Their Party Crashed. Ours May Too.

By Robert S. McElvaine
Sunday, September 28, 2008

"History doesn't repeat itself, but it rhymes." Mark Twain was supposed to have said that, but even if he didn't, there's no denying that we're seeing proof of the adage in today's financial crisis.

Consider this statement: "The extraordinary rate of default on residential mortgages forced banks and life insurance companies to 'practically stop making mortgage loans. . . .' " Sounds like 2008, doesn't it? It is in fact a comment from Ben S. Bernanke, current chairman of the Federal Reserve board. But when he wrote those words in 1983, he was talking about the Great Depression.

We've been hearing a lot of comparisons to the Great Depression lately, because today's crisis rhymes with that one to an extraordinary degree. At the most basic level, the cause of the current crisis is simple: Economists, business leaders and policymakers have all been ignoring the lessons learned from that early 20th-century calamity.

I've written extensively about the Great Depression, and in my view, the collapse of the "un-real" estate market of recent years was as predictable as the collapse of the Great Bull Market of the late 1920s. Even though some politicians insist otherwise, the fundamentals of our economy are not strong, just as they weren't in 1929. And the principal reason is that, just as they were in the period leading up to the Great Depression, economic fundamentalists have been in charge.

It's one of the fascinating coincidences of history that Adam Smith's "The Wealth of Nations" was published in 1776, the year of the United States's birth. America then was seen as an unspoiled paradise, a "New Eden" where humans could return to what they imagined was a "state of nature." There was talk of an "American Adam" who roamed freely in this land where the "natural economy" of the free market that Smith postulated could operate, well, freely.

Almost from the start, many Americans have operated on the assumption that this American Adam's surname was Smith, and have taken the market as their economic god. The great irony, though, is that a new type of economy was being born in Great Britain at the same time. And industrialism would remove men and women from a state of nature more completely than ever before.

By the 1920s, the industrial economy was mass-producing at a rapid rate, which meant that its survival required the rise of mass consumption. Trying to play by the rules of Adam Smith's pin factory at a time when Henry Ford's massive River Rouge complex was closer to the true nature of the economy was a prescription for disaster. Such huge economic actors don't behave according to the "natural" laws of the simple economy of Smith's day; under modern circumstances, a more visible hand is needed to guide the market onto a course that benefits all. Yet both economists and political leaders of the time maintained their faith in market-god fundamentalism.

The task facing business in the 1920s was replacing the work ethic with a consumption ethic. If the American people were to be made into insatiable consumers, traditional values would have to be undermined and reversed. The means of accomplishing this? Advertising. The Mad Men of the '20s made over the traditional wisdom of "Waste not, want not" into the essential message of the consumption economy: "Waste and want." Bruce Barton of Barton, Durstine & Osborn, for instance, famously portrayed Jesus as the ultimate advertiser and businessman in his 1925 bestseller, "The Man Nobody Knows."

But wanting isn't enough. If the masses are going to be able to buy what they've been persuaded to want, they have to receive a sufficient share of total income to do so. Yet the opposite happened in the '20s. President Calvin Coolidge and his Treasury secretary, Andrew Mellon, drastically reduced taxes on the highest incomes. Meanwhile, anti-union policies produced less income for worker-consumers. The share of total national income going to the very richest grew enormously, peaking in 1928, just months before the economy began to contract in the summer of 1929. The top 10 percent of American earners then were getting 46 percent of total income.

Providing large tax cuts for the richest was precisely the wrong policy. To stimulate consumption, taxes should have been cut at lower income levels. Cutting taxes on higher incomes stimulated speculation instead. Sound familiar?

"Don't kill the goose that lays the golden eggs" is one of the favorite sayings (and warnings) of champions of high profits, low taxes on the rich, concentrating wealth and income at the top, and the rest of trickle-down economics. But when profits become too high and taxes on the very rich too low, the geese get obese, eventually stop laying eggs and develop coronary problems.

What the economy needed was an effective weight-loss program for the monetarily corpulent and a program to help underweight consumers put on a few pounds (i.e., dollars). Yet those who argued for such an approach, such as progressive Republican Sen. George Norris of Nebraska, were ridiculed by the followers of the god of the unfettered market.

Instead, 1920s financiers gave consumers an injection of the economic steroid known as credit. And the economy temporarily became extremely robust. Sales of automobiles, radios and other new products to people who couldn't actually afford them soared. The ratio of private credit to GDP nearly doubled between 1913 and 1929. During the '20s, short-term personal loans from personal finance companies ballooned by more than 1,200 percent.

But a steroid-induced burst of great strength is always likely to be followed by impotence. Sooner or later the limits of consumer credit are reached -- consumers find themselves with more debt than they can repay, sales decline and banks, left holding bad loans, begin to fail.

"Sooner or later" arrived in October 1929, as it has again in September 2008.

Today isn't an exact replay of the 1920s, but it's a pretty good rhyme. Over the last three decades, top-end tax rates have been slashed; unions' power has become diluted; top corporate pay has skyrocketed; the minimum wage has been allowed to fall in real terms and the average wage has flatlined. And the credit bubble on which the economy has been riding in recent years is vastly larger than the one in which Americans danced the Charleston and drank bathtub gin 80 years ago.

After a long period of less income inequality from the 1940s through the 1970s, inequality began to increase again in the 1980s and has continued to rise almost continually ever since. By 2005, income concentration slightly exceeded the levels of just before the Great Depression: The richest 1 percent of Americans were receiving nearly 22 percent of the nation's income, and the top 10 percent took in more than 48 percent.

Yet there are some significant differences between the 1920s and today. Some make our current situation more dangerous. These include today's huge federal budget deficits (compared with the more or less balanced budgets of the late 1920s) and the war in Iraq, which has undermined confidence in the administration and, along with other policies and the flood of federal red ink, makes a stimulus through a massive deficit difficult, if not impossible. There's also the trade imbalance: In the 15 years preceding the 1929 collapse, U.S. exports exceeded imports by $25 billion. Now the trade imbalance is decidedly in the other direction.

On the other hand, we learned a good deal from what happened in the Great Depression, so the consequences of a major collapse may be less severe. We came to understand that we live in an economy far removed from a state of nature and that the market can't be allowed to rule over us without any restraints. And although they've been weakened in recent years, we have in place many regulations and countercyclical programs from the New Deal, including unemployment insurance and Social Security.

Here's the main lesson the Great Depression taught us: Capitalism is the best economic system just as democracy is the best political system, but both contain inherent dangers that require checks and balances to ensure that they work properly. One of the most prominent dangers of capitalism is that income will become too concentrated at the top, undermining the functioning of a consumer-based economy. The fruits of this lesson were put into effect during the New Deal through higher taxes on the rich, support for unions to help working people get a larger share of the national income, social programs to aid the poor, and such regulatory agencies as the Securities and Exchange Commission. A system of regulated capitalism was in place and worked very well from World War II to 1980.

Then economic fundamentalism staged a revival -- and once again got us into a mess. The only thing that can begin to get us out of it is replacing it with the sort of reasonable, balanced policies that produced a long period of widespread prosperity through the middle of the 20th century.

Bottom line: The fundamentalists of the economy are wrong.

Robert S. McElvaine, a professor of history at Millsaps College, is the author of "The Great Depression" and, most recently, "Grand Theft Jesus: The Highjacking of Religion in America."

View all comments that have been posted about this article.

© 2008 The Washington Post Company