Hartford Courant, September 29, 2008, p. A13.

Financial crisis resembles many predecessors

RICHARD S. GROSSMAN

Are we headed for another Great Depression? The downturn in the housing market, combined with the failure, distress sale or bailout of Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch and AIG have prompted comparisons of the current crisis to that of the 1930s.

 The focus on the Great Depression makes great copy and warms the heart of financial historians everywhere, but the emphasis on that one noteworthy crisis is misplaced. When you consider recent events in the context of the past two centuries of financial crises, the origins, cost, and resolution of the crisis of 2008 bears as much resemblance to those other crises as it does to those of the Great Depression.

Like the British crises of 1825, 1836-39, 1847, 1857, 1866 and 1890 and the American crises of 1873, 1893 and 1907, the current episode was preceded by several years of strong economic growth and increased speculation. In previous crises, objects of speculation included Latin American investments, banks, railroads and agricultural products. Each speculative adventure saw an impressive run-up in prices prior to the collapse, much as real estate has in recent years.

Each speculative boom was fed by easy credit and low interest rates. The boom that preceded the American crisis of 1873 was fanned by inflationary Civil War finance, while the Baring crisis of 1890 was preceded by a debt refinancing, which lowered interest rates on British government debt. The recent crisis was fueled by expansionary monetary policy championed by Alan Greenspan earlier in this decade.

Commentary on the current crisis often focuses on the decision to rescue Fannie May and Freddie Mac, while allowing Lehman Brothers to fail. Some argue that not bailing out Lehman Brothers risks a devastating blow to confidence, while others insist that a bailout would reward Lehman’s bad behavior and encourage other financial institutions to get into similar trouble.

 Perhaps the most striking historical parallel is with the Bank of England’s treatment of the firms of Overend, Gurney, which was allowed to fail in 1866, and Baring Brothers, which was rescued in 1890. Because Baring was an international firm, its failure would have jeopardized Britain’s ability to maintain the gold standard and, therefore, the cost of allowing it to fail was judged to be high. Overend was not considered as crucial to the national interest. The anticipated consequences of failure account, at least in part, for the differing treatment accorded Fannie Mae, Freddie Mac, Lehman and AIG.

It is too early to predict the ultimate macroeconomic cost of the crisis, although historical evidence suggests that it will be high. Bailouts following the banking crises in the 1980s and 1990s in Finland, Israel, Japan, Norway and Sweden were on the order of 10 to 20 percent of gross domestic product. The most severe 19th century US crises — in which there were no bailouts — had a similarly sized macroeconomic impact — equivalent to between $1.3 and $2.6 trillion.

Congress and others will undoubtedly convene committees to determine the sources of the crisis and to suggest reforms. Given that policy makers — and the public — generally have short memories, the more rapidly the financial situation improves, the less likely it is that any of the suggested reforms will be enacted.

Unfortunately, history teaches that no matter what sort of risky behavior policy-makers ban, the financial community will, within a few years, manage to find new ways to get into trouble all over again.

Richard S. Grossman is department chairman and professor of economics at Wesleyan University in Middletown and a Visiting Scholar at the Institute for Quantitative Social Science at Harvard University.