Great Depression Warning - WSJ

Misleading shadowstats affecting Federal Reserve policy and the similarity of the current financial troubles to the Great Depression. This analysis not by blogging amateurs like me but by a Nobel Prize winning economist in the Wall Street Journal, although buried on page A15.

Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus: Mortgage loan originations increased an average of 56% per year for three years -- from $1.05 trillion in 2000 to $3.95 trillion in 2003!

By the time the Federal Reserve began to slowly raise the fed-funds rate in May 2004, the Case-Shiller 20-city composite index had increased 15.4% during the previous 12 months. Yet the housing portion of the CPI for those same 12 months rose only 2.4%.

How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.

With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since "owners' equivalent rent" is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.

With nominal interest rates around 6% and inflation around 6%, the real interest rate was near zero, so household borrowing took off. As measured by the Case-Shiller 10 city index, the accumulated inflation in home-ownership costs between January 1999 and June 2006 was 151%, but the CPI measured a mere 23% increase. As the Federal Reserve monitored inflation in the early part of this decade, home-price increases were no longer visible in the CPI, so the lax monetary policy continued. Even after the Fed began to slowly raise the fed-funds rate in May 2004, the average rate remained low and the bubble continued to inflate for two more years.The events of the past 10 years have an eerie similarity to the period leading up to the Great Depression. Total mortgage debt outstanding increased from $9.35 billion in 1920 to $29.44 billion in 1929. In 1920, residential mortgage debt was 10.2% of household wealth; by 1929, it was 27.2% of household wealth.

The Great Depression has been attributed to excessive speculation on Wall Street, especially between the spring of 1927 and the fall of 1929. Had the difficulties of the banking system been caused by losses on brokers' loans for margin purchases in 1929, the results should have been felt in the banks immediately after the stock market crash. But the banking system did not show serious strains until the fall of 1930.

Bank earnings reached a record $729 million in 1929. Yet bank exposures to real estate were substantial; as the decline in real estate prices accelerated, foreclosures wiped out banks by the thousands. Had the mounting difficulties of the banks and the final collapse of the banking system in the "Bank Holiday" in March 1933 been caused by contraction of the money supply, as Milton Friedman and Anna Schwartz argued, then the massive injections of liquidity over the past 18 months should have averted the collapse of the financial market during this current crisis.

The causes of the Great Depression need more study, but the claims that losses on stock-market speculation and a monetary contraction caused the decline of the banking system both seem inadequate. It appears that both the Great Depression and the current crisis had their origins in excessive consumer debt -- especially mortgage debt -- that was transmitted into the financial sector during a sharp downturn.

Wonder what Paul Krugman thinks of this analysis? In many ways he predicted it, actually, but using the Asian and South American financial problems of the last quarter century to issue warnings about America in 1999. The Nation:

For a slender book, The Return is ambitious--actually, it's three polemics in one. The first sketches out the ways financial capital in Asia and Latin America flowed, or didn't, to cause sudden recessions, or inflationary spirals, or currency devaluations, or all of these at once. Various governments, even those trying to play by the rules of fiscal conservatives, were confronted with terrible choices: either decline to print money, endure recession and let ordinary people suffer now; or print money, discourage investment and cause them to suffer later. The second polemic draws parallels between what happened in these places and what might happen--actually, what is happening--in America, Europe and more developed parts of the world, suggesting what dislocations to expect and remedies to pursue. Krugman sighs when thinking about economists--including, notably, his Princeton colleague Ben Bernanke--who assumed that officials at Treasury and the Fed had evolved the means to reduce economic imbalances to the point where regulations could be relaxed and the term "business cycle" would seem an anachronism.

The third polemic, the thinnest and most implicit of the three, consists of arguments scattered throughout the book regarding how changes in the "real economy"--the businesses that actually make, transport and design things--shape financial markets or are shaped by them. How, in particular, might revolutionary changes in information technology--producing changes in the structure of corporations and their terms of competition--yield a changing financial pattern? Or how might those changes entail a revised superintending of the business cycle? Krugman allows, for example, that the globalization of industrial markets and their much higher rates of productivity--both the result of a new, pervasive information platform--might have justified Greenspan's unwillingness to hike interest rates after the "irrational exuberance" of the dot-com bubble, although low rates, both men knew, were bound to sustain the value of houses--in effect, risking an even bigger bubble. Krugman writes that it was clear by the 1990s "that the information industries would dramatically change the look and feel of our economy."

Krugman answered questions online at the Washington Post.

D.C.: What did Japan do wrong in the 90's and how can we avoid the same fate?

Paul Krugman: To be honest, I think US economists are feeling a bit more respect for the Japanese, or at least sympathy for their plight. Avoiding a Japan-type experience is proving harder than most economists thought -- even economists like Ben Bernanke, who'd worked hard on analyzing Japan.

But the big message I take from Japan's experience is the folly of excessive caution. If you're half-hearted about taking on the slump -- if you wait to cut interest rates, nickel-and-dime your fiscal stimulus, penny-pinch on your bank bailouts -- then by the time you realize more is needed, deflation has set in, and it's really hard to get out of the trap.

So you want to be really, really aggressive on policy early on.

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Honeydew, California: Will you please explain how or if we can adapt Depression era lessons to the current crisis?

Paul Krugman: The Depression offers a lot of more or less direct lessons. For example, the Big Mistake of 1937: FDR let himself be persuaded that he should try to balance the budget even though the economy was still depressed; the result was a severe recession in 1938. What the Depression teaches us is that when the economy is so depressed that even a zero interest rate isn't low enough, you have to put conventional notions of prudence and sound policy aside. Now as then, we've got an economy that needs temporary life-support from the feds; not where we want to be, but where we are.

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Richmond, Va.: I am interested in reading some Keynes, several years ago I took some economics courses and recall the professor saying that Keynes had been reconciled to the history books and was not really relevant in our current world. Where should I start?

Paul Krugman: Read "The Great Slump of 1930" -- available online for free, via Gutenberg Project. It will give you a sense of how Keynes thought. Also his open letter to FDR in 1933.

If you're feeling tough enough, you might also try the first few chapters of the General Theory; they summarize the main argument, and are easier going than the later chapters (though that's not saying much).

And your teacher was quite wrong: Keynes is utterly relevant to the modern world. Read The Great Slump and tell me that this doesn't sound like a description of current events.

Krugman on video: