The Great Depression...and Now (updated 6-09)

While listening to Simon Johnson on Bill Moyer's Journal tonight, it struck me that the primary cause of the Great Depression, the main factor that deepened then prolonged the 1929-30 recession, isn't clear for many people. Near the end of the first segment in Moyer's program, Simon quips that economists will still be debating the Great Depression 50 years from now. While some may, I believe we can decipher these events in a way that will decisively end the general debate soon.

When I reflect on the hundreds of articles and blog posts I've read on the Great Depression and our situation now, and on my own evolving thoughts over the last two years, one fundamental economic process stands out in this grand worldwide train wreck. Let me illustrate this decisive force and its play within the complex string of events.

The 1929 recession came after a period of significantly increasing consumer installment and mortgage debt. When a growing stock speculation bubble continued in 1928, the Federal Reserve raised rates to slow the expanding stock borrowing. A recession began in the summer of 1929, which in turn helped destabilize the stock market bubble, leading to the October crash, which contributed to a reduction in demand and availability of consumer credit. As job losses mounted from the 1929 recession into 1930-1931, increasing numbers of bank loans went bad, which made more and more banks reluctant to lend just as more consumers became reluctant to borrow. Banks were taking in payments from those able to pay on their (still significant) debts, but not lending out much. This was a reversal of the run-up in credit, and the deflation which followed made debts harder to pay and the balloon mortgages unrefinanceable.

Various other effects further crimped demand and income: tax increases meant to gather more revenues from those still working, and trade wars which destroyed jobs in export industries.

As the job losses and fear mounted, many with jobs became more cautious in spending what they had. The circle of reduced spending leading to job losses which in turn further reduced spending drove the economy downward towards its essentials, its base, where what was being produced and sold were largely necessities. The slide continued under its own momentum.

By early 1933, this process had advanced far enough and long enough that the remaining demand and economy still in operation was the harder stuff of necessity. From this point, it should be no surprise that Roosevelt and Congress were able to quickly halt the downward drift and move things upward by ending the bank runs for the surviving (hardier) banks with new FDIC insurance, by widening economic rescue efforts, and by calming the people with fireside chats.

By 1933 the weak, frothy parts of the 1929 economy were all gone, and only the strong, hard base remained, ready to build upon.

Nevertheless, people had been trained into frugality by this time, and the debt burden was still significant. It would take years of gradual psychological gains in general confidence and the gradual development and appearance of new products and new wants to strengthen and broaden the economy so that more and more people could find work. Time was required to re-weave economic fabric exactly because so many who had lost jobs were also broke and had unpaid debts, so that even when they worked they were still miserly. World War II capped this process of slowly building up jobs and paying down debt, ending the remaining lack of demand and unemployment and accelerating technological innovation. By the end of the war, the U.S. was prepared in all essential ways for significant economic growth -- with increased general confidence and new technology ready to be put to work -- and only needed to be turned loose from wartime governmental control, which is exactly what happened next.

An analogy for America and its economy of 1928-1945 would be a story that starts with a drunk driver on a mountain road.

Drunk on overindulgence (stock speculation and debt) and driving too fast, our Driver careens into roadside trees at high speed (October 1929). But then worse, our hero tumbles down the cliff face (1930-31), taking further injuries, and finally goes without help or food for days (1931-33).

After what seems an eternity, our desperately injured Driver is finally rescued and put in hospital for a long, slow recovery (1933-1940). After gradually regaining health in this painful, slow recovery, our patient is then put into a strenuous, lengthy physical therapy program (WWII).

Finally, our Driver is released one day (1945), after what seems ages, now hale and full of strength and power, his confidence restored. He is a new man.

...

Will it take us 10 or 12 years to get back to a thriving economy?

Only if we have years of downward spiral, which is a threat due to the weight of household debts. And for the "thriving" part -- only if we undergo serious re-conditioning.

But our tumble down the cliff (joblessness) is being seriously fought and contested by the Fed and the Federal stimulus program, with multiple ropes.

Our modern Accident included air bags.

Rescuers are hard at work, bringing the Driver water and oxygen through the broken car window, hanging by ropes on the face of the cliff.

We may not need a 12-year recovery -- we have not yet suffered 1931-1933.

The ropes are creaking, and several have snapped or slipped off, but others have been hurriedly attached.

Nothing is clear yet at this point. ...Except, perhaps, that the old jalopy is totaled.

Nothing is certain. The car may yet go tumbling, or the ropes may hold.


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Update: Here is a good source of ongoing world economy graphs showing our progress vs. the Great Depression. It takes time for the effects of the stimulus program, and also of general confidence to show up in this kind of data. Perhaps by late summer we will have a better idea whether the world economy can deviate upward from the Great Depression trends we have followed so far.

Congressional Oversight Panel's Hearing with Sec. Geithner

For those wanting the complete video of the Congressional Oversight Panel's hearing with Sec. of the Treasury Geithner click here. The hearing starts around 17.5 minutes into the video (expanding the video size can help with adjusting the time slider).

Starting at about 50.5 minutes, Geithner offers an overview of the current economy-wide credit situation and broad economic goals, concluding everyone's opening remarks/statements. (The opening statements of panel members earlier will be interesting to many). Questions and answers follow.

Just past 66 minutes, comes Citigroup -- the issue (discussed on this blog here and here) of how little equity (future upside potential) taxpayers have gotten in return for all their money and having taken on the massive risk of bad Citigroup securities. This is a major question.

The question on Citi from Silvers here includes interesting charts and seems headed to the central issue of whether taxpayers have the appropriate upside potential in Citigroup that our taxpayer dollars should reasonably purchase. But then Silvers clouds this essential question with the irrelevant issue of exchanging the weak seniority of the current taxpayer-owned TARP-1 preferred shares (more "senior" investments take losses after other classes of investment lose first if Citi goes into receivership or gets restructured) vs. common shares (aka "equity", which takes losses first). Being second in line for losses after common shareholders is practically being first in line for losses (as the common stock would already be near $0, since the net value of Citi would presumably be significantly negative in that scenario, or only of value because of use of the taxpayer-funded guarantees of much of Citi's risky securities). Put another way, if taxpayer guarantees of Citi's risky holdings protect common shareholders enough for Citi stock to have value, then will taxpayers receive an appropriate amount of Citi stock in the end (regardless of stock price) if those guarantees cost taxpayers significantly? In other words, the question of seniority clouds the real issue.

The real issue is entirely whether taxpayers have upside in Citi in proportion to their total funds put into Citigroup including the taxpayer guarantees of risky Citi securities after a restructuring or massive actual guarantee costs. i.e. -- would taxpayers get a proportional share of new stock like any typical debt-for-equity swap (where bondholders and other bank creditors get stock in exchange for their loans to a business being restructured). Silvers recovers somewhat at the end, asking a more open general question, but the cloudiness makes the obscures the broad question.

Geithner then gives the standard response about saving the entire economy as being the taxpayer upside. Of course, Geithner cannot suggest Citi is insolvent (or would have been without the massive blank-check-like guarantees). As Sec. of the Treasury, he cannot suggest any particular bank is in any particular condition, until after the fact. But he does not address the essential question about why the rescue of Citi involves so little upside for taxpayers.

We can rescue Citi with or without transferring taxpayer wealth to rich bank investors.

Question we'd like to hear: "Why are we effectively transferring so much taxpayer wealth to bank investors when it was not necessary in order to rescue Citigroup or for bigger goals of restoring credit and system-wide stability?"

I use present tense because we do not have to make bondholders (senior bank investors) 100% whole at taxpayer expense. These bonds are already at some market discount (below their original value) exactly because they rely on what will likely become a semi-political decision as to what degree of losses they may eventually take. We should define that possible "haircut" precisely ahead of time, to remove uncertainty, and thus encourage private capital, as the Secretary no doubt wishes to do.

It's fair to guess that Geithner wishes to avoid adding extra complexity. Congress should specify the precise losses bank investors take in a restructuring or massive taxpayer guarantee infusion of funds so that the question is resolved. The "haircut" link just above is an example of how to do that.

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There is much more in the hearing, and many will find it rewarding.

I especially recommend just past 84.5 minutes, where Warren raises the big picture issue of just what is on the table to address failing banks.

IMF: $2.7 Trillion in Losses from U.S. Loans

The Wall Street Journal reports the IMF estimate of total financial system losses from 2007 through 2010 from bad U.S. loans to be $2.7 trillion dollars, and over $4 trillion from bad loans around the entire globe:

U.S. and European banks need to raise $875 billion in equity by next year to recapitalize banks to a level similar to the pre-crisis years -- and twice that amount to match the level of the mid-1990s, the International Monetary Fund estimated.

The steep funding requirements reflect a financial crisis that the IMF said continues to deepen along with the global recession. The banking sector's woes have spread from the housing sector to commercial real estate loans and emerging-market debt. Overall, the IMF estimates that the U.S., European and Japanese financial sectors face losses of about $4.1 trillion between 2007 and 2010. Of that amount, banks are confronting $2.5 trillion in losses, insurers $300 billion and other financial institutions $1.3 trillion.

The banking sector has already written down $1 trillion of those losses, said the IMF, which didn't estimate how much other financial firms such as insurance companies and hedge funds, have written down thus far.

"Without a thorough cleansing of banks' balance sheets of impaired assets, accompanies by restructuring and, where needed, recapitalization, risks remain that banks' problems will continue to exert downward pressure on economic activity," said the IMF's Global Financial Stability Report, its twice-yearly review of the world's financial sector.

While problems in the U.S. mortgage sector are generally blamed for the global financial crisis, the IMF report, showed there other regions played a big role too. About $2.7 trillion of the losses from 2007 to 2010 were attributable to the U.S. market, the IMF reported, while about $1.2 trillion came from bad loans and security losses in Europe.

U.S. banks have written down roughly half their anticipated $1.06 trillion in estimated losses from 2007 to 2010, the IMF said...

NPR Jewel on the "New Normal"

I've had this jewel in a window for several days, and after listening again tonight, I thought I should offer it here:

NPR: Economic Downturn Signals a New Normal

Elizabeth Warren Offers a Clear, Comprehensive Review of the Situation with Banks

The author (co-author) of the great "The Two Income Trap", which explains one of the key facts and seeming contradictions of the modern American economy -- how a two-earner family can become less secure than a one-earner family through competitive bidding with other families to buy expensive homes in neighborhoods with good schools -- brings us more of her clear, insightful thinking below. This is a great overview of the entire banking situation and our options in a scant 8 minutes. Warren shows why she was chosen as a key public watchdog to report to Congress on this entire mess, and I recommend this video for anyone interested in this subject, from experts to those wanting to digest a well-explained summary in a few minutes. (Also see interesting excerpts from the full report and my comments after the video.)




The report is here.

Two highlights of many:

In addition to drawing on the $700 billion allocated to Treasury under the EESA, economic stabilization efforts have depended heavily on the use of the Federal Reserve Board’s balance sheet. This approach has permitted Treasury to leverage TARP funds well beyond the funds appropriated by Congress. Thus, while Treasury has spent or committed $590.4 billion of TARP funds, according to Panel estimates, the Federal Reserve Board has expanded its balance sheet by more than $1.5 trillion in loans and purchases of government-sponsored enterprise (GSE) securities. The total value of all direct spending, loans and guarantees provided to date in conjunction with the federal government’s financial stability efforts (including those of the Federal Deposit Insurance Corporation (FDIC) as well as Treasury and the Federal Reserve Board) now exceeds $4 trillion.

What this is saying: The Treasury Dept. is working in tandem with the Federal Reserve, and using the Federal Reserve's ability to create new money by just printing more of it and buying bonds and securities to effectively double down and triple down and quadruple down (well...etc., you get the idea) on their bet -- the uncertain gamble that bailing out various types of lending, from auto loans to credit cards, will work out for the best.

If it doesn't work out, if the loans go bad en masse, then the Federal Reserve could lose considerable capital. But that capital value is stored ultimately in the value of the dollar itself, what you and I rely on to conduct our economic lives. In other words, if the Fed loses, you and I are the actual ones that lose.

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The second highlight:

[One of several questions from the oversight panel to Sec. of the Treasury:]

2. The thrust of the TALF [the Fed's latest way to lend more money] appears to be to attract investors with large enough pools of capital, such as hedge funds, to the ABS [Asset-Backed Securities, or basically all sorts of lending packaged into a type of bond] market by allowing them to purchase ABS on a highly leveraged basis with risk of loss largely transferred to the taxpayer directly or, through the Federal Reserve System, indirectly, in a manner that confers substantial benefits on these private investors who have little at stake. Please explain in detail the rationale for such a transfer of risk to the taxpayer with so much of the benefit transferred to private investors and please provide the facts and figures that support this rationale.

[Geithner's response:]

"...Because the questions you have raised pertain primarily to the structure and operation of the FRBNY [Fed. Reserve Bank of NewYork] lending facility [TALF], FRBNY staff has taken the lead in responding...." [Note Treasury Sec. Geithner was the FRBNY president previous to his current post.]

The detailed response by the FRBNY below points out the risk capital (private investors' money) which those taking TALF loans put up (and if their gamble goes bad due to bad loans, they lose part or all of their risk capital; this is referred to as a "haircut" in the response), the risk-premium interest rate such TALF loans carry, and...this notable, perhaps hopeful, bullet point:

[excerpt from FRBNY response:]

"The current economic situation is extraordinary and the outlook is therefore especially uncertain. We accounted for that uncertainty by making very conservative assumptions when calibrating the haircuts. The haircuts are designed so that, even if the economy evolves in a manner significantly worse than we currently expect, all credit costs will be more than covered by the haircuts and the excess interest rate spread paid by investors, resulting in no credit losses for the Treasury or Federal Reserve."

hmmmm....

Let's hope so.

This is as well designed as can be, no doubt.

It's a gamble though.

A reasonable gamble. A double or triple-down.

In the end, it's reasonable to try to save the old system, to try to make it as easy as possible to get a car loan or a credit card for those that want to buy on credit. The only primary danger in the wide range of governmental efforts to prop up parts of the old status-quo I see is maintaining semi-dead corporations (including banks) that can't really flourish long-term without real restructuring, and thus crowding out better competition (such as better-managed banks) that might replace the subsidized corporations with something much better if they had the open space and opportunity.

But...too much household debt (vs. income) was and is the problem (see here, here, here and here.) We still need to reduce consumer (personal) debt, and the faster this finishes the better, and here's how to speed this up.

Poll: 70% Have Cut Back on "Luxuries", 40% on Necessities

Forty percent said they had cut spending on luxuries, and 10 percent said they had cut back on necessities; 31 percent said they had cut both. -- New York Times/CBS Poll

Of course, if 40% have cut back on luxuries, and another 31% on both luxuries and necessities, then 71% have cut back on luxuries.

But the stark number is the total of about 40% that have cut back on necessities.

This leaves open the question of whether eating out is considered a luxury or a necessity by respondents. But if eating out is a luxury for many now, then what necessities might be cut by as many as 40% of Americans? Variety of food eaten at home might be one necessity that could be cut back on. Auto maintenance might be another. Health care is certainly being cut back on by many.

We can only hope that the necessity of good nutrition is not being cut back too much by too many.

Americans took on an additional $5 trillion in mortgage debt from 2001 to 2007. Since roughly 51 million homes had mortgages at the end of 2008, this amounts to roughly $100,000 more mortgage debt owed on the average home than in 2001. Even at a favorable mortgage rate of 5.25% for instance, that $100,000 costs about $550/month in extra mortgage payments vs. payments levels of 2001, for an average home. Of course, some owe the same payment as in 2001 (not having moved or refinanced or taken money out), but many owe an extra amount considerably more than this average.

The interest cost of $5 trillion at 5.25% is some $260 billion per year.

That $260 billion per year (eased down a small bit with every foreclosure) is money that could have been spent in the economy on other goods and services, resulting in diverse and lasting employment for many millions of Americans.

This extra mortgage interest over just 3 years is about as large as the stimulus package.

This is what we are up against.

But there is one form of great relief and source of new strength for the U.S. economy in this dark reality.

With as many as 8 million foreclosures by 2012 (one estimate), possibly as much as $2 trillion of this debt burden could be removed from households (who become renters at typically much lower monthly costs).

Such a large amount of debt-relief (monthly living cost relief) would help the economy immensely.

We have a ways to go yet, as only 1.4 million foreclosures have accumulated since July 2007.

But Congress, which appears at times in thrall to vested interests or under the spell of clever lobbyists, does not appreciate the crucial economic stimulus foreclosure debt-relief brings to the U.S. economy. House prices return back to normal levels sooner due to foreclosures, allowing a recovery in buying (and eventually building) sooner.

We need a clearing, a chance for people to get out of homes far too expensive for them. We need these Americans back -- back in the economy -- able to live in a more economically participating way: with money to spend on more than only a gigantic mortgage payment (any payment more than around 1/3 of income). We have yet to see whether large numbers will benefit from Obama's foreclosure prevention plan to ease payments down to 31% of income. But many underwater home owners would often be better off, and the economy in turn, to let go of a home that is too expensive, lowering their monthly shelter costs even further, and have more money to spend on the other parts of life.

Such as the necessities.