Finance Globe

U.S. financial and economic topics from several finance writers.
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The Great Depression Compared to the Current Financial Crisis

The next Great Depression?
You've probably heard the media comparisons between the current economic crisis and the 1929 stock market crash that preceded the Great Depression, but is there really any reason for the scare tactics?

Well yes, we have recently experienced a number of similarities with the series of events that led up to the worst financial crisis in history, but there are also some very important differences.

Due to the many complex issues that led up to the Great Depression, and the simple fact that many historians and economists don't completely agree on its exact cause, we'll just look at an over-simplified comparison of the times in this article.

Speculation fueled growth and credit was cheap.
1920's - Consumers were living large and over-spending on credit, and people were generally optimistic about the future. Business was booming as many workers enjoyed better wages than they had in the past, and were able to purchase life's little luxuries such as cars, household appliances, and radios.

The Dow Jones Industrial Average shot from 63 in 1921 to an astonishing peak of 381 in 1929, for a gain of almost 600% in eight years' time. Investing in stocks was seen a sure way to become rich, and even novice investors borrowed excessively, including mortgaging their homes, to fund their stock purchases. Buying stocks on margins of around 10% became an easy way to buy stock without the capital to do so, meaning investors only needed $1 to borrow $9.

2000's - Demand for homes rose along with property values, as millions of home buyers sought out financing that allowed them to purchase a home with very little, if any, cash saved. Builders fed from the frenzy and churned out homes at a record pace.

Adjustable-rate mortgages, interest-only mortgages, sub-prime loans, and Alt-A loans allowed people to buy without the cash, current income, or income documentation previously required by traditional lending standards. It was easy for any one to own a home if they would just agree to the type of financing available to them.

Many who were not ready for the long-term financial responsibility of home-ownership suddenly had the keys to the American dream in their hands. Owner-occupants and investors alike thought that buying a home under any terms would give a quick profit as real estate prices soared.

Overvalued asset bubbles popped.
1929-1932 - From 1925 up to the point of the market crash, businesses were actually over-booming, by putting profits into increased production beyond what was sustainable in the marketplace. Consumer demand for durable goods was high, but there was no way that consumers could use all that was being manufactured, causing a surplus of product inventory. With super-high stock prices and little business profits to show for it, the Dow fell from its peak at 381.17 in September of 1929.

After the initial crash, widespread investor panic caused a massive sell-off, sending the stock market lower. The market experienced a short partial-recovery, and then continued in a downward trend over the next couple of years. The Dow finally settled at its low of 41.01 in July '32, leaving the stock market to become worth only 11% of its value from just three years earlier.

2005-2007 - Speculation drove the real estate market until the mortgage mess came to light, as droves of over-extended borrowers could no longer pay their rising adjustable-rate mortgage payments. In 2007, nearly 1.3 million homes were subject to foreclosure activity, up 79% from 2006. Troubled borrowers, who were facing foreclosure, saturated the market with homes for sale.

As the the supply exceeded the demand, property values declined - as much as 20% or more in the most over-built parts of the country. The false wealth, created by overvalued properties, was gone - leaving many to owe more than their houses are worth with the help of creative financing or home-equity loans.

Financial institutions, building contractors, home-improvement stores, furniture stores, and other types of businesses dependant on the growth of the housing industry suffered, as well as the workers who depend on these businesses for employment.

Overextended borrowers couldn't pay back the banks.
1929-1933 - The Roaring Twenties screeched to a halt when the stock market crashed. Banks had loaned heavily on stocks, and were unable to collect on those loans as over-extended investors' holdings lost significant value.

And as the recession deepened, farmers who had already been struggling for the past decade had even more difficulty in paying their mortgages, adding to banks' losses. 9,000 banks went belly-up as they faced a lack of capital and a credit crisis.

The failure of the New York Bank of the United States, though not government-owned, was a severe blow to any remaining confidence in the American banking system. Bank runs - massive deposit withdrawals due to customers' widespread fear that the bank would fail - wiped out much of banks' remaining cash.

2006-2008 - Sub-prime mortgage lenders faced heavy losses and started closing their doors. Big banks who had their hands in the sub-prime market, often by funding the sub-prime lenders, also suffered huge losses and faced bankruptcy or a sell-off. These mortgages with poor underwriting standards had been repackaged into complicated securities and sold to investors, and were beginning to look much riskier than once presumed.

Individual investors, banks, and corporations suddenly wanted out of these toxic mortgage investments that had been sliced-and-diced and spread around the world. Unsure of how far the sub-prime damage would spread, surviving financial institutions hoarded their cash in an effort to maintain capital.

The problems on Wall Street threatens a global economic downturn.
1933-1941 - Since the public widely held the belief that the strength of the economy was reflected by the performance of the stock market, its collapse caused an extended downturn as people cut spending, pulled their deposits from banks, and stopped investing in the stock market. And even though relatively few - the wealthy - actually invested in stocks and lost their fortunes, the stock market's collapse spread fear among consumers.

With decreased consumer spending added to the difficulty in gaining credit, businesses closed their doors or cut production, forcing many workers to lose their jobs or take reduced hours. Americans who became unemployed or underemployed were no longer able to afford the extras - or even the necessities, and businesses cut back even more to continue the downward spiral.

It took 25 years for the Dow to reach the same point it was at before it fell from its peak. Unemployment reached an all-time high of 25% in 1933, and many lost their homes, their cars, and all their savings. Though the stock market crash didn't cause the Great Depression, it certainly contributed to a massive loss of wealth among households and businesses that took over a decade for the world to recover from.

2008-? - Foreclosures and defaults of home mortgages creep up, long-timers in the financial industry are acquired or go bankrupt, the government-sponsored enterprises (GSEs) that buy or back half of the nation's mortgages are seized by the U.S. government, businesses affected by the ensuing credit crunch close their doors, unemployment is at 6.1%, and consumers who have gotten used to the home-equity line of credit no longer have funding for their over-spending. And the stock market's turmoil reflects the fear and panic across the world.

It's true, there are a number of similarities in the events leading up to this point in history.
But this article is not meant to cause fear for what the future will bring, only to illustrate how irresponsible lending standards, investors' lack of risk-control, and consumer over-spending could bring us to a point where many now worry that history may repeat itself.

Our current crisis hasn't been resolved yet, but even though there are some similarities in the past and present, there are substantial differences in how Washington's policy-makers are dealing with the situation at hand. Let's hope that they have learned from the past, so that we will never again experience a Great Depression.

Next article, we'll take a look at some very important differences between now and then.


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Saturday, 22 June 2024

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