Time2008-10-13

October13,2008Vol.172No.15TheNewHardTimesPHOTOGRAPHFROMCORBISBETTMANN.INSETS,FROMLEFT:JOSEPHCONNOLLY/GETTY;JAMESNACHTWEY/VII;BERTSIX/MPTVCOVERTheEndofProsperity?ByNiallFergusonThursday,Oct.02,2008Chicago,1931CorbisCongress'sinitialrejectionoftheBushAdministration's$700billionbailoutplancallstomindanunhappyprecedent.Backin1930,theSenatepassedtheSmoot-HawleyTariffAct,whichraiseddutiesonsome20,000importedgoods.HistoriansdefinethisasoneofthecriticalstepsthatledtotheGreatDepression—atippingpointwhentheworldrealizedthatpartisanself-interesthadtrumpedgloballeadershiponCapitolHill.It'sfairtoaskwhetherAmerica'slawmakerscoulddoitagain.Theburstingofthedebt-fueledpropertybubbleandthecripplinglossessufferedbybanks,togetherwiththepoliticalditheringofrecentdays,havesetinmotionachainreactionthat,intheworst-casescenario,couldleadtosomethinglikea21stcenturyversionoftheDepression—evenifabailoutpackagedoeseventuallygetapproved.TheU.S.—nottomentionWesternEurope—isinthegripofadownwardspiralthatfinancialexpertscalldeleveraging.Havingaccumulateddebtsbeyondwhat'ssustainable,householdsandfinancialinstitutionsarebeingforcedtoreducethem.Thepressuretodosoresultsfromadeclineinthepriceoftheassetstheyboughtwiththemoneytheyborrowed.It'saviciousfeedbackloop.Whenfamiliesandbankstipintobankruptcy,moreassetsgetdumpedonthemarket,drivingpricesdownfurtherandnecessitatingmoredeleveraging.Thisprocessnowhassomuchmomentumthateven$700billionintaxpayers'moneymaynotsufficetostopit.Inthecaseofhouseholds,debtrosefromabout50%ofGDPin1980toapeakof100%in2006.Inotherwords,householdsnowoweasmuchastheentireU.S.economycanproduceinayear.Muchoftheincreaseindebtwasusedtoinvestinrealestate.Theresultwasabubble;atitspeak,averageU.S.housepriceswererisingat20%ayear.Then—asbubblesalwaysdo—itburst.TheS&PCase-Shillerindexofhousepricesin20citieshasbeenfallingsinceFebruary2007.Andthedeclineisaccelerating.InJunepricesweredown16%comparedwithayearearlier.Insomecities—likePhoenixandMiami—theyhavefallenbyasmuchasathirdfromtheirpeaks.TheU.S.realestatemarkethasn'tfacedanythinglikethissincetheDepression.Andthepainisnotover.CreditSuissepredictsthat13%ofU.S.homeownerswithmortgagescouldenduplosingtheirhomes.Banksandotherfinancialinstitutionsareinanevenworseposition:theirdebtsareaccumulatingevenfaster.By2007thefinancialsector'sdebtwasequivalentto116%ofGDP,comparedwithamere21%in1980.Andtheassetsthebanksloadeduponhavefallenevenfurtherinvaluethantheaveragehome—byasmuchas55%inthecaseofBBB-ratedmortgage-backedsecurities.Todate,U.S.bankshaveadmittedto$334billioninlossesandwrite-downs,andthefinaltotalwillalmostcertainlybemuchhigher.Tocompensate,theyhavemanagedtoraise$235billioninnewcapital.Thetroubleisthatthenetlossof$99billionimpliesthattheywillneedtoshrinktheirbalancesheetsby10timesthatfigure—almostatrilliondollars—tomaintainaconstantratiobetweentheirassetsandcapital.Thatsuggestsadrasticreductionofcredit,sinceabank'sassetsareitsloans.FewerloansmeantighterbusinessconditionsonMainStreet.Yourlocalcardealerwon'tbeabletogetthecreditheneedstomaintainhisinventoryofautomobiles.Tosurvive,he'llhavetolayoffsomeofhisemployees.Expecthigherunemploymentnationwide.AnyonewhodoubtsthattheU.S.isheadingforrecessionislivingindenial.Onanannualizedbasis,realretailsalesandindustrialproductionarebothdeclining.Unemploymentisalreadyatitshighestlevelinfiveyears.Thequestioniswhetherwe'reheadedforashort,relativelymildrecessionlikethatof2001—oralatter-dayversionofwhattheworldwentthroughinthe1930s:Depression2.0.TheHistoricalParallelsWetendtothinkoftheDepressionashavingbeentriggeredbythestock-marketcrashof1929.TheWallStreetcrashisconventionallysaidtohavebegunonBlackThursday—Oct.24,1929,whentheDowJonesindustrialaveragedeclined2%—thoughinfactthemarkethadbeenslippingsinceearlySeptember.OnBlackMonday(Oct.28),itplunged13%,thenextdayafurther12%.Overthenextthreeyears,theU.S.stockmarketdeclinedastaggering89%,reachingitsnadirinJuly1932.Theindexdidnotregainits1929peakuntil1954.OnSept.29ofthisyear,asinvestorsandtradersreactedtoCongress'srejectionofthebailoutplanpresentedbyTreasurySecretaryHankPaulson,thestockmarketsell-offwasdramatic:theDowfellnearly7%thatday,aone-daydropthathasbeenmatchedonly17timessincetheindex'sbirthin1896.FromitspeaklastOctober,theDowhasfallenmorethan25%.YettheunderlyingcauseoftheGreatDepression—asMiltonFriedmanandAnnaJacobsonSchwartzarguedintheirseminalbookAMonetaryHistoryoftheUnitedStates:1867-1960,publishedin1963—wasnotthestock-marketcrashbutagreatcontractionofcreditduetoanepidemicofbankfailures.Thecreditcrunchhadsurfacedseveralmonthsbeforethestock-marketcrash,whencommercialbankswithcombineddepositsofmorethan$80millionsuspendedpayments.Itreachedcriticalmassinlate1930,when608banksfailed—amongthemtheBankoftheUnitedStates,whichaccountedforaboutathirdofthetotaldepositslost.(ThefailureofmergertalksthatmighthavesavedthebankwasanothercriticalmomentinthehistoryoftheDepression.)AsFriedmanandSchwartzsawit,theFedcouldhavemitigatedthecrisisbycuttingrates,makingloansandbuyingbonds(so-calledopen-marketoperations).Instead,itma