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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)

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 kind of leveraging. Crashes also make it difficult for companies to raise the needed funds to grow. Finally, a stock market crash can destroy the confidence needed to get the economy going again.
  2. 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. Until housing prices rise, banks will continue to hoard cash to write off a backlog of foreclosures. It's estimated there are 1 million foreclosures pushed out to 2012. This will keep the housing market depressed, causing further foreclosures.
  3. 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% of all new jobs that they provide.
  4. 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.
  5. High oil prices signaled to many people the end of cheap oil, which had been the foundation of the fast-growing global economy. Others became concerned that current prices are signaling poor demand that could still lead to depression.
  6. Deflation is an even bigger threat, despite oil price spikes. We've seen this already with housing, which has experienced 30% deflation. Even those who could afford to buy houses are waiting until the market improves. The longer they wait, the lower prices go. Second, people become reluctant to take out loans. Again, we see this in housing. Those who are upside-down in their mortgages see no light at the end of the tunnel, and walk away even though they can afford to pay it. This sends prices even lower. Those who keep paying their loan have less money to spend on other things, driving down demand in other sections of the economy. What do they get in return? An ever-deflating asset. Third, as prices fall, so must wages. Those who don't accept lower wages are laid off. Once deflation sets in, the pessimism is notoriously difficult to break, and can ultimately lead to a Great Depression.

Arguments Against

  1. Stock price declines haven't exceeded 11% in one day, or 30% 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% in just four days.
  2. Housing prices and foreclosures seem to be leveling off. Rental rates are relatively high, which could bring investors back to the housing market. Once confidence begins to be restored, housing prices will rise. Banks with foreclosures can start to recoup losses, as demand for foreclosed homes rises.
  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%. 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 siad it will keep the Fed Funds rate at nearly zero through 2012. This certainty helps calm markets, and provides needed liquidity.
  5. Oil prices at $85 per barrel translate into gas prices that are still less than half of what Europeans pay, thanks to heavy gas taxes. Furthermore, OPEC prefers to keep the price of oil under $100 per barrel to keep others from exploring their own oil reserves and developing alternative fuels. Lower demand for oil, and lower oil prices, has removed this summer's inflationary pressure.
  6. Economic output fell 4% from its high of $14.4 trillion in the 2nd quarter of 2008 to its low of $13.9 trillion a year later. In fact, GDP in 2011 has surpassed its prior 2007 peak. It fell a whopping 25% in the U.S. during the Depression.
  7. Deflation has been restricted to housing so far. Money that's been invested in gold and oil could, with the right policies or a little confidence, go rushing back into housing.

Outcome

The U.S. economy had been living on borrowed money for a long time, even before the financial crisis. The economy is experiencing the unwinding of that excess, and probably will be for some time. It's unlikely to be enough to cause a worldwide depression, thanks to growth in China and other emerging market countries that have excess cash reserves. Instead, what you are seeing is slow deleveraging.

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 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.

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