Worst of Times

Most economists predict a recovery late next year. Don't bet on it.

Economists regard the Great Depression as something akin to the Black Death: a fascinating and terrifying historical aberration that, thankfully, can never happen again. Despite a stock market collapse and the demise of several huge financial institutions, this reassuring view of the Depression remains intact. On October 10, Lawrence Summers, the former Treasury secretary and a senior economic adviser to Barack Obama, said that "barring egregious errors, this is not going to be anything like the pictures people saw of the 1930s." A few days later, Federal Reserve Chairman Ben Bernanke said the U.S. economy will "emerge from this period with renewed vigor."

Among noneconomists, there is much more concern about what lies ahead. In October, a CNN poll found that 59 percent of Americans believe another 1930s-style depression is very or somewhat likely. Dismissing feel-good suggestions that the turmoil on Wall Street won't have much impact on the rest of the economy, 55 percent of the respondents said the financial crisis would affect them personally within the next year. A separate poll for Condé Nast Portfolio shows that people working in the finance business are even gloomier: 77 percent of them say their industry is in a state of crisis, and 50 percent say the economy is the worst it has been in their careers.

So who are we to believe: the experts who failed to predict the current crisis or the great American public? With due respect to my fellow dabblers in the dismal science, I share Joe the Plumber's queasy feeling. Unless something miraculous happens in the next few weeks, the new inhabitant of the Oval Office will inherit an economy flailing under the weight of record debts and rising unemployment. If a depression is defined as a deep, extended recession of a severity that nobody under the age of 75 can recall, then it is quite likely that we are already in one.

Despite the recent stabilization in the financial markets, which followed the agreement to inject vast sums of taxpayers' money into many of the country's biggest banks, deflationary forces are still ripping at the economy: There's the housing slump, an unprecedented collapse in consumer confidence, and a global downturn that is getting more severe by the week. In addition, a reckoning in hedge funds and private equity firms is just starting, and the ripples (and potential tidal waves) of the banking crisis are just beginning to hit the rest of the U.S. economy.

Having buried their heads firmly in the sand for much of the past year, most professional economic forecasters are now predicting a moderate recession that will last until the middle of 2009-a consensus that could well prove as overly optimistic as the previous one, in which the U.S. was expected to avoid recession altogether. Even allowing for another significant stimulus package sometime in the spring, consumer spending, business investment, and exports all seem set to fall throughout most of next year, which would rule out any meaningful recovery.

In the summer of 2007, when the subprime crisis erupted, Bernanke failed to appreciate its significance. Once he realized what was at stake, he took remedial action. In the past 15 months, the Fed has cut the federal funds rate in the most rapid monetary easing on record. For months now, it has been lending hand over fist to troubled financial institutions, and in October it started lending to nonfinancial companies through the purchase of commercial paper.

For some inexplicable reason, Bernanke almost undid his previous work by allowing, with Treasury Secretary Hank Paulson, Lehman Brothers to go bankrupt, a move that sparked the systemwide panic he had been so desperate to avoid. Paulson, who for the first few weeks of the crisis had been held up as a superhero economic rescuer, has recently seen sentiment turn against him, with economists and commentators now arguing that the entire crisis may have been muted if Lehman had been rescued. Even that blunder may ultimately have worked out okay though, because it brought in Congress and other fiscal authorities worldwide, who are the only ones with the financial wherewithal necessary to restore lenders' confidence. Now that governments have agreed to guarantee many of the dubious liabilities that banks and other financial institutions incurred during the great credit boom, the specter of a global cataclysm has greatly diminished, at least for the time being.

That is the good news. But even if another Great Depression is now "off the table," to quote the sage Jim Cramer, several other parallels with the 1930s still worry me greatly, beginning with the continuing threat of international contagion. Perhaps the most remarkable aspect of the September financial earthquake was how rapidly it spread to places far from the epicenter, such as Iceland and Ireland, and how much damage it did there. Even now, the aftershocks are being felt in countries like Brazil, Hungary, and South Korea. Not since the collapse of the Viennese bank Creditanstalt in the spring of 1931, which unleashed a wave of instability that culminated in the decline of the gold standard, has the international monetary system seemed so fragile. For the U.S. economy, this matters for a couple of reasons. Another big financial collapse in Europe or Asia could well generate more carnage on Wall Street. Even if this doesn't happen, as economic weakness spreads around the world, American exports suffer.

Second, even after the current round of capital injections, many big banks will be thinly capitalized relative to the quantity of potentially bad loans on their books. In their most recent reporting periods, Goldman Sachs and Morgan Stanley each had on their balance sheets more than $60 billion worth of level-three assets-the ones that can't currently be valued properly and haven't yet been written down.

As for the big commercial banks, Citigroup still has tens of billions of dollars' worth of subprime and other risky securities on its books, and even the supposedly healthy J.P. Morgan and Bank of America are heavily exposed to the junkiest end of the property sector. On top of this, the big banks have massive loans outstanding to leveraged buyout firms and other companies that will struggle to survive the recession. Relative to all of this, even the billions of dollars that each of the big banks stands to receive from the government recapitalization won't be enough.

Until the U.S. follows the example of the Swiss government, which recently took all of UBS's toxic assets and shifted them into a separate "bad bank," most big American banks will continue to hoard capital rather than lend, which means credit will remain hard to come by.

Third, once the recent collapse in commodity prices makes its way through the system, a real danger of deflation could emerge-not on the scale of the 1930s but significant enough to greatly slow a recovery. Oil prices, which I predicted would tumble from their triple-digit highs, have begun falling faster than most people thought; OPEC is now scrambling, belatedly, to rein in production. The threat of rising inflation, which Bernanke and his colleagues were citing as recently as the summer, has already disappeared. In September, the annualized rate of consumer price inflation fell to zero. (The core rate of inflation, which excludes energy and foodstuffs, was just 0.1 percent.) As unemployment continues to rise, wages and prices are sure to be trimmed in many other parts of the economy, which will only add to the incipient deflation.

John Maynard Keynes pointed out in the 1930s that when prices go up slowly or not at all, monetary policy is much less effective because people are inclined to hold money instead of spend it. Moreover, once interest rates are reduced to 1 percent-which the federal funds rate reached in October-the Fed can't cut them much further, and other, more drastic means of stimulating demand have to be used, such as introducing a tax cut and financing it by printing money. (Back in 2002, Bernanke advocated such a policy as an antidote to deflation.) Setting aside the political difficulties of adopting such a plan, the very prospect of it could well spark a run on the dollar, which would force the authorities to reverse course.

We are, of course, still a very long way from the Great Depression, which, after all, wasn't just any old depression: It was a slump of such longevity and enormity that, even now, it is unlikely to repeat itself. Between late 1929 and early 1933, inflation-adjusted G.D.P. fell by some 30 percent, industrial production plunged 47 percent, and the unemployment rate rose to more than 20 percent. And that four-year period wasn't the end of it. After appearing to recover for a few years, the economy entered another deep downturn at the beginning of 1937 that lasted until the middle of 1938. Unemployment didn't drop back below 10 percent until the country mobilized for World War II.

The decline in economic activity during the Depression was quite remarkable. In terms of lost G.D.P., it amounted to more than 10 times the decline seen in all the other recessions of the 20th century combined. In many urban areas-in New York's Central Park, in the Anacostia section of Washington, along the banks of the Mississippi in St. Louis-tent villages of homeless people, known as Hoovervilles, sprang up, while in the drought-stricken interior, countless families lost their homes and followed the "dirty plate trail" to California.

While the financial system was contracting dramatically, a big fall in wholesale and retail prices, as well as the values of real estate and most financial assets, subjected the rest of the economy to ruinous "debt deflation." If wages and prices gradually rise, as they do in normal times, the inflation-adjusted value of debts diminishes. But if wages and prices fall sharply-between 1929 and 1933 the wholesale price index fell by a third-debt burdens increase.

Borrowers who can't meet their interest payments are forced into distress sales of assets, putting more downward pressure on prices.

Between 1929 and 1933, that is what happened. Even today, with an economy much less dependent on bank loans than it was in 1930, a wholesale failure of the banking system, together with an extended fall in prices, could have a devastating impact. The reason most economists discount this possibility is that they don't believe policymakers will make the same disastrous mistakes their predecessors made in the 1920s and 1930s, when the authorities stood by as the financial system imploded and withering deflation developed.

After approving the foundation of the Federal Reserve in 1913 to help guard against future financial panics, Congress and the executive branch neglected to establish a system of deposit insurance, which left the system acutely vulnerable to runs. (Franklin D. Roosevelt quickly rectified the omission.) Then, after the stock market crash of 1929 dealt a serious blow to the economy, the young Fed, rather than extending credit to troubled banks, did next to nothing. Some of its top officials actually welcomed the growing number of bank failures as a sign that bad debts were being purged.

Bernanke is an expert on the Depression, and under his leadership the Fed was never likely to repeat its earlier errors. In November 2002, shortly after he became a Fed governor, Bernanke attended a conference to celebrate Milton Friedman's 90th birthday. It was Friedman who, with economist Anna Schwartz, popularized the view that the Fed blundered in the 1930s. "I would like to say to Milton and Anna: Regarding the Great Depression, you're right. We did it," Bernanke told the crowd. "We're very sorry. But thanks to you, we won't do it again."

Yet it isn't entirely clear what he should do. During Japan's "lost decade" of the 1990s, it discovered that navigating a deflationary real estate and credit bust is far from easy, no matter what you do. To be sure, the Japanese government made some initial mistakes in following an inflexible monetary policy and allowing banks to hide losses. Eventually, though, it did most of the things that outsiders such as Bernanke had recommended, like recapitalizing the banks at the taxpayers' expense and experimenting with new monetary rules. Even then, prices kept falling, and the economy barely managed to expand.

As for the Japanese stock market, I can hardly bear to talk of it. In 1989, when I first visited Tokyo, the Nikkei was approaching 39,000. Ten years later, when I returned, it was languishing at about 14,000. Today, it is below 10,000. Before shifting what remains of your retirement fund into an S&P 500 index fund to take advantage of a coming rebound, you might want to take a look at the Nikkei chart. It is quite a sight.

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