exports as countries began to retaliate helped to make the Depression as severe as it was, but were not at the root of the ailment. The heart of the story has to do with a new and inexperienced Federal Reserve Bank (Fed) making a chain of mistakes. The first, and arguably most critical, mistake of the Fed was  contracting the money supply because they noted that banks were carrying a lot of reserves above and beyond what they were required to by law. The Fed thought that the excess reserves were a sign of inflation (i.e. there was too much money chasing too few goods), and they reduced the amount of money in circulation. The truth of the matter was that banks were holding excess reserves to stave off panic-induced bank runs. This meant that the contraction in the money supply could not have been at a worse time when people were already beginning to be leery about investing.

We are not going to see the same chain of events transpire this time. For one thing, while the Fed was new and nieve at the time, it is now headed by one of the foremost experts on the Great Depression, Ben Bernanke. This means that, while he is certainly capable of making any number of new mistakes, he is exceedingly unlikely to make the same ones that were made by his predecessor beginning in 1928. Second, while bank runs played a crucial role in the Great Depression, these devastating events seem less likely in an era in which we have the Federal Deposit Insurance Corporation (FDIC). With the federal government backing deposits (as long as you remember to divvy your money up into accounts of less than $100,000 each), panic-induced mattress-stuffing seems less likely.  

Can the levee break? That is, might people lose faith that the FDIC will be able to fully back their deposits? The government ultimately can make sure it is able to back these deposits because it has the unique solution of printing more money. Of course, just printing money is inflationary (the given amount of money you have is less valuable), but inflation fighting is not the major concern when one is trying to pull the country out of a deep recession. There is always a potential for panic if a critical mass of people pursues what they think is their individually optimal result, but is, in reality, a collectively devastating result. The situation is like the one described by Rousseau in his story about the Stag Hunt. In the stag hunt analogy, a tribe is trying to catch a stag to feed the village. They do this by encircling the stag and moving in from all sides, and by the time they get close enough for the stag to bolt from the trap it is nearly enveloped leaving no gaps in the circle to allow a route of escape. However, the challenge arrives in the guise of a rabbit that is quietly nibbling grass. Seeing the rabbit, one of the hunters is left in a quandary about whether to stick with the plan and end up with a possible feast (or possibly nothing) or follow the path that will, with greater certainty, provide a little something for himself and his immediate family. However, pursuing the rabbit almost ensures a disastrous outcome for the tribe (i.e. the stag will have a gap to run through.) Moving from analogy to the issue at hand, if enough people follow the “sure bet” of pulling their deposits, the loanable funds are removed from the system and the collapse is made imminent.

What are the elements of a modern day perfect storm? It appears that the core is that people are scared to invest their money because they don’t know if the institution in which they are putting their money is going to go belly up because it is holding a lot of bad loans (i.e. highly likely to be defaulted upon.) This basic story is often the route to economic crisis. The Asian Financial Crisis of the 1990’s was at least partially the result of the fact that people were investing money in those economies hand over fist. With so much money coming in, banks began to make loans that were progressively less sound. The Czech Republic had issues in the 1990’s, during their transition, in which the same people who were making loan decisions were the ones coming in control of most of the privatization vouchers. This created an incentive for them to make loans to firms that were not really creditworthy. Just as in the US, things seem really rosy until the defaults start to cascade. In the US, a profit incentive was created to make dubious mortgage loans, which were then packaged up as debt instruments so that there was little transparency- particularly because the rating system was broken as well. While it may not come down to everybody going to the bank and pulling out every dime they have, as they begin to reduce 401K contributions and otherwise reduce investment the vicious circle is born.

Beyond this central cause there are a number of potential exacerbating factors.  The share of consumption going to energy has risen considerably (meaning that individuals and firms have less to spend on all those other consumables that they used to buy.) We are so heavily indebted that there is a risk that foreigners will lose faith in dollar denominated assets and will engage in a massive sell off, and, in a related story, the system is so globalized that a crisis in the US could well be internationally contagious- meaning that there will not be a foreign cushion to loss of domestic consumption while foreign countries are experiencing their own recessions.

The fear at this moment is that people just wont see the whole picture. People are rightfully angered by the actions of people who were smart enough to know that the profit motive they were following could not end well, but put the whole economy at risk by collectively doing so anyway. However, there seems to be a sentiment, even among some Congressmen, that they should be allowed to go down with their ship. This would be an excellent notion if we were not all on the same ship as they.