DAVID

WHEELOCK

The Great Depression Q&A

Recently, St. Louis Fed Economist Dave Wheelock sat down to answer some questions about some parallels between the current economic recession and the Great Depression. Can you draw some parallels between the financial trauma of today and the financial trauma of the Great Depression? This is the worst financial crisis since the 1930s. However, the financial crisis of the 1930s was very different from the financial crisis that we have now. The crisis of the '30s was obviously punctuated by the stock market crash, but the real damage was done by the wipeout of the banking system. Lots of small banks got wiped out. In that era, they didnt have branch banking. If your local banker was gone, there was no source of funds in the local community. That was a severe impediment to the financial system. Also, there was no deposit insurance in those days, so people lost serious money when a bank failed. The financial crisis was really focused on the collapse of the banking system and the shrinkage of the money supply. The current financial crisis is centered in the whole subprime mortgage lending arena and has come about through the collapse of house prices and so many mortgage securities not paying their contracted amounts. The problem has been centered more outside the commercial banking system and more in this kind of shadow banking areathe investment banks, the securities firms, the mortgage brokers and so forth. Many people criticized the Fed for its response to the Great Depression. How is the Fed's response to the current crisis different? The key difference between the 1930s and today is how the Fed has reacted to the crisis. In the 30s, the F ed more or less let the banking system collapse, allowed the money supply to collapse and allowed the price level to fall. You had tremendous deflation, and that contributed to the contraction of the whole economy. In the current episode, very earlystarting in August 2007the Fed started taking a series of steps to try to contain the crisis to the financial system and prevent it from affecting the whole economy. Thats only been partly successful. The economy is slowing down, no doubt ab out that, but the key difference between now and the 30s is the numerous actions taken by the Fed to try to keep markets liquid and to keep the banking system from collapsing in order to keep the whole financial system from collapsing. Its not just the Fed, but steps taken by the Treasury Department. Theres a lot more being done to try to contain the crisis and minimize the damage. Are there any parallels that in the housing market now and the housing market in the 1930s? There was a big decline in house prices during the Great Depression and a large increase in mortgage foreclosure rates. To that extent, its exactly the same phenomenon. However, the cause of the housing distress during the Great Depressionthe rise of foreclosures, the number of homes with delinquent mortgages and so forth, was the depression itselfthe falling incomes, the collapsing price levels. That caused the distress in housing markets. Today, distress in the housing market is largely caused by the housing market itselfthe boom and the bust, which has been centered, of course, on the subprime market. So, there is a real difference between the 1930s and today. What got us out of the Great Depression? Thats not a settled answer. Traditionally, theres a lot of weight put on the New Deal programs of FDR. Others have pointed out that it wasnt until the start of World War II that the unemployment rate fell below 10 percent. More recent research on the New Deal points out that a lot of the New Deal programs actually hindered the recovery of the economy. So, the effect of the New Deal continues to be debated. Theres been research that shows the rapid growth of the money supply from 1934 on was particularly beneficial. We stopped having bank failures, and the money supply started ramping up. So I think the growth of the money supply had a role, but some of the things that FDR didparticularly those things that helped stabilize the banking system, like deposit insurance and changes to the gold standard, contributed to the recovery. Of course, FDRs leadership is hard to quantify, but it helped restore confidence. What is the legacy of the Great Depression? Certainly, it was an event that caused a big increase in the government's role in the economy. For example, everything from the birth of Social Security, to federal deposit insurance, to the minimum wage and so forth, all got started during the Great Depression. There was a tremendous legacy in that respect. Many consider the Great Depression the watershed event in U.S. economic history just because so many things changed as a result. Certainly the balance of power between the federal government and state governments changed. How did the role of the Federal Reserve change following the Great Depression? The Banking Acts of 1933 and 1935 changed the balance of power within the Federal Reserve System in favor of the Board of Governors, especially with regard to monetary policy. The Acts made clear the Board's power to set the discount rate and gave the Board a majority of votes on the Federal Open Market Committee, including the chairmanship of the Committee. The legislation also gave the Board new authority to set reserve requirements for banks and margin requirements on loans to purchase securities. More fundamentally, the Depression demonstrated how the collapse of a banking system and severe deflation can wreck an economy. Subsequently, the high inflation era from the mid-1960s to the early 1980s showed how inflation can also damage the economy. The lessons of these episodes are 1) that central banks must respond to financial crises that threaten the macroeconomy, and 2) that price stability should be the paramount objective for monetary policy because of the harm that deflation and inflation can do to the real economy. Why do we have these periods of booms and busts? Well, you do have shocks that are uncontrollablewhen you have wars and severe weather events, for instance. You have technology shocks. Then, you do have these episodes of financial mania that seem to just arise. Its hard to put your finger on it. Some people will describe it as myopia on the part of investors. Theyll think that prices will go one way forever. Other people will suggest monetary policy flooded the market with a lot of liquidity. That money and credit had to go someplace. Economists are generally reluctant to talk about irrational behavior, but there is a growing field of behavioral finance, which emphasizes this myopic behavior. Its a tough question to answer, but its certainly intriguing.