Could the Great Depression Happen Again?

Is the Second Great Depression Coming?

During the Great Depression, people lost their homes and lived in tents. Could that happen in the U.S. again? (Photo: Dorothea Lange / National Archives).

If the United States had an economic downturn on the scale of the Great Depression of 1929, your life would change dramatically. One out of every four people you know would lose their job. That's because the unemployment rate would quintuple from its current rate of 5 percent to 25 percent.

Economic output would plummet 25 percent. That means Gross Domestic Product (GDP) would fall from its current $18 trillion level to $13.5 trillion.

Instead of inflation at about 2 percent, deflation would cause prices to drop 10 percent. International trade would shrink 65 percent. That's how bad the Great Depression was.

Could it happen again? In a 2011 CNN poll, nearly 50 percent of Americans believed it could. They thought it would happen within a year. Fortunately, they were wrong.

But many people are still worried about a depression reoccurring. Others are convinced we are already in a depression. They just can't see where the drive for growth will come from. What makes these Americans so worried? 

First, stock prices fell in early 2016.  Investors lost trillions, and some countries went into recession. That followed losses in 2015, where nearly 70 percent of all U.S. investors lost money. According to some, it was the worst year for stocks since 2008.  Nearly 1,000 hedge funds shut down and junk bonds were crashing. (Source: "Will 2016 Bring the Next Great Depression?

" Charisma News, January 1, 2016.)

Second, volatility spooks investors when the Dow swings 400 points up or down a day. Stock market losses suffered during the 2008 stock market crash were devastating. The Dow dropped 53 percent from its high of 14,043 in October 2007 to 6,594.44 on March 5, 2009. It dropped 800 points during intra-day trading on October 6, 2008, its largest one-day drop ever.

Investors who lost money are understandably still spooked by that experience. For more, see Dow Closing History.

Oil prices have also been volatile. They rose to $50 a barrel after plummeting to a 13-year low of $26.55/barrel in January 2016. That was just 18 months after a high of $100.26/barrel in June 2014. Oil prices were pushed down by an increase in supply from U.S. shale oil producers and the strength of the U.S. dollar. Volatility makes people want to save, in case prices skyrocket again. Fore more, see Oil Price Forecast.

Third, the 2008 financial crisis weakened the economy's structure. That means it faces future global stresses without its normal resilience. 

  • The housing collapse was worse in the recession than the Great Depression. Prices fell 31.8 percent from their peak of $229,000 in June 2007 to $156,100 in February 2011. They fell 24 percent during the depression. In the early stages of the recovery, foreclosures made up 30 percent of all home sales. Many homeowners were upside down in their mortgages. They couldn't sell their homes or refinance to take advantage of record-low interest rates. The housing collapse was caused by mortgage financing reliant upon mortgage-backed securities. After 2008, banks literally stopped purchasing them on the secondary market. As a result, 90% of all mortgages were guaranteed Fannie Mae or Freddie Mac. The government took ownership, but banks still aren't lending without Fannie or Freddie guarantees. In effect, the Federal government is still supporting the U.S. housing market. See A Primer on the Subprime Mortgage Crisis.

    Fourth, the Federal Reserve used up its usual expansionary monetary policy tools to fight the financial crisis. It ended Quantitative Easing, but that only means it isn't adding to its bloated balance sheet. It keeps rolling over the $4 trillion in U.S. debt that it purchased for that program. The fed funds rate is 1.0 percent. The FOMC will raise it again in 2017 and 2018. Until then, the Fed has less firepower for the next financial crisis.

    Fifth, the federal government is unlikely to come to the rescue with stimulus spending as it did in 2009. The $19 trillion debt means that tea party Republicans in Congress have been looking to cut spending instead. 

    Arguments For 

    1. Stock market crashes can cause depressions by wiping out investor's life savings. If people have borrowed money to invest, then they will be forced to sell all they have to pay back the loans. Derivatives make any crash even worse through this leveraging. Crashes also make it difficult for companies to raise the needed funds to grow. Finally, a stock market crash can destroy the confidence required to get the economy going again.
    1. Lower housing prices and resultant foreclosures totaled at least $1 trillion in losses to banks, hedge funds and other owners of subprime mortgages on the secondary market. Banks continue to hoard cash even though housing prices have increased. They are still digesting the losses from one million foreclosures.
    2. Business credit is needed for businesses so they can continue to run on a daily basis. Without credit, small businesses can't grow, stifling the 65 percent of all new jobs that they provide.
    3. Bank near-failures frightened depositors into taking out their cash. Although the FDIC insures these deposits, some became concerned that this agency would also run out of money. Commercial banks depend on consumer deposits to fund their day-to-day business, as well as make loans.
    4. High oil prices could return once U.S. shale producers are forced out of business. Millions of jobs were lost when oil prices plummeted. At the same time, many consumers bought new cars and SUVs when gas prices were low. They will be pinched when prices rise again.
    1. Deflation is an even bigger threat. One reason the Fed doesn't want to raise rates is because inflation has yet to reach its goal of 2 percent annual price increase. Low oil and gas prices have had a deflationary impact. So has a 25 percent increase in the U.S. dollar. That depresses import prices. These deflationary pressures seem like a boon to consumers. But they make it difficult for businesses to raise wages. The result could be a downward spiral. That's similar to what happened in the Great Depression.

      Arguments Against

      1. Stock price declines haven't exceeded 11 percent in one day, or 30 percent in a year. The kick-off to the Depression was the Stock Market Crash of 1929. By the stock market's close on Black Tuesday, the Dow had fallen 25 percent in just four days.
      2. Housing prices and foreclosures have recovered. Rental rates are relatively high, which has brought investors back to the housing market. Now that confidence has been restored, housing prices will continue to rise. The foreclosure pipeline, which once seemed endless, has disappeared.
      3. Business credit has been affected the most. The world's central banks have pumped in much of the liquidity needed. In effect, they have replaced the financial system itself.
      4. Monetary policy is expansionary, unlike the contractionary monetary policies that caused the Great Depression. During the recession in the summer of 1929, the Fed decreased the money supply by 30 percent. It raised the Fed funds rate to defend the value of the dollar. Without liquidity, banks collapsed, forcing people to remove all funds and stuff them under the mattress, causing economic collapse. The FDIC helps prevent bank runs by insuring deposits. The Fed has said it will keep the Fed Funds rate at nearly zero through 2012. That certainty calms markets and provides needed liquidity.
      1. Oil prices are rising. But even at $85 per barrel, they translate into gas prices that are still less than half of what Europeans pay, thanks to high gas taxes. OPEC would prefer to return the price of oil to its sweet spot of $70 per barrel once it has bankrupted U.S. shale producers. That will reduce oil price volatility. OPEC wants to keep its enemy Iran and others from exploring their oil reserves and developing alternative fuels
      2. Economic output fell 4 percent from its high of $14.4 trillion in the 2nd quarter of 2008 to its low of $13.9 trillion a year later. It fell a whopping 25 percent in during the Depression. It has recovered to $18 trillion.
      1. There is a big difference between a recession and a depression. Even if another Great Recession does occur, it is unlikely to turn in a global depression.

      Outcome

      The U.S. economy had been living on borrowed money for a long time. The financial crisis scared businesses and families. That's why growth in this recovery is slower than in prior ones. You are witnessing a gradual deleveraging. It will continue for some time. In the United States, Europe, and Japan, it's aggravated by demographics. These countries have aging populations. Seniors don't need to spend as much on housing, cars, and furniture as young people starting a family. But this deleveraging is unlikely to be enough to cause a worldwide depression. That's thanks to growth in China, India, and other emerging-market countries that have excess cash reserves and younger populations.  

      What's good for the economy may not necessarily be good for you -- and vice-versa. When the economy is uncertain, it's time to get defensive. The only way to do that is to increase your income and reduce your spending. That way, you'll have money to reduce your debt. After that, make sure you have a cushion, and then build up your savings. The best investment is still a diversified portfolio.

      If possible, make sure you have a college degree. Education is the great divide in this society -- the unemployment rate for college grads is half the average. Although housing is historically cheap, as are interest rates, only buy a house you can easily afford. The smaller the house, the less furniture you'll have to buy to fill it. The economy will probably avoid another Great Depression, but either way, you'll be in a better position to weather it.