Lessons from the Great Depression

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BY THOMAS S. ZORN

The headline (LJS, Oct. 10) when I first wrote this piece was particularly alarming, “Economic options dwindle.”

Other commentators have made the point that the Treasury and the Fed are running out of bullets.

Well let me assure you, they are no longer shooting bullets; they have unleashed cannons.

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Thomas Zorn

Thomas Zorn

I thought that investors and the public were being silly when they expected these actions to have an immediate impact. Those that bought stocks at the bottom of each of the previous episodes of financial panic made a great deal of money. There is no reason to believe that this won’t happen again. 

Did the big rally in the market on Monday necessarily signal that we have turned the corner? Perhaps, but I suspect that there is still a great deal of uncertainty and fear out there.

It was not too long ago when we were in the warm glow of real estate euphoria. A lot of bets were made on the housing market by individuals and financial institutions, and encouraged by government policy. Asset price bubbles are always based on a good story. In Florida and Arizona, it was about all the baby boomers retiring and looking for retirement homes. In California, they were running out of land. 

You can always tell when you are in a bubble if you can’t sleep and you turn your TV on at 3 a.m. and see an infomercial on how you can get rich. In recent years, it was how you can get rich by flipping houses.

Everything was working fine as long as housing prices were going up. Inevitably in these bubbles, there comes a point where the buyers start balking at the prices sellers want. This starts the process in reverse, and the downward slide is typically much more rapid than the run-up.

As people’s wealth falls, they tend to panic. An unusual aspect of this financial panic is the degree to which financial institutions were vulnerable to the bubble bursting. This has happened before, during the Securities and Loan meltdown of the 1980s and, of course, the Great Depression of the 1930s.

Let me admit my forecasting ability is less than perfect. I have been telling my classes that I expected a hard landing in the real estate market for a number of semesters now. I also said I expected this to have a negative impact on financial institutions and I thought this would result in a recession. But I seriously underestimated how badly financial institutions would be hit. In a previous editorial piece for the LJS, I predicted that the price of oil would drop. The price of oil was nearly $150 a barrel at the time, but I also mistakenly predicted that it wouldn’t happen anytime soon. I also thought that the Huskers would beat Missouri.

I know there are a lot plans to rescue the economy; I even have my own ideas. But when a ship is taking on water and in danger of sinking, that is not the time to assemble the crew and passengers to discuss plans. Nor should you waste a lot of time figuring out whose fault it is.

It is important to recognize that, as Warren Buffet pointed out, we may not have much choice but to put our trust in Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke. I know that the Bernanke is a student of the Great Depression. He understands that a primary reason that the Great Depression was great is because the Federal Reserve was fighting the possibility of inflation when the problem was recession and that the government was worried about deficits when the problem was a lack of aggregate demand.

One of the other big mistakes made during the Great Depression was the attempt to artificially prevent prices and wages from falling. Everyone knew that during a depression, prices tend to fall. The attempt to keep prices up meant that people couldn’t afford the goods whose sale would have helped restart the economy. Dumping milk on the ground at a time when babies didn’t have enough to eat was foolish. Housing prices have to be such that people can again afford them. They will come back once the credit markets are operating near normality and sufficient liquidity has been injected in the economy.

While I am optimistic, for the long run it is important to be prudent. I believe that it would be foolish to think that recession will not affect us. The state, which is running a big surplus, should not throw those funds away when it is likely they will need them in the future. Nor should local government embark on ambitious plans when the economy may take a nasty turn. Prudence, not panic is needed.  

Dr. Thomas S. Zorn is the George B. Cook/Ameritas College Professor of Finance at the University of Nebraska-Lincoln.