No easy fix for troubles reminiscent of '30s, '70s

By ROBERT GAVIN
THE BOSTON GLOBE

last updated: July 20, 2008 03:26:29 AM

As Americans prepared for the July 4 weekend, oil rocketed past $145 a barrel, and U.S. employment fell for the sixth-straight month, a mix of rising prices and economic weakness that recalled the 1970s.

Last week, it was reminiscent of the '30s as plunging home prices, rising foreclosures and faltering credit markets pushed two major financial institutions, Fannie Mae and Freddie Mac, near the brink of failure. Policy-makers warned that the fallout from the housing crash could keep the financial system under pressure well into next year.

These comparisons to the Great Depression of the '30s and the national malaise of the '70s are a reflection of the serious difficulties facing the economy and the hard choices confronting policy-makers. While the situation is hardly as severe as the '30s or '70s, the threat comes as their different sets of problems hit the economy at the same time.

The reason: Solving one set of problems could make the other set of problems worse. Cutting interest rates could prop up housing and financial markets. But with oil and commodity prices rising rapidly, such a move could spark runaway inflation just as in the '70s.

On the other hand, raising rates to choke energy-driven inflation risks damaging weak housing, credit and financial markets, and sparking a '30s-style collapse.

"It's definitely a double whammy," said Nariman Behravesh, chief economist at Global Insight, a Waltham, Mass., forecasting firm.

Economists began making comparisons to the '30s earlier this year, when the meltdown in U.S. mortgage and housing markets squeezed the flow of credit and threatened to bring the financial system to a halt. Later, when Bear Stearns Cos. neared collapse, the Fed engineered the sale of the Wall Street firm, fearing its failure could spark runs on investment firms similar to runs on Depression-era banks.

It's no surprise the Fed would be particularly attuned to such threats. Chairman Ben S. Bernanke is a Depression scholar, and two other Fed governors, Frederic Mishkin and Randall Kroszner, also have studied the period. But you don't have to be a Depression scholar to see similarities.

In the 1920s, the bubble came in stocks; in the current decade, housing. As the value of these assets rose, so did U.S. consumer spending. They piled on debt, believing values would only go higher.

Much as today, Americans in the '20s had borrowed heavily to buy consumer goods. Cars, radios and appliances became widely available for the first time, and household debt rose by 12 percent from 1928 to 1929, and by 20 percent the following year, according to a 1978 paper by Mishkin.

Then the stock market crashed. Easy credit dried up. Asset values fell, but debt didn't. Consumers cut back, and spending on big-ticket items such as appliances fell 20 percent in 1931 alone, pulling the economy into a deeper hole.

"In the '20s, you had more and more people borrowing more and more money," said Gary Richardson, an economics professor at the University of California at Irvine. "You also heard some of the same things that we've heard over the past few years, like 'It's a new world' and 'Prices are justified at this level.' "

Another term heard in both periods: credit crunch. Today, lenders, struggling with losses from easy lending that fueled the housing boom, are reluctant to lend. As a result, business expansion and consumer spending have slowed, leading to increasing job losses and rising unemployment.

In the '30s, banks struggled with losses from easy lending that fueled the stock boom, according to a 1983 paper by Bernanke. They called in loans and stopped making new loans. The economy deteriorated, people lost confidence and pulled money out of banks. Panic ensued, banks failed, and the credit crunch became severe.

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