by John Paul Rossi on Nov 27, 2008
The United States is in the midst of the worst financial crisis since the Great Depression. The question is: How close are we to another Great Depression?
The answer is: Very close. Here's why.
The Great Depression was the result of the combination of the 1929 financial crisis and serious structural problems in the American economy such as widespread poverty. After the 1929 stock market collapse these factors cut deeply into business investment and personal consumption. The consequence was a downward spiral that created the worst economic collapse in American history.
Today's economy is hurtling downward on a similar path. The mortgage and financial crises have constricted credit and largely cut off business investment. Stagnant wages and over-borrowing have curtailed consumer spending.
The collapse of a stock market bubble in 1929 triggered the chain of events that led to depression. When stock prices fell in October 1929, investors, financial institutions and banks were caught overextended. The fall in stock prices produced a financial panic that bankrupted many. To repair damaged balance sheets, surviving banks and financiers dramatically reduced lending. The result was a long and steep decline in economic activity.
Much as in 1929, the 2008 collapse has been the consequence of a speculatory bubble, this time in real estate. It was pumped up by over-lending by banks and financial companies and over-borrowing by Wall Street. Rising interest rates helped burst the bubble. Subsequent property owner defaults caught investors, financiers and businesses holding mortgages, or investments based on them, short. Enormous losses for investment firms and banks followed. Despite government bailouts and aid, the country's surviving major banks have severely cut lending.
The 1920s stock market bubble hid serious structural problems in the underlying economy. The same is true for the real estate bubble in the 2000s.
In the 1920s widespread poverty and an inequitable distribution of wealth contributed to the depression of the next decade. In 1929 42 percent of American families were living in severe poverty. Consumer credit provided some purchasing power to those in society's bottom half, but by the end of the 1920s that group had exhausted its borrowing power. The bulk of the U.S. economy's income went to the to top 1 percent of the nation's families, who earned the same amount as the combined income of the bottom 40 percent.
A similar situation occurred at the end of the 1990s when workers' wages stagnated while the income of the wealthiest Americans rose. By 2003 the distribution of income had reached the 1929 point, with the richest 1 percent of families received the same income as the bottom 40 percent.
The decline of working Americans' income was somewhat masked by rising real estate and stock prices, as well as the rapid extension of consumer credit. To maintain their standard of living, middle class Americans turned to borrowing more through credit cards and home equity loans. By 2006 these practices had turned Americans' savings rate negative — its worst performance since the Great Depression — as many spent more than they earned.
The 1929 financial collapse combined with poverty and the distribution of income to significantly cut spending for all levels of American society. Demand was down, businesses could not get the credit needed to finance operations and employees were laid off. Declines in business and worker income followed, consumption dropped, and firms went bankrupt. This caused yet more banks to fail and created a downward spiral.
A similar process is underway now. The collapse of housing and stock prices and the credit freeze cut off borrowing as a means to support middle class consumption. Even worse, too many of those who over-borrowed are unable to pay; they're now defaulting on their mortgages, car loans, and credit-card debts. The result is rapidly falling levels of spending and consumption. These consumption declines are merging with the constriction of bank credit; many companies cannot get even short term loans to carry on operations.
Much as was the case in 1929 the twin declines of consumer and business spending are rippling through the economy. They're causing worker income and general consumption to fall and bringing on mounting layoffs. As unemployment rises, more individuals will be unable to pay their debts and additional personal and business bankruptcies will follow. This means more bank and investment company failures and bailouts.
The American economy in 2008 is following the same path it took in 1929. The collapse of a speculatory bubble has merged with problems of the distribution of wealth, working Americans' incomes and consumption. The consequence is that the economy is rapidly spiraling downward into the next great depression.
John Paul Rossi is an associate professor of history at Penn State Erie, The Behrend College. He writes on business and economic history and is a writer for the History News Service.