The Parallel with 1929 We Ignore at Our Peril

With markets teetering at the abyss, the collapse of Bear Stearns and Lehman Brothers, and the federal government's rescue of faltering behemoths like Fannie Mae, Freddie Mac, and AIG, some Americans are looking at the history of the 1930s in search of clues to the causes of the Great Depression. They want to know what went wrong in the past so they can make more educated judgments about what needs to be done to improve conditions in the present. Unfortunately, answers cannot be identified with confidence. Historians and economists still disagree sharply about the principal factors that produced an economic collapse nearly eighty years ago. But information that has emerged about the current economic crisis may throw new light on the events that led to disaster in the 1930s.

When Americans consult the history books for information about causes of the Great Depression, they are likely to be confused by a long list of complex explanations. The key factors listed in monographs and textbooks appear to be only loosely connected. Readers get little sense of a hierarchy of causes. Interpreters usually mention stock market speculation as a catalyst for the meltdown on Wall Street in the fall of 1929, but then they mention an abundance of other causes. Interpreters often suggest that the stock market crash represented only an early indication of problems. The Great Depression lasted for a decade, they point out, because more profound economic weaknesses were operating under the surface. A decline resulted from mal-distribution of wealth, trade protectionism, Allied war debts, currency contraction, failed leadership at the Federal Reserve, overdependence on the gold standard, poor banking practices, a flawed credit structure, and several other problems. Alan Brinkley, author of a popular history text, reports correctly that scholars "still have not reached anything close to agreement" regarding an explanation for the Depression. A reader examining histories of the troubles is likely to conclude that no clear lesson can be drawn from the past, since there is no consensus about what went wrong.

One element in the story of the Depression that began in the late 1920s, however, strongly resembles the emerging narrative about economic problems in our own times. In both 1929 and 2008 there was an absence of effective regulation for purposes of promoting sound business practices. Reckless speculation got dangerously out of hand. Business adventurers were able to market risky investment products free from public oversight. Those practices contributed to a meltdown of the national and international financial systems in the early 1930s. In our times, related practices have brought America's finances to the brink of a catastrophe. Decisive action by leaders from the Fed, Treasury and Congress may save America and the world from the kind of disintegration that plagued U.S. and global markets in the 1930s, but the factors that triggered economic shocks in 1929 and 2008 are strikingly similar.

Americans are now asking how the sub-prime mortgage debacle got so far out of hand during the years when various market analysts told the public that the American economy was fundamentally sound. Americans of the Depression era raised the same question. During the 1920s, analysts often expressed supreme confidence about conditions. The Wall Street Journal announced at the beginning of 1929 that, "One cannot recall when a new year was ushered in with business conditions sounder than they are today," and economics professor Irving Fisher of Yale judged in the autumn of 1929 that "Stocks have reached what looks like a permanently high plateau."

While the optimists were celebrating economic progress in the 1920s, investment leaders were marketing highly speculative and risky financial instruments to a gullible public. In the stock market, brokers got attractive commissions for selling securities with money borrowed from banks. They lent the cash to customers at a higher rate of interest. Lots of investors bought stocks on "margin," providing only a fraction of the cost as a down-payment. They believed their gamble was worthwhile, since the value of securities appeared to be surging permanently. When the crash came, they could not pay their debts. Also troubling were "investment trusts" which pooled money to speculate in many different securities. The managers of these instruments refused to disclose their stock holdings. Sometimes they invested in other investment trusts. With relatively small amounts of capital, they leveraged funds excessively. Their investments could produce handsome profits in boom periods, but these trusts could collapse like a house of cards in anxious times.

The crisis of the 1930s might have been averted if there had been more transparency so that investors had access to useful information and stronger regulation of investments for purposes of promoting responsible business practices. This oversight was noticeably lacking in the 1920s. When markets began their slide in late 1929, America's political leaders, enthusiasts of laissez faire, did not call immediately for strong government intervention. A crisis quickly got out of control.

The actors and scenes in the current financial drama are different, but the structure of the play looks quite similar. Once again, most of America's market analysts seem to have been caught off-guard. Few warned about the impending mortgage disaster, and few recognized that a profound credit crisis was on the horizon. Audiences that heard upbeat commentaries on C-NBC's television programs in recent years could easily imagine that the American economy was fundamentally robust, and the biggest challenge investors faced was choosing stocks that would produce large gains.

The worst abuses occurred in the mortgage industry. Like the stock brokers of the twenties who eagerly pushed questionable securities, collected commissions, and left vulnerable customers in the dark about risks, mortgage brokers in the 2000s eagerly registered debt-laden customers and then passed on the toxic documents to poorly informed buyers of bundled loans. Credit-rating agencies abetted the deception by granting Triple-A grades to institutions that marketed the mortgages.

As in the 1920s, in the 2000s the public lacked information about many unregulated business transactions that had the potential to make a huge impact on the economy. Americans were poorly informed about risky practices at major financial institutions, from Lehman Brothers to AIG to Freddie and Fannie. They were not aware that major firms were grossly undercapitalized and highly leveraged. The public had little knowledge about the workings of huge investments held through private equity funds and hedge funds, and they knew little about the largely unregulated credit default swaps, secret derivatives valued in the trillions of dollars. As in the 1920s, lots of newly designed business practices came into play in the years immediately preceding the financial crisis of this year. The shadowy and speculative trading system was little understood by outsiders and hardly visible to the American public.

Inadequate oversight in the twenties led to economic catastrophe in the thirties, and the lack of effective regulations in our own times almost produced a catastrophe during the week of September 14. As many economists acknowledged, the American and global financial system almost crumbled during that tumultuous week.

The causes of financial crises are infinitely complex, and no analysis of the troubles should neglect the multiple causes that historians and economists explore when trying to explain what went wrong. But the related conditions of 1929 and 2008 suggest a question if not an answer. Should one factor in particular -- poorly regulated markets -- receive the strongest emphasis when scholars try to identify the main cause of collapse?

In this case the present may inform our understanding of the past, and an understanding of the past can illuminate our thinking about the present. Conditions that fostered reckless speculation appear to be the prime factor behind the current mess, and it now seems clearer that related conditions were significant in the crises that led to the Great Depression. During the 1930s, leaders in Franklin D. Roosevelt's New Deal created regulatory measures that kept the American economy on a generally even keel for nearly half a century. It appears that we need a modern update of that governmental activism today to establish greater financial security.