Is It 1929 All Over Again?

It was 79 years ago today that the 1929 Wall Street Crash [1] marked the beginning of America's slide into the Great Depression. As we find ourselves in the middle of an economic crisis — during which the Great Depression has been referenced by just about everyone — I decided to mark the anniversary by talking with economist and author Robert Kuttner [2] about how we got from the Crash of 1929 to Meltdown 2008, and how we can avoid a repeat of what followed the 1929 crash.

TERRANCE HEATH: In his column about the 79th anniversary of the 1929 Wall Street Crash [1], Professor Maury Klein [3]asked, "Is it 1929 all over again?" Is it?

ROBERT KUTTNER: Yes, this is 1929 all over again. For the same reasons. The crash of 1929 was caused by too much speculation, with too much borrowed money, with too many conflicts of interest and too little transparency. And in the 1930's the New Deal mostly repaired that by much tighter regulation of banks, much stricter supervision of conflict of interest, much greater controls on leverage and much grater disclosure for investors.

But it fixed the problem for the known universe of financial institutions, and after the '70s all kinds of new exotic financial instruments were invented. And because deregulation came back into fashion, and the right wing really took over the conversation as well as government regulators did not keep up with the new instruments that Wall Street invented. And so all the same kinds of uses crept back in, and it took about 20 years until the house of cards was so high and so rickety that you then had the same kind of crash.

TH: When did the rolling back of those New Deal measures start?

RK: Well, it's interesting; it happened in fits and starts. Some of it was deliberate and some of it was simply people taking advantage of other things that had happened. For instance, in the period between 1971 and 1973 the Nixon administration dismantled dismantled one of the main pillars of Bretton Woods from 1944 [4], which had created a regime of fixed exchange rates and along the way prevented a great deal of international speculation in currencies

So, after the 1970s little by little you had a whole category of speculation that had been prohibited by the ground rules obtained in the '50s and '60s, namely a lot of currently speculation. You had the so-called eurodollar market of dollars that existed in Europe that are not really regulated by anybody.

Then in the '70s also you had Wall Street taking something that had been the monopoly of Fannie Mae back when Fannie Mae was a public institution and part of the government, namely the securitization of mortgage, and privatizing it, and having lower standards than Fannie Mae did.

Again this was OK from the first decade or so but then when securitized mortgages rendezvoused with subprime and subprime rendezvoused with contracts written against the risk of bonds going bad, the whole house of cards just goes higher and higher and because in the '80s and the '90s Democrats fingerprints were on this, too. Regulators were not really interested in keeping up with these new risk products that Wall Street invented.

So, then in 1999, the capstone of this is the repeal of the Glass-Steagall Act. [5] One other aspect of this was Greenspan's failure to enforce the Home Ownership Equity Protection Act of 1994, [6] which, had Greenspan enforced it, subprime never would have happened, because that legislation required anybody who made mortgage loans to use sound underwriting standards. And you had Democrats and Republicans preventing the Commodity Futures Trading Commission from regulating many categories of derivatives.

So it was in the air, the idea that whatever Wall Street invents is by definition efficient, by definition virtuous, by definition self-regulating, and little by little a whole parallel banking system gets created that is beyond the scope of what the regulators can monitor.

TH: Former Securities and Exchange Commission chair Harvey Pitt recently said that "We've got a 21st-century financial services marketplace and a 19th-century regulatory model," and that our banking regulations are outdated. How outdated are they?

RK: Well, let me just stop you there. Nothing that Harvey Pitt says should be taken seriously because Harvey Pitt was one of the worst offenders. Harvey Pitt was a lobbyist for the accounting industry, and when he was installed as chair of the SEC, he did everything he could to prevent accounting abuses from being regulated by the SEC.

So to say that we had a 19th-century scheme and a 21st-century economy is wrong in two respects. First of all, we had a 20th-century schema because is was the New Deal system of regulation. Secondly, it is the job of the SEC and the Fed and the other bank regulatory agencies to keep up with new inventions that might be abusive, and Pitt willfully refused to do that. That's why the SEC under the Republicans has been such a travesty.

TH: Beyond enforcing what's already in place, what needs to be done — and can be done — to put the brakes on this crisis.

RK: Let me reduce it to basic principles, and Barack Obama gave a wonderful speech to this effect on March 28th at Cooper Union in New York, where he basically said if it quacks like a bank it has to be regulated like a bank. He basically said financial institutions should be regulated for what they do, not for what they are.

And that's the point. So whether you call yourself a commercial bank or an investment bank or a private equity company or Charlie Brown, if you're giving credit, you are creating risks for the system and you need to be kept honest. So the problem is that in recent years something like 60 percent of the created was created institutions that are not part of banking system, institutions like subprime mortgage institutions and people creating credit swaps and all sorts of exotic derivatives that are not even understood by the people that create them, let alone by the people who buy them or by the regulators.

So you need to eliminate what some people call the shadow banking system, institutions that are not banks but that do what banks to, and every kind of institution needs to have capital requirements, needs to have limitations on leverage, it needs to have limitation of conflicts of interest. And there are some specific abuses, like the abuses on the part of the bond rating agencies that were walking conflicts of interest. And the fact the that derivatives are traded outside of stock exchanges or commodity future exchanges, so that nobody knows what they're worth until there's a crisis and and they turn out to be worth nothing.

One of the important efforts that was made by a conscientious regulator in the 1990s was the effort by Brooksley Born, [7] who was then the head of the Commodity Future Trading Commission, and she was attacked by everybody else in the Clinton administration — Greenspan and (Lawrence) Summers and (Robert) Rubin and even Arthur Levitt who is otherwise a good guy — because they didn't want to mess with the derivatives market because so many people were malign so much money.

And Born's proposal was, "Look, this thing is just growing like a weed, nobody understands what these things are worth, we have to bring this within the purview of the Commodity Future Trading Commission. We have to have these derivatives traded on exchanges rather than just be done a private contracts. So that they have some kind of market." I mean, if you have a trading market, you know what these assets are worth day to day. But if there is no trading market they could be worth $100 one day and worth nothing the next day, and that's exactly what happened.

And of course, she was isolated and forced to back down, and that was more emblematic of the kind of anything-goes mentality that was so prevalent. It was more purely Republican ideology, but I think a lot of Democrats like Robert Rubin were equally culpable.

So you need to get back to few basic principles. You need to simplify the banking system, so that there's a relationship between the party who makes the loan and the party who gets the loan. You need to get rid of all the intermediaries that are complicating the system and reducing the transparency of the system.

TH: One thing Maury Klein pointed out was that the Great Crash and the Great Depression were separate events, the Depression taking more than a year after the crash to make its grip on the economy felt. Have we dodged a depression yet? Can we still?

RK: We're still in danger of one and whether we have one or not depends entirely on what the next administration does. A depression is preventable and I think there are four things that the next administration has to do. This administration has done one of them rather badly, and it hasn't done the other three at all.

The first thing it has to do is recapitalize the financial system. and Paulson has gone about that in a very clumsy way.

If the government and the taxpayers are going to put money into banks, they need much greater supervision of banks, not just the banks that get the money but the banking system general. So the thing we need to do is re-regulate it to that you don't invite more speculation, more bubbles and more crashes and more bailouts.

The third thing we need to do is put a floor under housing prices. The way Paulson has gone about this, you rescue the banks, you rescue the bondholders, and if the mortgage holder gets any relief, it's incidental or accidental. We need direct federal refinancing of mortgages, so that this downward spiral of housing prices ceases.

And then most importantly we need massive public spending to compensate for the huge hit that demand is taking. Some of that can be deficit-financed in the short run. Some of it can be financed by raising taxes on very wealthy people, and winding down the war.

And if the next president does all those things, we'll have a recession but we won't have a depression. If the president lets this thing get out of control and plays catch-up we could well have a depression.

What's interesting is that if you look at how long it took after October 24th for the air to come out of the economy, and those were the years when Hoover dithered and didn't do enough to prevent a crash from turning in to a depression, and that's why it's so important that the next president get out ahead of this.