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Recession to Depression PDF Print E-mail
Written by Dennis Walsh   
Friday, 24 October 2008

Why History Will Not Repeat (Part II)

Our situation is quite different from the early days of the depression. Yes, we have a credit crisis and are in a recession. All recessions can be traced back to overextension of credit. Business requires capital. Capital can come from investors in the form of equity ownership or from credit. Businesses use credit to purchase equipment, inventory, or expand into new markets and all sorts of other activities. People use credit to make major purchases such as a home, car, etc. During good economic times, businesses as well as consumers tend to overextend themselves.  When the economy slows, they retrench, creating your normal recession.

For years, banks were encouraged to write mortgages for subprime customers...often with nothing down. The assumption was that housing prices would continue to rise and that a sufficient number of subprime customers would make their payments so that these types of mortgages would be profitable overall. Both assumptions were wrong!

Fannie Mae and Freddie Mac (a quasi-government/quasi-private entity)purchased these mortgages from the financial institution. Then, working with investment bankers, split mortgages up into little pieces (both quality mortgages and subprime), and packaged them as securities.  The "mortgage securities" were sold to financial institutions around the world.  When subprime mortgage default rates rose, financial institutions' mortgage securities became toxic.  The credit freeze had begun. After Lehman Brothers, an investment bank, went under, a "run" of sorts occurred on money market funds, and the stock market perienced panic selling. The crisis spread.

History will not repeat!  Our current situation and response is altogether different from the depression era. In 1929, America had 2.3 million businesses. Our economy was dependent on large companies for employment growth. Few industries dominated the overall health of the economy. Today, America's economic strength is far more widespread than in the past. Our economy is much more diverse.  We have over 30 million businesses in America. The vast majority of our economic growth comes from small businesses.  In fact, nearly 100% of job growth over the last few years has come from small business. While a recession hurts big and small, the impact is not the same. Small businesses are slower to fire employees, and faster to respond to the needs of their customers. They tend to be more nimble. If big always won, then
dinosaurs would still roam the earth.

Another major difference is that we have a very aggressive Federal Reserve increasing money supply. The Fed Chairman, Ben Bernanke is the foremost expert on the policies that turned the recession into the depression. He has taken a different approach from the 1929-1933 Federal Reserve policy. Then, the Fed tightened credit and money supply at the very time banks needed it to survive.  The effect of the Federal Reserve tightening of the money supply was to make money more valuable and products less valuable. Prices fell and with them profits and jobs. From 1930-1934 widespread deflation turned the recession into a depression.  Today, the Fed is cutting interest rates, opening up the discount window, buying commercial paper, etc.  This Fed will not allow widespread, prolonged deflation. Ben Bernanke has outlined a number of tools that the Federal Reserve has to increase money supply. Cutting the discount interest rate is just one of many. Hehas publicly stated that he will use them if necessary.

On the fiscal side of the equation, the Federal Government has moved to inject capital into the system. Few, if any, like the idea of the $700 billion bailout.  The idea is bad, but the alternative is worse. In the depression era, the Federal Government took money from the private sector through tariffs, income taxes, corporate taxes, and estate taxes. Raising taxes in an economic downturn is only second to tightening the money supply on the list of dumb things to do...unless, of course, you like depressions. The Treasury Department is investing capital into banks and buying up toxic mortgage securities... in other words, injecting capital into a capitalist system, which is the opposite of the depression era policies.

Contained in the bailout bill was an increase in the FDIC insurance from $100,000 to $250,000 per account.  This increase is temporary. It ends as of 12-31-2009, but look for an extension. This government guarantee protects depositors against bank failures, a measure that was not in place during the depression. Then, over 9,000 banks failed as every rumor caused a run on the bank.  This measure also helps banks. Banks fearful of bank "runs" tend to hoard cash. When that fear is lessened, they are more apt to loan funds. Additionally, the Treasury Department acted swiftly to the recent run on money market funds by providing a government guarantee to individual investors. This effort eased the widespread outflow of money from these funds. The Federal Reserve has even recently started to buy up some of the money market fund assets to provide liquidity to the moneymarket funds.

A careful review of the U.S. banking system will show that many community banks and credit unions are doing just fine.In fact, they are making loans and mortgages.  Many of these institutions did not get caught up in the subprime mess. In 1930 alone, over 1,000 banks failed and customers lost their savings. Today, only 15 banks have failed. Most were shut down and sold to other banks.  All the customers' accounts were sold to other banks and no depositor lost money. The FDIC closely monitors bank financials.They act aggressively to protect depositors.

As Americans, it is our responsibility to hold our elected officials' feet to the fire. There is a lot of talk about tax cuts and/or stimulus packages. That is all fine and good. It is election time...promises abound. But, it is up to us to keep the officials in check. Raising taxes is unacceptable in these trying economic times. It makes matters worse. Tax cuts or rebates are helpful.  An intelligent stimulus package might prove helpful. Even government spending in the short term can help the economy today. But the rate of interest in long-term government spending must be slowed. We cannot afford to let government spending increase at a rate ten times faster than the average person's income. It is simply unsustainable. Further, we must not let our elected officials resurrect Trade Barriers. "Trade Wars" hurt everyone, even those who they are supposed to protect.

Denis Walsh
President & CEO
Work 561-472-2000
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