A Long Way From the Dust Bowl

Every day it seems someone is seeking to compare the current financial crisis with the Great depression of the 1930s. There's no doubt these comparisons are an attention grabber. But how do today's events really match up?

A search of a newspaper database reveals 30,000 mentions so far this year of the term 'Great Depression'. References to dust bowls, long and winding dole queues and overflowing soup kitchens are getting a real workout.

These are striking metaphors, particularly for the generations (and that encompasses most of us by now) whose only knowledge of the misery of the 1930s comes from grainy newsreels, Hollywood movies and John Steinbeck.

Certainly there are parallels now in the breathtaking day-to-day market volatility, rising default rates, financial instability, banking strains, worsening economic indicators and the global nature of the crisis.

But there are also as many, if not more, ways in which this crisis is different from what occurred eight decades ago. These other signs suggest that while we face the prospect of an economic downturn, this is unlikely to turn into a 30s-style Depression.

By the way, there is no universally accepted definition of a recession or a depression. The standard international definition of a recession is a period in which an economy contracts for two consecutive quarters.

However, In the US, the National Bureau of Economic Research, uses a broader definition as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales."1 The bureau says it typically takes 6-18 months after a recession is started to make its declaration. Often by that time, the recession is over.

As to the term depression, there is no commonly agreed definition of that either, other than as a particularly deep and prolonged recession. So what are the signs that argue against a 1930s-style downturn?

Firstly, there is a keen awareness among policymakers about not repeating the mistakes of that time, when the Federal Reserve actually tightened monetary policy at a time when the system needed additional liquidity.2

Current US Federal Reserve governor Ben Bernanke, himself a scholar of the Great Depression,3 has shown he is highly aware of the risks of such an approach and has led efforts in the current crisis to recapitalise the banking system, cut interest rates and provide liquidity in certain areas of the market, such as commercial paper.

Also worth noting is that policymakers in other countries are taking a similar, flexible approach. Extraordinary policy actions in recent weeks by central banks and governments in Canada, the UK, Europe, Asia and Australasia have made progress so far in unfreezing credit markets. In addition there has been an increase in global cooperation among central banks, primarily through coordinated interest rate cuts.

Global policy coordination was rare in the 1930s. At that time, most nations adhered to the gold standard, a system in which currency values were expressed in terms of the price of ounces of gold. In 1931, Britain left the standard after a speculative attack on the pound. When speculators turned their attention to the $US, panic ensued. Depositors withdrew their money from banks to convert them into gold. To stop the loss of gold reserves and defend the dollar, the Federal Reserve raised interest rates sharply.

As scholars of the Depression, such as Bernanke, have since identified, the Fed made a significant error in tightening monetary policy at a time when an easing of conditions was required.
In contrast with the 1930s, we now have a level of global oversight that was unheard of between the wars. Bodies such as the G7, the G20 and the International Monetary Fund provide forums for international cooperation and coordination during economic and market crises.
But aren't the banking failures of 2008 a mirror image of what happened in the Great Depression? Again, some perspective is needed.

Between 1930 and 1933, thousands of US banks failed. In 1933 alone, 4,000 institutions went to the wall.4 By contrast, by late October only 19 US banks had failed in 2007 and 2008.
On the other side of the Atlantic, a dozen or so banks have been bailed out or nationalised by the UK and European governments. While suffering strains, Australian banks remain highly profitable, with a relatively low level of problem loans.5

Bear in mind, also, that prudential regulation, while still clearly imperfect, has improved immeasurably since the Great Depression. Up until 1933 in the US, there was no Federal Deposit Insurance Corporation. When a bank failed, depositors lost everything.

People subsequently hoarded cash, stashing it in old coffee containers, burying it in the backyard and, yes, hiding it under the mattress. This withdrew hard currency from circulation, adding to liquidity pressures.

Another contrast between then and now is the broad commitment of governments internationally to free trade and capital flows. The problems of the Depression era were compounded by protectionism. In the US, the Smoot-Hawley Tariff Act raised tariffs on more than 20,000 imported goods, triggering tit-for-tat trade restrictions and making the downturn even worse.

Further fuelling the downturn in the United States were the effects of the 'Dust Bowl'—a prolonged drought which combined with poor farming practices to devastate the Plains states. More than 500,000 Americans were left homeless by the drought and more than 2.5 million migrated from those affected areas. In many countries, particularly in the US, there was virtually no social safety net, so the hit to household spending from rising unemployment (the unemployment rate in the US rose to nearly 25 per cent versus around 6 per cent today6 ) was exacerbated by a lack of jobless benefits. These days, most western democracies operate a mixed economy where governments provide protections for workers.

This brings us to the understanding that governments now have about the role they can play in economic downturns by providing liquidity and attempting to increase confidence in the markets. Back in the Depression era, there was not the same sense that governments could play these roles.

In summary, governments have learned from past downturns that quick, decisive action can limit the economic effects of a financial crisis. They also understand that global problems require global solutions, and there are signs of coordinated efforts on that front.

While the level of banking failures has been alarming, it is nowhere near the proportions of the 1930s. In any case, prudent regulation, insurance and government guarantees are acting to protect investors.

Protectionist responses similar to the Smooth-Hawley Act are now seen as unlikely given the broad commitment of governments to free trade and capital flows. And within their borders, governments generally are committed to providing social safety nets for those dislocated by tough economic times.

While markets have fallen a long way, it is worth remembering that they are forward looking. So by the time a peak or trough in the business cycle has been identified, the market has already incorporated that information into prices.

None of the above is intended to downplay the seriousness of the situation the world economy finds itself in. But it does seek to put current events into historical context. We are still a long way from the Dust Bowl.

The author would like to thank Gerard O'Reilly of our research group for his assistance in researching this article.
1National Bureau of Economic Research, 'Business Cycle Expansions and Contractions'
2Christiano, Motto and Rostagno, 'The Great Depression and the Friedman-Schwartz Hypothesis', Federal Reserve Bank of Cleveland, Jan 2004
3Bernanke, 'Money, Gold and the Great Depression', the Federal Reserve Board, March 2004
4Source: FDIC
5'Financial Stability Review', Reserve Bank of Australia, September 2008
6Bernanke