Economic Crashes: Only One Great Depression?

Did you know that the Great Depression was not the worst economic depression in American history?

There was a depression that lasted far longer than the Great Depression. In fact, it lasted so long that economists named it the Long Depression. It began with the Financial Panic of 1873 and extended until 1896.

That was a 23 year downturn, far longer than the 1929 to 1941 depression. Of course, some of us might feel encouraged by the news that our economy was once able to recover from a catastrophe as severe as that one. But some of us might blanche at the thought that economic downturns can last such a long, long, long time.

Most of us don’t spend much time thinking about economic cycles that occurred over a century ago. But if we study the ebbs and flows of our capitalist system over very long periods of time, we start to notice some recurring trends.

Crashing Like Clockwork

To put it simply, periods of economic prosperity seem to crash to a close every thirty years or so. Three decades after the Long Depression ended in 1896, for instance, the Great Depression began in 1929.  And three decades after the Great Depression ended in 1941, the next great economic malaise and stock market collapse began during the 1970s.

Yes, our economy suffered brief recessions in 1990 and 2001. But how much time elapsed between the great 1970s crisis and what is now being called the Great Recession of 2008-09? That’s right: roughly three decades. It seems as if our capitalist economy is only capable of sustaining thirty consecutive years of prosperity before collapsing in exhaustion for a relatively long period of time.

Some economists may protest that our capitalist system has evolved too dramatically during the 20th century to make such comparisons meaningful. And yet, although it would be foolish to get carried away with ancient history, the similarities between the economic crashes of yesteryear and the one that we are experiencing today are quite striking.

For instance, the Long Depression of 1873 was triggered by the collapse of the banking system, the bursting of a speculative stock market bubble, and a massive number of bankruptcies that swept through the high growth railroad and real estate industries. And what happened to trigger the Great Depression of 1929? Again, it was a banking collapse, a stock market crash, and a massive number of bankruptcies that swept through high growth industries. In fact, one of those industries was again real estate; its crash brought the careers of entrepreneurs like Florida swampland promoter Charles Ponzi to a close.

The 1970s witnessed its own stock market collapse and the mammoth bankruptcies of railroad systems like Penn Central. And those of us who are witnessing today’s Great Recession are experiencing more of the same: a collapsing banking system, a bursting stock market bubble, a bankrupt real estate industry, and the emergence of a new generation of Ponzi Scheme operators like Bernard Madoff and Allen Stanford.

Don’t Trust …

There’s a certain consistency to this pattern, isn’t there? New high growth industries emerge over time, but banks fail to adjust their risk management practices accordingly. Government regulators become complacent, and investors grow accustomed to unnaturally high investment returns. As the economy starts to slow, charlatans gain attention and briefly become successful by promising returns that cannot possibly be maintained indefinitely. And then, when the high growth industries begin to overheat, the economic house of cards falls to the ground with a mighty crash.

So what can we learn from this pattern? Here are a few things to keep in mind as you develop your own long range financial plan:

Don’t trust real estate. The conventional wisdom is that real estate is always a good investment because people will always need a place for living and working. But investors who bought Florida swampland from Charles Ponzi might disagree with that recommendation. Those who recently bought homes with subprime mortgages might as well.

Don’t trust new technologies. It must have been exciting to invest in the new railroad industry of the 1870s, the new automobile industry of the early 1900s, and the new internet industry of the late 1990s. For a while, new companies in high growth industries often take their investors for a fun ride. But when the inevitable industry shakeout ends the party, most of the fledgling firms are driven into bankruptcy.

Don’t trust banks. They have a distressing tendency of collapsing whenever great recessions and depressions occur, don’t they? And when they do, they drag down our entire economy with them. And speaking of our entire economy …

Don’t trust entire economies. Huh? Hasn’t the American economy always bounced back from depressions and deep recessions? Well, yes, but it took 23 years for Americans to get rid of the Long Depression, and an even longer time until they could enjoy the emergence of an extended period of prosperity. And some regions never, ever recover. Did you know that Argentina was one of the world’s ten wealthiest nations during the 1920s? And that among American cities, Charleston was the fifth largest in 1800, Baltimore was second largest in 1850, St. Louis was fourth largest in 1900, and Detroit was fifth largest in 1950?

To put it succinctly, don’t trust any of the conventional wisdom that you may have learned over the years. But that’s not to say that old lessons no longer apply; in fact, in a sense, we actually need to heed the lessons of history.

Glass Steagall: A Protection Against Time Itself?

Are you curious about the events that sunk Bear Stearns and other financial institutions, kicking off a series of financial catastrophes that torpedoed the global economy? You might want to read William D. Cohan’s House of Cards, which occupies the #3 slot on the New York Times bestseller list for hardcover nonfiction this week. You can peruse the first nine paragraphs at no charge, courtesy of our friends at NPR; unfortunately, you’ll then need to purchase the remainder of the book if you wish to continue reading it!

Those first nine paragraphs, though, say quite a bit about the nature of Bear’s downfall … and they leave us feeling reminiscent about the good ol’ days of Glass Steagall. That particular legislation didn’t simply prevent banks from entering inappropriate lines of business; in a sense, it served to protect bank depositors and investors from the ravages of time itself.

What did Glass Steagall do? Passed into law during the heart of the Great Depression in 1933, it established the FDIC to ensure that money placed in savings accounts would remain protected. It also prohibited bank holding companies from operating investment houses, thereby compelling investment bankers at institutions such as J.P. Morgan to spin off into firms like Morgan Stanley.

The FDIC still exists, of course, but the investment banking prohibition was repealed in 1999. When President Bill Clinton signed the repeal into law, Senator Phil Gramm proclaimed “”We are here today to repeal Glass Steagall because we have learned that government is not the answer. We have learned that freedom and competition are the answers. We have learned that we promote economic growth and we promote stability by having competition and freedom.”

Huh? Was Glass Steagall a law that was anti-freedom, anti-competitive, anti-growth, and anti-stability? From the post-meltdown perspective of today’s environment, a more nuanced view emerges.

Timing Is Everything

If preventing an organization from “doing whatever it wants” is anti-freedom, then Glass Steagall can certainly be considered anti-freedom. And to the extent that certain investors do face less competition when commercial banks are constrained from entering their investment space, then Glass Steagall can be considered anti-competitive as well.

But anti-growth? Citigroup took advantage of the repeal to enter the investment banking sector, and it certainly isn’t growing today. Instead, it’s shrinking its way to insolvency. And anti-stability? The financial sector is no longer looking very stable as it crashes to the earth, dragging the world economy with it.

One can only speculate what Senator Graham had in mind when he labeled Glass Steagall as anti-growth and anti-stability. Truth be told, Glass Steagall was never designed to preclude banks from operating in all other industries; it simply precluded them from entering the investment banking industry. And, as the first few paragraphs of Cohan’s House of Cards so clearly indicates, the problem that Glass Steagall addressed wasn’t one of competitive instability … it was simply one of timing.

A Time Bomb, Ticking For 30 Years …

Cohan clearly explains why firms like Lehman Brothers and Bear Stearns suddenly collapsed. Namely, for 30 years, these firms financed their operations by borrowing huge sums of money on the overnight debt markets.

The problem was that the collateral they pledged to secure their borrowings suddenly became unattractive to lenders late last year. Much of that collateral was invested in real estate mortgage securities, securities that will eventually recover in value as the real estate markets stabilize and then resume growth. But lenders in the overnight markets aren’t willing to wait years for the value of that collateral to recover. As overnight lenders, they continually demand repayment within 24 hours, and the real estate mortgage securities of Lehman and Bear will remain unmarketable for many years to come.

In a sense, Lehman and Bear faced the same problem that any homeowner would face if his mortgage banker were to demand “You’ve pledged your home as collateral to secure your mortgage. Now prove to me that you could sell your home tomorrow if I decide to call your loan for repayment tonight.” As long as the residential real estate remains healthy, that wouldn’t be a problem. But as soon as the market takes a dip, the homeowner might not be able to meet the mortgage banker’s demand, and might end up defaulting on his debt.

The Glass Steagall Solution

How did Glass Steagall address this problem? Simply enough, the law forced bankers to make a choice. If they wanted to continue to accept savings account deposits from the “man on the street,” deposits that they might need to repay in full at any time, they couldn’t invest those deposits in complex securities that might remain depressed in value for many years.

That’s why bankers like Henry S. Morgan and Harold Stanley spun off and established their own investment houses. They wanted to continue investing in securities that might remain illiquid for many years, and thus they agreed that they wouldn’t accept savings deposits from the “man on the street.” But beginning in 1999, banks no longer needed to make such decisions; instead, they were given the freedom to “do whatever they wanted” with their funds.

And now, what is the federal government’s solution to the problems that were caused by the repeal of Glass Steagall? Apparently, investment houses like Goldman Sachs and Morgan Stanley are being encouraged to convert to bank holding companies to gain access to federal bail-out funds. Such a policy arguably moves our economy even further away from the constraints that were originally established by Glass Steagall.

Is that a wise move? Time was an enemy of Lehman and Bear, and now only time will tell whether Goldman and Morgan will suffer the same fate.