The Great Depression Q&A

The 2007-2009 recession was the worst financial crisis since the 1930s. However, the financial crisis of the 1930s was very different from the financial crisis of 2007-2009. 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 didn’t 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 2007-2009 financial crisis was centered in the whole subprime mortgage lending arena and came about through the collapse of house prices and so many mortgage securities not paying their contracted amounts. The problem was centered more outside the commercial banking system and more in this kind of shadow banking area—the investment banks, the securities firms, the mortgage brokers and so forth.

The key difference between the 1930s and 2007-2009 was how the Fed has reacted to the crisis. In the ‘30s, the Fed 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 2007-2009episode, very early—starting in August 2007—the 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. That was only partly successful. The economy is slowed down, no doubt about that, but the key difference between 2007-2009 and the ‘30s was 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. It wasn’t just the Fed, but steps taken by the Treasury Department. There was a lot more done to try to contain the crisis and minimize the damage.

There was a big decline in house prices during the Great Depression and a large increase in mortgage foreclosure rates. To that extent, it’s exactly the same phenomenon. However, the cause of the housing distress during the Great Depression—the rise of foreclosures, the number of homes with delinquent mortgages and so forth, was the depression itself—the falling incomes, the collapsing price levels. That caused the distress in housing markets. In 2007-2009, the distress in the housing market was largely caused by the housing market itself—the boom and the bust, which was centered, of course, on the subprime market. So, there is a real difference between the 1930s and 2007-2009.

That’s not a settled answer. Traditionally, there’s a lot of weight put on the New Deal programs of FDR. Others have pointed out that it wasn’t 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.

There’s 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 did—particularly those things that helped stabilize the banking system, like deposit insurance and changes to the gold standard, contributed to the recovery. Of course, FDR’s leadership is hard to quantify, but it helped restore confidence.

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.

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.

Well, you do have shocks that are uncontrollable—when 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. It’s hard to put your finger on it. Some people will describe it as myopia on the part of investors. They’ll 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. It’s a tough question to answer, but it’s certainly intriguing.