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Is the U.S. Headed Towards the Second Great Depression?

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Is the U.S. Headed Towards the Second Great Depression?

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 U.S. were to experience an economic downturn on the scale of the Great Depression of 1929, your life would change dramatically. Unemployment would rise from its current rate of 9% to 25%. Economic output, as measured by GDP, would fall 25%, from $14 trillion to $10.5 trillion. Instead of inflation at about 2%, deflation would cause prices to plummet 10%. World trade would shrink 65%. That was the extent of economic decline that occurred during the Great Depression of 1929.

Could it happen again? In a 2011 CNN poll, nearly 50% of Americans believed it could -- and within the next 12 months.

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Why have Americans started to worry about a depression again? (Updated August 18,2011)

  1. Stock prices fell 2,000 points in three weeks in late July/early August. Volume traded was nearly 500 million shares on August 11. Volatility is spooking investors, as the Dow swings 400 points up or down a day.
  2. Housing prices fell to a new low of $156,100 in February 2011. That's down 31.8% from their peak of $229,000 in June 2007. That's even worse than the Great Depression, where prices fell 24%. Foreclosures make up 30% of all home sales. Many homeowners are upside down in their mortgages, so can't sell their homes, or even refinance to take advantage of record-low interest rates.(Source: National Association of Realtors)
  3. Unemployment rates won't budge. Around 14 million people are looking for a job. Over 40% of them have been looking for six months or more. Another 8.4 million are working part-time, but only because they can't find a full-time job. Then there's the 2.8 million who are so discouraged, they'd given up looking for work, and so were counted in the unemployed numbers. Total number of people who need a full-time job, but can't get one? 25 million, or 16% of the potential labor force.
  4. The Federal government is unlikely to come to the rescue with stimulus spending as it did in 2009. The credit ceiling crisis means that Congress is looking to cut spending instead.
  5. Business credit is still hard to come by. Banks are sitting on cash, unwilling to lend. recent stock market volatility and the crisis in Europe seems to confirm their fears. However, Americans are looking for a return from the $700 billion bailout. They don't realize that most banks have paid these funds back. People only know about the high bank profits.
  6. The Federal Reserve has let QE2 expire, and is unlikely to launch QE3. Why? Its attempts to add liquidity hasn't found its way to the general economy. Instead, frightened banks are sitting on trillions in cash.
  7. Oil prices rose to a recent high of $133.93 on April 29, 2011. Once again, investors stormed out of the stock market and rushed into commodities. The resultant high food and gas prices have consumers feeling pinched, and worried about inflation.

Background

The economy is facing these stresses without its normal resilience. The global economic crisis has left it weakened, and its used up its usual macroeconomic tools. People can't see where the drive for growth will come from. Here's how badly the economy was damaged:

  1. Stock market losses suffered during the recession have not yet been recovered. The Dow dropped 40%, from its all-time high of 14,043 in October 2007 to 6,594.44 on March 5, 2009. Between its peak and its bottom, the Dow dropped over 50% in just 17 months. It dropped 800 points during intra-day trading on October 6, 2008, its largest one-day drop ever.
  2. Housing price declines and foreclosures were a result of mortgage financing reliant upon mortgage-backed securities, and lax lending standards. (See A Primer on the Subprime Mortgage Mess) 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 supporting the U.S. housing market. As housing prices dropped, homeowners went upside-down in their mortgages, preventing them from selling. As a result of this and high unemployment, foreclosures skyrocketed, creating a backlog of shadow inventory overhanging the housing market.
  3. Business credit froze up. Demand for any type of asset-backed commercial paper virtually disappeared. This panic over the value of these commercialized debt obligations led to the financial sector's crisis, causing the intervention of the Federal Reserve and the Treasury. The governments of the world stepped in to provide all the liquidity for frozen credit markets. The U.S. debt has been downgraded, and there are concerns that Europe is next.
  4. Bank near-failures destroyed some of the most prestigious financial services companies, including Lehman Brothers, AIG, Wachovia, Bear Stearns, Washington Mutual and IndyMac Bank as well as many foreign banks. Since this was a result of their inability to raise funds, either through debt offerings or sale of stock. As a result, frightened banks are sitting on cash they should be lending.
  5. Oil prices set new records, rising to $145 per barrel in July 2008, then plummeting to $30 per barrel in December 2008. High prices take cash away from other consumer products. Overall volatility makes people want to save in case prices skyrocket again.
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