The Financial Market
There is a crisis of confidence building in the system. Trust has eroded between institutions, not unlike the conditions that existed during bank runs at other times in our history. Some economists contend that this crisis of confidence is due mostly to the psychology created by the rhetoric of our political leaders:
"The isolated storms in housing, finance and energy, are now being exaggerated by excessive government intervention (on a knee-jerk basis), mark-to-market accounting and panicky words from political leaders. As a result, consumers are pulling back, credit is being squeezed even to solid, well-run businesses and the economy is being threatened by this spreading panic."
This idea seems supported by the fact that, while the financial panic reminds us of the 1930s, there are more differences than similarities:
If you look at the data, you will see more differences than similarities between the 1930s and today:
- In the crash of 1929 the Dow Jones industrials plunged 40% in two months; this time around it has taken a year to fall 22%.
- The jobless rate jumped to 25% by 1933; it is little more than 6% today.
- The gross domestic product shrank by 25% during the early 1930s; it is up over 3% during the past year.
- Consumer prices fell by about 30% from 1929 to 1933; and the last time I looked they were still rising.
- Home prices dropped more than 30% during the Depression vs. about 16% today.Some 40% of all mortgages were delinquent by 1934 compared with 4% today.
- In the 1930s, more than 9,000 banks failed compared with fewer than 20 over the past couple of years.
Remember also it was policy errors, not the stock market crash, that caused the Great Depression:
- Instead of increasing the money supply, the Federal Reserve of that era reduced it by one-third.
- Instead of lowering taxes, Herbert Hoover raised them.
- And to channel whatever demand was left into U.S.-made goods, the government enacted the Smoot-Hawley Tariff Act to keep out foreign products; this only provoked our trading partners to do the same.
Of course, if credit continues to dry up, the money supply may actually contract, regardless of Federal Reserve action. As banks lose confidence, they pull in capital and don't use it to create new capital. The Wall Street Journal suggests three criteria for a plan to recapitalize the system:
Any plan has to fulfill at least three objectives: It has to have a real chance of preventing the deep and prolonged recession that is likely to ensue if the financial system is not recapitalized. It should strive to achieve that first objective at the lowest possible costs to the U.S. taxpayer. And it should not bail out the existing investors to avoid sowing the seeds for the next crisis.
The article goes on to offer suggestions on how to fix the current proposal to achieve these goals, but it seems to me that there are a few other things to consider.
The reasons for the difference in the 30’s and today are many, but most are related to the fact that, in reaction to the bank runs of the 1930s, we built a system designed to prevent them in the future. This system relies on the Federal Reserve as a lender of last resort, and the transaction account deposit insurance of the FDIC.
This security system was designed to create confidence in the banking system, which back then was most of the financial system. Today, banks are no longer the only substantial portion of the financial system, and this is why we have seen the Federal Reserve expand its lending to non-banks.
Where the Fed is adapting its role as lender of last resort to the new financial system, the old FDIC limit of $100,000 is no longer adequate to serve its purpose and must be raised or eliminated to create a refuge of confidence in the system. Raising this limit and creating this refuge for capital could also help recapitalize banks by encouraging deposits to return.
In any case, adapting the old safety system to the new reality of the financial market, or even bailing out bad decisions can not accomplish what is necessary for our economy to recover from this massive loss of wealth: economic growth. Lawrence Summers points out that:
Indeed, in the current circumstances the case for fiscal stimulus -- policy actions that increase short-term deficits -- is stronger than ever before in my professional lifetime. Unemployment is almost certain to increase -- probably to the highest levels in a generation. Monetary policy has little scope to stimulate the economy given how low interest rates already are and the problems in the financial system.
If we really want to speed recovery, it is time to address the fact that the US has the second highest corporate tax burden in the world and cut taxes that improve the long-term health of the economy.