Bubble Leading to a Depression

Two renowned economists, writing in the Wall Street Journal, claim that the Great Depression and the current economic crisis are eerily similar, in that the financial system has been virtually crippled as it absorbs huge sums of consumer debt.  

Steven Gjerstad, a visiting research associate at Chapman University, and Vernon L. Smith, a professor of economics at Chapman University and the 2002 Nobel Laureate in Economics, write that the parallels between then and now are numerous. 

"The events of the past 10 years have an eerie similarity to the period leading up to the Great Depression," they write.  "Total mortgage debt outstanding increased from $9.35 billion in 1920 to $29.44 billion in 1929.  In 1920, residential mortgage debt was 10.2% of household wealth; by 1929, it was 27.2% of household wealth." 

Just as then, the housing bubble which began in 1997, has witnessed an explosion of home ownership and consumer debt, fueled by government policies.   

"Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus: Mortgage loan originations increased an average of 56% per year for three years -- from $1.05 trillion in 2000 to $3.95 trillion in 2003," they writes.   

Unlike the previous housing bubbles, which burst in 1979 and 1989 respectively, the Federal Reserve took actions that only further expanded the bubble this time around.  Instead of pushing back against the bubble, the Fed increased the flow of money, making borrowing even easier and creating the conditions for the subprime market – which was the first to go bust.   

When those loans turned sour, the financial institutions were left to foot the bill on the defaulted mortgages.  In 2006, as loan defaults began to increase, the balance sheets of banks across the country began to take a serious hit.   

"When housing prices turned down, many borrowers with low income and few assets other than their slender home equity faced foreclosure,' they write.  "The remaining losses had to be absorbed by the financial system. Consequently, the financial system has suffered a blow unlike anything since the Great Depression, and the source is the weak financial position of the people holding declining assets."

Those losses at financial institutions crippled credit markets, and with them consumer spending, throwing the economy - reliant on consumer spending - into a downward spiral.   

"We are seeing this process playing out now as loan funds for automobile purchases have withered," they write.  "Auto sales fell 41% between February 2008 and February 2009.  Retail and labor markets too are now part of the collateral damage from the housing debacle.  Housing peaked in early 2006. Losses from the mortgage market began to infect the financial system in 2006; asset prices in that sector began to decline at the end of 2006.  Meanwhile, equities and the broader economy were performing well, but as the financial sector deteriorated, its problems blindsided the rest of the economy." 

During the Great Depression, "the remaining losses had to be absorbed by the financial system.  Consequently, the financial system has suffered a blow unlike anything since the Great Depression, and the source is the weak financial position of the people holding declining assets." 

» left by Grammy Guru (3 years 34 days ago.)

This was a great article. I read the WSJ and Financial Times, and get a more accurate picture of the economy and our current financial crisis than I do by listening to the news and reading the regular newspapers. I think those two economists are right on in their assessments. Good job.

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» left by robert melaccio sr (3 years 34 days ago.)

Alexia good article but remember there is no credit period for the meat and potatoes of this economy. Of course those that have will even prosper for the time being but even as they buy how much a can they? They forget without credit nothing moves and they have killed, not crippled killed the average working family, not going, going gone, gone. I'll give you and example right off the press. Ok for those of you who still think this president is for the average ordinary person, families, your neighbor about to get the boot, go to the government site and take the "qualifier". Yes his program even while he talks in the media of all the help on the way and surrounds himself with the lucky ones who got, hum? Yes help, once again lets use their terms for those who "qualify". Now who is that may we ask? Well go and take the test, his or anyone you know at- 

 

makinghomeaffordable

Good job, best wishes.

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» left by Connor Davidson (3 years 33 days ago.)

Great article. Well done.

 

There is some similarities yes. I doubt it will be as bad thought.

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