The U.S. is in the midst of the worst financial crisis since the Great Depression.  The  question is: how close are we to another Great Depression?

The answer is: Very close.  Here’s why.

The Great Depression was the result of the combination of the1929 financial crisis and serious structural problems in the American economy such as widespread poverty.  After the 1929 stock market collapse these factors joined to deeply cut business investment and personal consumption. The consequence was a downward depressionary spiral that created the worst economic collapse in American history. 

Today’s economy is hurtling downward on a similar path to depression.  The mortgage and financial crises have constricted credit and largely cut off business investment. Stagnant wages and over-borrowing have curtailed consumer spending.

The collapse of a stock market bubble in 1929 triggered the chain of events that led to depression.  In the late 1920s investors and financial institutions poured money into stock.  Banks, assisted by the Federal Reserve’s low interest rates, lent money on easy terms to investors.  Rapidly rising stock prices created a get-rich euphoria that attracted more dollars.  Both investors and financiers assumed that stock prices would continue to rise and continued to over-borrow and over-spend on stocks. 

But when stock prices began to fall in October 1929, investor euphoria to panic and stocks were sold at any price.  Many investors, financial institutions, and banks were caught over-extended and bankrupted.  To repair damaged balance sheets, surviving banks and financiers dramatically reduced lending.  The result was that economic activity began a long and steep decline.

Much as in 1929, the 2008 collapse has been the consequence of a speculatory bubble, this time in real estate.  Rising home prices led many to purchase homes and condos on the assumption that housing prices would continue to rise while interest rates would not.  Banks lent money on shockingly easy terms with adjustable rate, interest only, sub-prime, and no documentation of income mortgages.  By wrapping up mortgages into new financial instruments such as CDOs (collateralized debt obligations), investment companies, banks, and private investors poured more and more money into real estate, further pumping up prices.  This process was assisted by the Federal Reserve’s easy money policy.

At the end of 2006 the real estate bubble burst.  As interest rates reset or high payments were required under the original mortgages, many property owners found themselves unable to pay and went into default.  This left the investors and businesses holding mortgages or investments based on them such as CDOs ,with investments worth much, much less than they had either paid for or lent against.  They also found securities based on real estate, such as CDOs, unsalable.  This created enormous losses for investment firms and banks.  Subsequent property owner defaults piled the loses on and created the current financial crisis.  Some firms failed, others merged or were taken over by the U.S. government.  Despite government bailouts and aid, the collapse of the housing market continues.  In response to the losses, the country’s surviving major banks have severely cut lending.

The speculatory bubbles at the end of the 1920s in stocks and in the first half of the 2000s in real estate hid serious structural problems in the underlying economy.  In 1929 it was the combination of financial crisis with these structural problems that led to the Great Depression.  The same combination is causing a major contraction in the U.S. economy today.

In the 1920s the problems of widespread poverty and an inequitable distribution of wealth contributed to depression in the next decade.  In 1929 42 percent of American families were living in severe poverty.  Consumer credit provided some purchasing power to those in society’s bottom half, but by the end of the 1920s this group had exhausted its borrowing power.  The bulk of the U.S. economy’s income went to the top 1 percent of the nation’s families who earned the same amount as the combined income of the bottom 40 percent. 

A similar situation occurred at the end of the 1990s when workers’ wages began to stagnate, while the income of the wealthiest Americans soared.  By 2003 the distribution of income had reached the 1929 point, with the richest 1 percent of families received the same income as the bottom 40 percent of the nation’s families.

The decline of working Americans’ income was somewhat masked by rising real estate and stock prices, as well as the rapid extension of consumer credit.  To maintain their standard of living, middle class Americans turned to borrowing through more credit card debt and home equity loans.  By 2006 these practices had turned Americans’ savings rate negative–its worst performance since the Great Depression–as many spent more than they earned.

In 1929 financial collapse combined with poverty and the distribution of income to significantly cut spending for all levels of American society.  Demand was down and the financial crisis left businesses unable to get the credit needed to finance operations.  Employees were laid off, declines in business and worker income followed, consumption dropped, and firms went bankrupt.  This caused yet more banks to fail and created a depressionary spiral downward.

A similar  process is underway now.  The collapse of housing and stock prices and the credit freeze cut off borrowing as a means to support middle class consumption.  Even worse, too many of those who over-borrowed are unable to pay; they are now in the process of defaulting on their mortgages, car loans, and credit card  debts.  The overall result is rapidly falling levels of spending and consumption as consumers cut back.   These consumption declines are merging with the constriction of bank credit as many companies cannot get even short term loans to carry on operations. 

Much as was the case in 1929 the twin declines of consumer and business spending are rippling through the economy.  They are causing worker income and general consumption to fall and bringing on mounting layoffs.  As unemployment rises, more individuals will be unable to pay their debts and additional personal and business bankruptcies will follow.  This means even less demand and more bank and investment company failures and bailouts.  

The American economy in 2008 is following the same path it took in 1929.  The collapse of a speculatory bubble has merged with problems of the distribution of wealth,  working American incomes, and consumption.  The consequence is that the economy is rapidly spiraling downward into the next great depression. 

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This piece was distributed for non-exclusive use by the History News Service, an informal syndicate of professional historians who seek to improve the public's understanding of current events by setting these events in their historical contexts. The article may be republished as long as both the author and the History News Service are clearly credited.

Raul A Garcia - 12/16/2008

All right, so we argue causative factors ad nauseum in comparison to an earlier depression, and no doubt our paradigm is challenged....from my puny perspective, my question is, how do we now create wealth, instead of works programs and gross pseudo-financing? The only "normalcy" for the working classes is the current fuel price- the inevitable levied taxes will seem all-too oppressive and we embark on a dangerous road.

John Paul Rossi - 12/10/2008

I do not think that short-selling is a major factor in the financial crisis, but it has harmed individual firms, particularly in the finance sector. The SEC ought to prohibit the naked variety and generally restrict other types until the current financial crisis is over.

Mike Schoenberg - 12/8/2008

I doubt that the number of short sellers out there makes a huge difference though there are so many ways one can do it. Buying ETF's or put options or covered calls are all ways to do it besides directly short selling.

Elliott Aron Green - 12/8/2008

John, do you agree that short selling has to be banned in order to prevent the kinds of steep declines that the markets have experienced since September? Isn't it reckless for the SEC to allow speculators to sell what they don't own which has its own downward pressure on the markets? Should short selling be considered a structural problem?