Depression offers lessons for financial crisis

updated 12:01 p.m. ET Oct. 4, 2008

They are the stories we heard from our grandparents, the pictures we studied in history books — bread lines stretching around street corners, shantytowns sheltering the unemployed, small-town banks with darkened windows.

Today's financial crisis is hardly that grim, though it does share some similarities with the economic collapse of the 1930s — both were preceded by a housing boom, a long period of cheap credit and a falling stock market. But those same similarities may offer some reassurance.

What was then economic calamity is today a history lesson. This time, America has been through it before, and there's a guide, at least for mistakes to be avoided as the nation's leaders try to prevent another catastrophe.

Economists have spent decades dissecting the Great Depression. Their findings demonstrate the crippling effect fear has on economic decisions, the tremendous cost of not acting quickly and the risk of damaging the larger economy in efforts to make individuals pay for financially irresponsible investments.

"The number of people with personal memory of the Great Depression is fast shrinking with the years," one noted expert said in 2004 in a speech at Washington and Lee University. "However, although the Depression was long ago ... its influence is still very much with us."

That expert was Ben Bernanke, a former Princeton University professor and an expert on causes of the Depression. He's now the chairman of the Federal Reserve.

Placing blame
Today economists partly blame the Fed for the Depression because it raised interest rates even as the economy was slowing in the late 1920s. Then when banks began to fail, it took a hands-off approach.

But if those policymakers were able to speak up now, they could offer at least one defense of their actions: How were they supposed to know?

"In the Great Depression, what the Fed did at the beginning was to tighten interest rates. It took a long time to essentially recognize the magnitude of the problem, but of course it was a problem we had not had before," said Robert Aliber, a University of Chicago professor emeritus who's written on financial panics.

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Today's policy makers and lawmakers know better, or at least they should. They've had the benefit of studying not just the Great Depression, but numerous other financial crises, both in the U.S. and abroad.

They also have tighter regulation of financial markets, bank deposit insurance and other policies that were adopted to prevent history from repeating itself.

On the edge
The current panic has pushed the economy to the edge of a cliff. In the Depression, it plunged off.

During the 1920s, stock prices had more than quadrupled. But on Oct. 28, 1929, the Dow Jones average fell 13 percent in a single day, another 12 percent the next and 10 percent more a few days later.

Stocks bottomed out in 1932 — down 80 percent from the peak.

Millions of people lost their jobs, with unemployment reaching 25 percent in 1933.

Interactive Winners and losers A look at who is benefiting and who is suffering from the economic mess.

The banking system went into convulsions. About 9,000 banks failed in panics between 1930 and 1933, and hundreds of others were closed by the Roosevelt administration in the first days of its term.

The nation's economic output plunged by a third.

The underlying causes were different than today's crisis, but the two time periods share important similarities.

America in the 1920s was swept up in a boom. In some respects, it was a bubble, one that was bound to pop.

The bubble was clearly evident in real estate, most notably in Florida. It was cheap to borrow, and investors plowed money that wasn't theirs into new cities fashioned out of swamps, hoping to take advantage of sharply rising housing prices. When land values began to fall, they couldn't make payments, squeezing banks.

Fed policymakers viewed the soaring stock prices of the 1920s as fueled by immoral speculation. They responded by raising interest rates in an effort to restrict the supply of cheap cash.

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