Wednesday, March 26, 2008


This is a nice little article from Robert Samuelson (fyi, a really smart economist guy) about why the current financial "crisis" and "turmoil" is not the beginning of the end of the world.

We just covered the Great Depression in my intermediate class, and then compared it to the current situation in the U.S.. For the current situation to generate anything approaching the Great Depression, we would have to see GDP shrink by 7% a year for four straight years. Current estimates are flat GDP or possibly a loss of GDP this year of 0.4% - and then next year we'll grow again. In the Great Depression, unemployment went from 3.2% to 25% - currently unemployment is about 4.8% and estimates suggest it might go to 6-6.5%. So even if we DO enter a recession, it's not even close to economic collapse. In fact, this recession will very likely be milder than the 1980-82 recession or 1973-75.

So why do people suggest that the current situation is like the GD? Probably because both seem to be initiated by financial collapse. In 1929 the stock market crashed. In late 2007 the housing bubble burst. In both cases the financial corporations had run up huge debts to each other to finance investments - and suddenly everyone wanted to be paid back. The credit markets seized up and banks were unwilling to loan to each other. So far, things in 1929 and things in 2007-08 look the same.

Why won't we go down the same path towards GD as they did in 1929? Here's three big reasons
1) Deposit insurance. You know that FDIC sticker on the door of your bank? That means you have Federal Deposit Insurance, to the tune of up to $100,000. So if your bank were actually to fail (and remember, Bear Stearns is NOT a bank), then you would still get your deposits back. In 1929, the FDIC did not exist, and so people panicked and started runs on the banks to withdraw their money. This was self-fulfilling and thousands of banks failed, and millions of people lost their savings. (Remember the end of "It's a Wonderful Life"? That's a bank run). Today, are you so worried that you think you should keep your cash under the mattress? No? That's because of the FDIC.

2) Inflation. Perhaps the biggest problem in 1929-1933 was falling prices. Not just slow inflation, but DE-flation - prices were falling. Sounds good, huh? Well, ask yourself what falling prices do to your incentives to spend. Should I buy that new DVD player today, or wait 6 months for the price to drop another $50? Should I open that new store, or wait 6 months until wages, building materials, and inventory are cheaper? Once everyone thinks prices will fall, everyone waits to buy things. If everyone waits to buy things, then current economic activity collapses. If current economic activity collapses, prices tend to fall - and the whole process is self-fulfilling and generates a downward spiral.

Currently, people are worried not about deflation, but rather inflation. Prices are rising, and maybe "too fast" (whatever definition you use for that). So we do not have this potential death spiral that sent the U.S. down the path to the Great Depression.

3) Smarter Fed. Macroeconomics did not exist until after the GD, because people were trying to figure out what caused the GD. The current chairman of the Fed, Ben Bernanke, made his name by explaining the causes of the GD. The Fed today understands what their role should be in this situation. In 1929, the Fed tried too hard to keep the exchange rate high (because we were on the gold standard), and therefore did not act aggressively to raise the money supply. If they had, they might have avoided the deflationary death spiral. Today, the Fed is more aware of this danger, and so is happily pumping liquidity into the markets to keep deflation from occurring.

Now, whether or not you agree with the Fed's policy of "bailing out" Bear Stearns or other financial institutions that made dumb bets on mortgages, to avoid big recessions (much less the GD) it is necessary to pump money into the economy. The Fed can try to do this without bailing out idiotic investment banks, but its likely that some idiots will get bailed out in the process. However, the actions are probably necessary beause to punish the "bastards" that did this, you'd have to endure a more severe recession.

To sum up - calm down.

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