A Depression Coming? Not Likely
Expect to see a recession similar to those in the 1970s and early 1980s.
Former Goldman Sachs chairman John C. Whitehead got a lot of attention last week with his statement that the federal government could face a downgrading of its credit rating, aggravating the recession. The result, he said, "would be worse than the Depression." Now, "would" is a squishy word in forecasting, but the headlines screamed, "Whitehead Sees Slump Worse Than Depression."
Whitehead, a distinguished American of 86 years, was an adolescent during the 1930s, so he should remember those horrible times well. I wasn't born until after World War II, so my knowledge of the Depression comes largely from books. Here are some things I've learned:
The Great Depression was a global economic collapse of unfathomable magnitude, and today's statistics of pain would have to be multiplied manyfold to match those of the 1930s.
And the Depression was preventable -- if governments worldwide had responded earlier and smarter after the stock market crash of 1929. The lessons learned since then greatly reduce the likelihood of a reprise of that decade of hardship.
America's national output plunged for four straight years, 1930-1933, with a total drop in dollar value of some 50%, because of a combination of lower volume and falling prices (deflation).
The massive federal spending of Franklin D. Roosevelt's New Deal caused the gross domestic product (GDP) to rise from 1934 through 1937. Then the nation was shocked by a severe relapse (the "Roosevelt Recession") that saw national production fall in 1938. The Great Depression was finally ended not by the New Deal, but by rising U.S. industrial output in 1940-1941 to aid our allies in Europe, under assault by Adolf Hitler.
By comparison, in this recession we're likely to see several quarters of low-single-digit declines of GDP over the coming year. A 7% quarterly contraction, last seen in mid-1980, would be highly surprising in this slump, and most quarterly declines will probably be smaller, on the order of 2% to 4%.
In the first year after the stock market crash of 1929, unemployment tripled from 3% of the labor force to 9%, and then it kept on rising -- from 16% in 1931 to an appalling 24% in 1932. That's nearly one out of every four workers, in an era when most families were supported by one wage earner. The New Deal's public works programs cut joblessness dramatically, but it was still running at 14% in 1937 and soared again to 19% during the 1937-1938 relapse.
Today, by contrast, we're just north of 6% unemployment in households typically supported by two earners, which staves off severe hardship while the jobless worker looks for new employment. At Kiplinger, we expect the unemployment rate to peak at 8% to 9% over the coming year as layoffs continue in sectors ranging from construction and autos to finance and retailing.
With no federal deposit insurance in the early 1930s, the failure of some 9,000 banks caused an estimated $140 billion in depositor losses. Many Americans saw their entire life savings wiped out. But today's bank failures measure in the hundreds, and not a dime of insured money has been lost. Even depositors who were over the FDIC limits have received some protection. For example, in the July 2008 failure of California's IndyMac Bank, half of depositors' uninsured funds have been returned to them and more may eventually be recovered.
However, a much higher percentage of Americans own stocks today -- either directly or in mutual funds, and in IRAs and 401(k)s -- than in the 1920s, so today's market declines, though much milder than in the Great Depression, affect many more Americans than back then.
Falling stock prices
The Dow Jones Industrial Average plunged 89% from 1929 to 1932, and it didn't return to its pre-Depression high until the mid-1950s. Today the major indexes are down about 40% from their highs in the fall of 2007, and they are below their levels of a decade ago. So far, this latest bear market hasn't reached the 50% drop last seen in 2000-2002 and 1973-1975.
As I've noted before on this site, no one knows when a market bottom will be reached, but I believe stocks purchased now and in the coming months will see strong gains over the next few years as the global economy recovers.
Homeownership was much lower at the beginning of the Depression than today, but homeowners' inability to refinance five-year balloon mortgages led to massive foreclosures.
Today an estimated 5% of U.S. homes are in foreclosure or at risk of being lost, a number that is likely to rise as layoffs mount. But home losses will be dampened by some sort of foreclosure prevention program envisioned by Congress. The 5% number is more than twice the level of a few years ago, but still a small share of all households.
There is a mounting worry today about the threat of deflation -- a broad, sustained fall in consumer prices and wages. Falling prices cause consumers to postpone purchases in the hope of even lower prices later, which dampens the economy further.
Deflation last occurred in the early 1930s, because of a collapse of consumer purchasing power due to soaring unemployment, and it was aggravated by the Federal Reserve's foolish contraction of the money supply. In the three years after the market crash of 1929, the Fed apparently shrank the money supply by nearly one-third -- precisely the wrong medicine for a fearful and credit-starved economy.
Consumer prices fell for three straight years, 1930-1932, for a total drop of more than 10%. Over the following five years, because of the massive New Deal stimulus, the price level stabilized and then rose modestly, but there was a return to deflation during 1938-1939.
Today the risk of a long, sustained fall in wages and prices is much less. Yes, consumer and business spending will contract, but it won't collapse. The Federal Reserve is pulling out all the stops to get credit flowing better, and free spending by Washington will go a long way toward bolstering private sector demand.
Another governmental mistake that contributed to the Great Depression was shortsighted trade policy, such as the Smoot-Hawley tariffs of 1930, which raised duties on imported goods and led foreign governments to do the same. From 1929 through 1933, U.S. exports fell by some 50% in volume and by nearly two-thirds in dollar value.
Today global trade is more important to the U.S. and world economies than it was 80 years ago, and governments will not repeat the mistake of excessive protectionism. My colleagues and I at The Kiplinger Letter expect U.S. export growth -- a star of our economy today -- to cool from the double-digit annual gains of recent years, but not collapse. There will continue to be strong demand for American goods and services from such high-growth economies as China, India and Brazil.
In the 1930s, there was an absence of international cooperation in fighting the crisis. Today there is both coordination among central banks and rapid emulation of creative solutions born in one country or another.
Herbert Hoover's administration -- contrary to today's mythology -- did attempt a lot of stimulus. It boosted infrastructure spending on roads and dams, created the Reconstruction Finance Corporation to aid industry, banks and cities, and started unemployment benefits through the Emergency Relief Agency.
Roosevelt, as candidate for president in 1932, castigated Hoover for wild deficit spending and vowed to balance the federal budget. But in the five months between his election and inauguration day (in March back then), FDR did the most amazing about-face in political history.
His "brains trust" quickly decided that short-run stimulus was more important than budget deficits, and the New Deal embarked on a radical restructuring of the U.S. economy -- the efficacy of which is still being debated by economists generations later.
By the end of the 1930s, the accumulated U.S. national debt had multiplied from $17 billion to $43 billion, and it continued to soar through World War II.
In today's recession, Congress and the White House (both outgoing President George W. Bush and incoming President Barack Obama) seem inclined to spend whatever is necessary to forestall a deep, long recession -- budget deficits be damned. Next year, the deficit could hit $1 trillion dollars. At 7% of GDP, it would top the modern deficit record of 6% set in 1983, following the last severe U.S. recession. It would be well short of the 30% of GDP represented by the deficit in 1943, at the height of World War II.
Someday all of this borrowed money will have to paid off by inflation or higher taxes -- most likely by both.
Today's safety nets
Finally, it should be noted that America in the early 1930s was largely without the financial safety nets of today: Social Security, Medicare and Medicaid, unemployment insurance, bank deposit insurance and private pensions.
Though the finances of all of these are under severe pressure now and will need shoring up, they are still functioning and providing financial support to millions of Americans, whether employed, retired or jobless.
Frames of reference
In short, in the past 75 years the world has learned how to prevent recessions from turning into cataclysmic depressions.
So if this recession is not likely to morph into a depression, what is more likely to happen?
I believe that better frames of reference are the last two bad U.S. recessions, in 1981-1982 and 1973-1975. Each lasted more than a year (about 16 months), with several single-digit quarterly declines in national output. Unemployment rates during those two slumps rose to the highest levels since the 1930s -- about 9% in 1974 and nearly 11% in 1982.
Many of today's middle-aged adults remember those recessions well, and they were awful. In the 1970s, the world was slammed by a ten-fold increase in oil prices -- far worse and longer lasting than the brief doubling of prices earlier this year, from which energy prices have now retreated to normal levels.
In the 1970s and early 1980s, high inflation pushed interest rates on business loans into the mid-teens and mortgages over 20%.
In the 1970s and early 1980s, the industrial heartland of American went through a massive restructuring, causing great pain in job losses but setting the stage for surging manufacturing productivity gains -- more output from fewer workers and hours worked -- during the late 1980s and 1990s.
Déjà vu anxiety
It should be noted that during these last two severe recessions, there was also deep anxiety, like today, about the possibility of another Great Depression looming.
I remember a cover story in Newsweek in mid-1982 that asked this very question. The question seemed plausible because the slump was severe, unemployment continued to rise, and people were scared. (For the record, Newsweek acknowledged the risk of depression but concluded it wouldn't happen.)
That summer turned out to be the darkest hour before the dawn. The Dow stocks ended their 16 years of price stagnation and took off like a skyrocket from a low of 777. And the broad economy entered a long, strong expansion of production and personal income.
As a business forecaster for some 30 years, I have learned never to say "never," so I'm not saying that a deep depression could not happen again. This year has been very humbling for forecasters. Things that I once thought to be inconceivable -- the collapse of AIG, Freddie Mac and Fannie Mae and the near bankruptcy of Detroit automakers -- have indeed come to pass.
When I hear my more pessimistic peers saying that this or that calamity "could happen" or "might happen," I do not dispute them because anything could or might happen.
Since the economic improvement won't be immediate -- indeed, things will get worse before they get better -- there is a risk that people will lose confidence in government plans before they are even implemented and act out their fears.
There is a risk that people who are able to consume normally -- secure in their jobs and earning what they always have -- will pull back unnecessarily and worsen the slump.
At Kiplinger, we try to deal in likelihood and probability. And for all the reasons listed above, we believe it is likely that this slump can be contained to a duration and severity no greater, and probably less, than those of the slumps of the 1970s and early 1980s. And we believe that stock prices will start to recover when corporate earnings resume a modest upward path, probably near the end of next year.
Working our way through these challenges will be difficult and lengthy, with the fiscal hangover lasting many years. But as a nation, we seem to have decided that preventing near-term economic collapse is worth virtually any long-term cost.