How close did we come to the Great Depression 2.0? Doubtless, that question will spawn a cottage industry of books, studies, and conferences. But Christina Romer, the head of President Obama's Council of Economic Advisers, already has an answer: pretty darn close. Her conclusion deserves attention because Romer, in her previous academic career, was a scholar of the Great Depression. (Click here to follow Robert J. Samuelson)
"Depression" is a term of art. It's more than a serious economic downturn. What distinguishes a depression from a harsh recession is paralyzing fear—fear of the unknown so great that it causes consumers, businesses, and investors to retreat and panic. They hoard cash and desperately curtail spending. They sell stocks and other assets. A devastating loss of confidence inspires behavior that overwhelms the normal self-correcting mechanisms (lower interest rates, inventory resupply, cheap prices) that usually prevent a recession from becoming deep and prolonged: a depression.
Comparing 1929 with 2007–09, Romer finds the initial blow to confidence far greater now than then. True, stock prices fell a third from September to December 1929, but fewer Americans then owned stocks, and prices had risen early in the year. Moreover, home prices barely dropped. From December 1928 to December 1929, total household wealth declined only 3 percent. By contrast, the loss in household wealth between December 2007 and December 2008 was 17 percent—more than five times as large. Both stocks and homes, more widely held, dropped more.
Thus traumatized, the economy might have gone into a free fall ending in depression. Indeed, it did go into free fall. The anniversary of Lehman Brothers' bankruptcy in September inspired much commentary that saving the investment bank wouldn't have averted crisis. True. But allowing Lehman to fail almost certainly made the crisis worse. By creating more unknowns—which companies would be rescued, how much were "toxic" securities worth?—it converted normal anxieties into abnormal fears that triggered panic.
As credit markets froze, stock prices collapsed. By year-end, the Dow Jones industrial average was down 23 percent from its pre-Lehman level and 34 percent from a year earlier. Financial panic poisoned popular psychology. In September, the Conference Board's Consumer Confidence Index was 61.4. By February, it was 25.3. Shoppers recoiled from buying cars, appliances, and other big-ticket items. Spending on such "durables" dropped at a 12 percent annual rate in 2008's third quarter and at a 20 percent rate in the fourth. With a slight lag, businesses canned investment projects; that spending fell at a 20 percent rate in the fourth quarter and a 39 percent rate in 2009's first quarter.
That these huge declines didn't lead to depression mainly reflects, as Romer argues, countervailing government actions. Private markets for goods, services, labor, and securities do mostly self-correct, but panic feeds on itself and disarms these stabilizing tendencies. In this situation, only government can protect the economy as a whole, because most individuals and companies are involved in self-defeating behavior of self-protection.
Government's failure to perform this role in the early 1930s transformed recession into depression. Scholars will debate which interventions this time—the Federal Reserve's support of a failing credit system, the TARP, guarantees of bank debt, Obama's "stimulus" plan and bank "stress test"—counted most in preventing a recurrence. Regardless, all these complex measures had the same psychological purpose: to reassure people that the free fall would stop and, thereby, curb the fear that would perpetuate a free fall. Confidence had to be restored so that the economy's normal recovery mechanisms could operate. That seems to have happened. By September, the Consumer Confidence Index had rebounded to 53.1. Housing prices had stopped falling. By the Case-Shiller index, they've increased for three months.
But this improved confidence is not optimism. It is the absence of terror. The consumer sentiment index is still weak, and all the rebound has occurred in Americans' evaluation of future economic conditions, not the present. Unemployment (9.8 percent) is abysmal, the recovery's strength unclear. Here, too, there is an echo from the 1930s. Despite bottoming out in 1933, the Depression didn't end until World War II. Some government policies aided recovery; some impeded it. The good news today is that the bad news is not worse.