Ghosts of the Great Depression

With some observers saying that the ongoing financial crisis could be the worst since the Great Depression, the greatest living expert on that period is getting the chance to apply its economic lessons.

The depth of the crisis came 20 years before Federal Reserve Chairman Ben Bernanke was born, but his academic research gives us a sense of what sort of policies to expect if confidence in the financial system continues to wilt. As radical and unorthodox as the Fed's playbook has been the past eight months, investors should be prepared for far more if lending continues to sputter because the stakes are very high indeed.

One of the people who knows Bernanke best, his colleague Burton Malkiel from the Princeton economics department, explains that the Fed will be focused on tackling the fear now gripping the lending system.

"He's a scholar of the 1930s and the fact that we basically allowed the money supply to decline by 25 per cent - not the stock market crash - was (the bigger problem)," said Malkiel. "It's exactly the situation we have now - that the banks are afraid to lend to anybody but the strongest credits in the world."

The good news for investors is that exhaustive research on what went wrong back then has given the Fed and the Treasury Department a keen understanding that interest rate, tax and import tariff increases early in the downturn greatly exacerbated the problem. A repeat of the crisis that saw stocks lose nearly 90 per cent of their value and take a quarter century to regain their peak is highly unlikely given that we at least know what not to do.

And the bad news? The Fed has used a lot of its conventional firepower and has stretched its mandate already with little to show for it. Aside from the three percentage points in overnight rate cuts in the past six months - a hefty dose of stimulus to be sure - the other, unconventional and largely unprecedented moves by the Fed have been massive. There has been an alphabet soup of liquidity facilities TAF, TLSF and PDCF, plus the $US30 billion put at risk in bailing out Bear Stearns via JP Morgan Chase & Co, that Merrill Lynch economist David Rosenberg puts at a total of $US495 billion so far. The Fed's normally very conservative balance sheet has gotten riskier.

As "shareholders" of the Fed, that puts taxpayers on the hook and some public backlash may be expected. Then there are unpleasant side-effects of easy money like a slumping greenback and soaring commodity prices. The Treasury Department's proposal to increase the Fed's powers may get a sceptical hearing by Congress as there are suggestions that it may already have overstepped its role.

How much more radical will Bernanke get? The Bear bailout was a serious escalation that will raise many questions when he visits Capitol Hill Wednesday. CNBC commentator Rick Santelli summed up the shock some felt over the Fed risking $US29 billion of its own money, noting that they "might as well put a hammer and sickle on the flag."

In a more nuanced criticism, fund manager and former finance professor John Hussman laments that "unelected bureaucrats are committing public funds to facilitate private business transactions and selectively defend the holders of corporate securities."

"Unfortunately, the ongoing provision of short-term liquidity by the Fed stands in strong contrast to the dangerous and misguided application of public funds in the Bear Stearns deal," he wrote. "That deal should be quickly busted and reorganized in a manner that assures that Bear's bondholders, not the public, carry the risk of loss."

Milken Institute research director Glenn Yago disagrees that the Bear bailout and possible future actions are radical.

"I wouldn't use the word 'radical' because similar things have been done in central banking in Europe and elsewhere," he said. "What it reflected was that he used the monetary levers to the extent that he could use them and saw (the problem) was institutional. Clearly, assets needed to be repriced, but the institutional reaction was much greater."

He notes that the creators of the Fed envisioned it leading bailouts and avoiding the wrenching economic crises that hit about once a decade from the 1870s onwards, often caused by crop failures. Propping up a non-bank institution like Bear isn't really so different.

"Here you have a crop failure in the credit market," he said.

The last time the financial system teetered in a similar way was nearly a decade ago when Long Term Capital Management imploded, but banks were convinced by the Fed to put their own capital at risk then.

"I think what's different from LTCM is that the Fed has actually put its money up and has put $US30 billion into these dodgy assets - that's a sea change," said Malkiel. "I worry about moral hazard, but I think it was probably the right thing for my friend Ben Bernanke to do. I don't think you want to take the risk that the system is so fragile that one financial institution can cause a cascade of problems. You don't like the moral hazard (but) that's what led a free market economist like he is and like I am to do what he did."

Yago said that, while allowing Bear to fail may not have started a domino effect, Bernanke's research led him to believe that such an event could have been catastrophic. It was too big of a risk to take.

"He was the guy who coined the term 'financial accelerator,' that you could have product failures that would amplify the shock to the system," said Yago. "We're nowhere near a depression, but he wants to (take precautions). There was no reason that the Great Depression needed to happen."

Though the term "depression" has been tossed around in the media lately, few people living today realize just how different it was from run-of-the-mill hard times. Consider the fact that the worst postwar economic downturn from 1974-75 saw economic output shrink by 3.4 per cent and unemployment go from 4 per cent to 9 per cent. By contrast, the period from 1929-1933 saw output fall by 30 per cent and unemployment go from 3 per cent to about 25 per cent, even with many officially employed people only working part-time. About half of the banks failed and unemployment stayed in the double digits until World War II.

Financial pundits seeking to guess Bernanke's upcoming moves should keep the severity of the 1930s crisis in mind not because a repeat is likely but because Bernanke is convinced that being meek today may greatly worsen the crisis tomorrow. In "Essays on the Great Depression," released in 2004, he notes that understanding that period is the "holy grail of macroeconomics."

"Those who doubt that there is much connection between the economy of the 1930s and the supercharged, information-age economy of the twenty-first century are invited to look at the current economic headlines - about high unemployment, failing banks, volatile financial markets, currency crises, and even deflation," he wrote. "The issues raised by the Depression, and its lessons, are still relevant today."