Samuelson: Is This a Replay of 1929?

Watching the slipping economy and Congress's epic debate over the Treasury's unprecedented $700 billion financial bailout, it is impossible not to wonder whether this is 1929 all over again. Even sophisticated observers invoke the comparison. Martin Wolf, the chief economic commentator for the Financial Times, began a recent column: "It is just over three score years and ten since [the end of] the Great Depression." What's frightening is not any one event but the prospect that things are slipping out of control. Panic—political as well as economic—is the enemy.

There are parallels between then and now, but there are also big differences. Now, as then, Americans borrowed heavily before the crisis—in the 1920s, for cars, radios and appliances; in the past decade, for homes or against inflated home values. Now, as then, the crisis caught people by surprise and is global in scope. But unlike then, the federal government is now a huge part of the economy (20 percent vs. 3 percent in 1929) and its spending—for Social Security, defense, roads—provides greater stabilization. Unlike then, government officials have moved quickly, if clumsily, to contain the crisis.

We need to remind ourselves that economic slumps—though wrenching and disillusioning for millions—rarely become national tragedies. Since the late 1940s, the United States has suffered 10 recessions. On average, they've lasted 10 months and involved peak monthly unemployment of 7.6 percent; the worst (those of 1973–75 and 1981–82) both lasted 16 months and had peak unemployment of 9.0 percent and 10.8 percent, respectively. We are almost certainly in a recession now, but joblessness, 6.1 percent in September, would have to rise spectacularly to match post-World War II highs.

The stock market tells a similar story. There have been 10 previous bear markets, defined as declines of at least 20 percent in the Standard & Poor's 500 Index. The average decline was 31.5 percent; those of 1973–74 and 2000–02 were nearly 50 percent. By contrast, the S&P's low point so far (Friday, Oct. 3) was 30 percent below the peak reached in October 2007.

The Great Depression that followed the stock market's collapse in October 1929 was a different beast. By the low point in July 1932, stocks had dropped almost 90 percent from their peak. The accompanying devastation—bankruptcies, foreclosures, bread lines—lasted a decade. Even in 1940, unemployment was almost 15 percent. Unlike postwar recessions, the Depression submitted neither to self-correcting market mechanisms nor government policies. Why?

Capitalism's inherent instabilities were blamed—fairly, up to a point. Over borrowing, overinvestment and speculation chronically govern business cycles. Herbert Hoover was also blamed for being too timid—less fairly. In fact, Hoover initially expanded public works to combat the slump. The real culprit was the Federal Reserve. Depression scholarship changed forever in 1963 when economists Milton Friedman and Anna Schwartz argued, in a highly detailed account, that the Fed had unwittingly transformed an ordinary, if harsh, recession into a calamity by permitting a banking collapse and a disastrous drop in the money supply.

From 1929 to 1933, two fifths of the nation's banks failed; depositor runs were endemic; the money supply (basically, cash plus bank deposits) declined by more than a third. People lost bank accounts; credit for companies and consumers shriveled. The process of economic retrenchment fed on itself and overwhelmed the normal channels of recovery. These mechanisms included surplus inventories being sold so companies could reorder; strong companies expanding as weak competitors disappeared; high debts being repaid so borrowers could resume normal spending.

What we see now is a frantic effort to prevent a repetition of this destructive chain reaction by which a disintegrating financial system compounds the economic downturn. It's said that the $700 billion bailout passed by Congress will rescue banks and other financial institutions by having the Treasury buy their suspect mortgage-backed securities. In reality, the Treasury is bailing out the Fed, which has already—through various channels—lent financial institutions roughly $1 trillion against myriad securities. The law's increase in federal deposit insurance from $100,000 to $250,000 aims to discourage panicky bank withdrawals (nearly three quarters of deposits will now be insured, up from almost two thirds before). In Europe, governments have taken similar actions; last week, Ireland guaranteed its banks' deposits.

The cause of the Fed's timidity in the 1930s remains a matter of scholarly dispute. Economist Barry Eichengreen of the University of California, Berkeley, suggests a futile defense of the gold standard; Allan Meltzer of Carnegie Mellon University blames the flawed "real bills" doctrine that, in practice, limited the Fed's lending to besieged banks. Either way, Fed chairman Ben Bernanke—a student of the Depression—understands the error. The Fed's massive lending and the congressional bailout both aim to prop up the financial system and avoid a ruinous credit contraction.

This doesn't mean the economy won't get worse. It will. The housing glut endures. With unemployment rising, cautious consumers have curbed spending. Economies abroad are slowing, hurting U.S. exports. Banks and other financial institutions will suffer more losses. But these are all normal symptoms of recession. Our real vulnerability is a highly complex and interconnected global financial system that might resist rescue and revival. The Great Depression resulted from the perverse mix of a weak economy and government policies that magnified the weakness and that were only partially neutralized by the New Deal. If we can avoid a comparable blunder, the great drama of these recent weeks may prove blessedly misleading.