Before we get started, a quick clarification and correction. First, a friend of mine pointed out last week that the Gramm-Leach-Bliley Act did not contribute to the financial meltdown; instead, its permission of mergers helped stabilize the financial system by letting healthy corporations subsume unhealthy ones. I did some digging; the criticism is half-right. What is important is that the Glass-Steagall Act prevented commercial banks from underwriting securities - which, if I understand correctly, is precisely what happened with mortgage-backed securities. So the merging of financial corporations wasn't so much responsible for the crisis as commercial banks underwriting securities with mortgages as collateral.
With that out of the way, let's go to the past for lessons about this downturn and talk about the Great Depression - more correctly known as the recession of 1929-1933. What caused it? The primary cause was monetary: the Federal Reserve felt lending was getting out of hand and contracted the money supply in 1928. As a result, the economy started to contract in August 1929, and the bottom fell out of the stock market in October, wiping out wealth.
The effects of the stock market crash and tightening credit spread through the financial system, causing banks to fail. This led to a failure of confidence in the banking system and waves of bank runs, which caused more banks to go out of business, credit to tighten further, and more people to pull their money out of the financial system.
For three and a half years, banks fell across the country. Nobody would lend to anybody, so the growth engine couldn't get started. The money supply meanwhile dropped by nearly a third as a result of bank failures: by lending, banks increase the velocity of money and hence the effective money supply, so if banks stop lending, the effective money supply decreases. This deflation also dampened growth: since people expected the value of money to continue rising, investments ground to a halt.
This continued until the inauguration of Roosevelt in March 1933. He declared a bank holiday to restore trust and confidence in the financial system. He also passed the New Deal in several components over the next couple of years. Some parts of the New Deal - such as the FDIC, the SEC and the removal of the gold standard - were excellent for economic recovery; other measures - such as the Smoot-Hawley Tariff Act and union protections - continued to depress the economy.
What's happening now? When the supply of easy money slowed in 2006, the housing market peaked and started to decline, wiping out the value of households' assets. While the effects of rising mortgage defaults percolated through the financial system in 2007 and 2008 and lending froze, the overall level of demand for goods and services began to drop.
Why did it drop? Businesses couldn't easily borrow to invest, so they began to lay off workers. These laid-off workers cut back on purchases, while other families struggled to meet their mortgage payments as the value of their home dropped. The recession officially began in December 2007; general state of the economy worsened through 2008. In fact, during the last quarter of 2008, demand for goods and services fell so quickly that businesses didn't have time to cut back production.
How do we fix this? This is where economic stimulus comes in. By spending money, the government can put people back to work and get money moving through the economy. This will raise the general level of consumption and jump-start growth. That's the theory behind the $720 billion stimulus package now before the Senate.
But several important caveats are in order. First, the stimulus is entirely financed by deficit: it raises taxes on the future, which means that it comes out of our wallets and our children's wallets. Second, if the financial sector isn't whipped back into shape, this isn't going to prompt any sustained growth. And third, as we learned from the Great Depression, some measures that seem to be helpful - such as protectionist "Buy American" clauses - are actually counterproductive.
The proposed government spending is going to affect us all: if it starts the economy in the next three years, we'll be more likely to find jobs out of college; but if it's too large or fails, we'll be saddled with debt much greater than our parents'. That's why we need to talk about it and reason through it: to make sure we understand what's in it for us.
Write to Neal at necoleman@bsu.edu
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