As of spring 2008, we're probably just a third of the way through the unfolding debacle in the housing, credit, and financial markets. In political and regulatory terms, the ultimate problems and remedies have only begun to define themselves. We're not just looking at an ordinary recession. Since the 1970s, the United States has redefined itself from a manufacturing nation to a financial economy built on debt, leverage, and a considerable ratio of speculation. Both political parties have been complicit in this, and the downturn now beginning will be unusual and potentially tragic.
The case being made in some reform-minded and progressive circles--that we are on the cusp of a grand political, ideological, and pro-regulatory opening such as that of 193a--has some logic but also merits a considerable amount of economic and historical caution. The plausible analogies deserve a quick run-through. To begin with, there is the prospect that, over the next few years, the largest credit bubble since the Roaring Twenties is going to unwind with at least some of the angst and pain of the Depression years. In 2007, total credit-market debt in the U.S. reached almost 340 percent of gross domestic product, far above the previous high-water mark of 287 percent a few years after 1929. Second, it is also becoming likely that the 2006-2010 decline in U.S. home prices will be the largest in three-quarters of a century.
However, there are also good economic reasons why the analogy should not be overindulged; today's U.S. political economy is quite different from that of 70 years ago in several ways. First, whereas the 1929 crash came in the wake of three to four years of strongly deflationary trends in the global commodity markets, today's international economy is caught up in what appear to be major inflationary pressures in global agricultural and energy prices. In its panic over deflation, today's Federal Reserve may be more likely to err in the direction of feeding inflation.
The second relevant caution is that finance is a far more dominant element in the current-day U.S. economy than anyone could have imagined in the era of Herbert Hoover. Even amid 1929 ballyhoo and tickertape, finance was overshadowed by manufacturing. In the 1990s, by contrast, financial services sprinted ahead of manufacturing as a share of U.S. GDP. By 2006, financial services counted for over 20 percent of the economy, and manufacturing just 12 percent. As of 2008, portions of this swollen sector--mortgage finance, reckless securitization products like Collateralized Debt Obligations (CDOs), and elements of the credit markets--now threaten to implode. Still, even if the de-leveraging of the U.S. economy over the next few years is as painful as it was during the 1930s, that does not necessarily re-recommend the New Deal regulatory model. It will probably recommend some model that the 2008 political debate has not even touched upon.
The third relevant caveat is that the United States is now far more exposed to negative international actions and perceptions than it was in the 1920s and 1930s. Back then, the United States enjoyed three beneficial attributes: It was the world's leading energy producer, the world's leading manufacturer, and the world's leading creditor nation. So favored, the U.S. economy was able to survive the years of Herbert Hoover's inactive stewardship. Over the last decade, however, under the derelict management of George W. Bush, the United States has cemented its embarrassing status as the world's leading debtor nation, the No. 1 importer of foreign manufactured goods, and the No. 1 importer of foreign oil. As a result, the shrunken dollar has lost over 40 percent of its value against the euro since 2002. That shrinkage could even intensify if foreigners believe that the U.S. government, in particular the Federal Reserve Board, is committed to supplying liquidity to rescue reckless financial institutions at risk of inflation and at the expense of dollar holders. …