President Bush argued that the passage of the Treasury rescue plan was necessary to prevent the U.S. from entering a severe downturn. Yesterday, the Federal Reserve announced it will begin buying commercial paper to, in the words of Fed Chairman Ben Bernanke, help "financial firms cope with reduced access to their usual sources of funding."
Both of these actions were designed to restore confidence in our financial markets. Unfortunately, they have created considerable fear about the underlying strength of the U.S. economy. This panic has roiled stock markets and led to comparisons between today's crisis and the Great Depression of the 1930s.
The Treasury plan and the Fed's emergency measures are certainly useful. However, their main contribution is not preventing a Depression-like scenario from evolving out of the current financial crisis. The real economy is a great deal stronger than many believe.
Despite the September employment report, there are no signs that the economy is on the verge of a depression. Real GDP rose at an annual rate of 2.7% over the last five quarters, which is on trend, once a correction is made for the decline in the growth rate of the working-age population. Productivity growth remains rapid. Consumer installment borrowing, which represents most consumer nonmortgage borrowing, is up 5% year over year, and the interest rates on these loans are equal to, or below, the levels that prevailed over the last five years. Commercial and industrial loans are up 9% year over year. And to those with good credit histories, conforming mortgages are available at 30-year fixed rates of around 6%. That represents an inflation-adjusted mortgage rate that is low by historical standards. So the current financial crisis is not as deep or as broad as some have feared.
Moreover, financial panics and crises are not as depressing as many believe. Current discussions point to the banking crises of the Great Depression as the best evidence that the financial crisis would devastate the U.S. economy. This is based on the very common misperception that the banking crises of the 1930s helped turn a garden variety recession into the Great Depression.
Banking panics did not create the Great Depression, nor did the elimination of panics via the introduction of deposit insurance generate economic recovery. The first banking crisis of any national significance didn't occur until the fall of 1931. Before this, there were regional banking crises that had no measurable impact on capital markets, as the spreads between Treasurys and risky obligations changed very little. However, the Great Depression was already "great" at this point -- industrial production and employment had fallen by more than 35%. The genesis of the Great Depression was not a banking crisis.
Given my view that the crisis is not as deep as some have feared, and that the potential impact of the crisis would be smaller than what has been advertised, should we even have adopted the Treasury plan?
Absolutely. While the economy would avoid a serious downturn in the absence of the Treasury plan, recent financial market conditions left unchecked could lead to a moderate recession. And there is a real danger that even a moderate recession, along with the current perception of an economic crisis, would lead to calls from various quarters for bad economic policies -- policies that tend to either pander to special-interest groups, benefiting relatively few at the expense of many, or raising taxes, particularly on the nation's most productive citizens, many of whom create jobs through their own enterprises.
There are many historical precedents of bad policies following crises. The worst case was after the stock-market crash in October 1929, which produced a truly perfect storm of bad policies. Tax rates rose, tariffs rose (reflecting special interest groups attempting to insulate domestic producers from foreign competition), and both Presidents Herbert Hoover and Franklin Roosevelt strongly promoted industry-labor cartels that were designed to stifle domestic competition.
In the absence of these policies, the Great Depression would almost certainly have been like every other U.S. recession -- short-lived and relatively mild. Normal recovery didn't begin until the most onerous of these policies were reversed, a process that didn't begin until the end of the 1930s when antitrust activity was resumed, and during World War II when the National War Labor Board reduced union bargaining power by limiting negotiated wage increases to cost-of-living adjustments only.
Bad polices impact the two most important determinants of living standards: output per worker and the amount of time devoted to market work. We need look no further than Western Europe to see how bad policies have depressed a number of advanced market economies. Hours worked per adult in the average Western European country have declined nearly 30% since the 1960s, as tax rates on labor are up 15 to 20 percentage points.
Japan in the 1990s is an example of bad policies that depress productivity growth. Once Japan stopped subsidizing inefficient production and reformed its banking system, productivity growth resumed. Another example is Mexico. After a financial crisis in 1981, Mexico had a depression resulting from polices that depressed productivity by severely restricting competition in its banking sector and by allocating loans to preferred borrowers at artificially low rates. Chile also had a financial crisis in 1981, but in contrast to Mexico, introduced policies that fostered competition in its banking sector and streamlined bankruptcy process. These policies contributed to substantial productivity growth that has sustained Chile's growth "miracle" for the past 25 years.
I am particularly concerned about bad policies because significantly higher taxes have been proposed by Barack Obama. His plan would raise the marginal tax rate on the most productive workers more than 10 percentage points -- an increase that would bring us near Western European levels. His plan would also raise capital income taxes, taxing capital gains and dividends at 20%, compared to a 15% rate under Sen. John McCain's plan. A five percentage-point difference might strike you as small, but it is not. I have calculated that a five percentage-point difference in overall capital income taxation over the long haul is equal to a difference in the nation's capital stock of about 18%. This means a 6% difference in GDP and a 6% difference in the average wage rate. This means that real GDP and the average wage would fall, gradually but persistently declining about 6% after 25 years. That's not quite a Great Depression, but a significant step towards one.
What should be done? We should encourage the immigration of prime-age individuals. Beginning in 2007, net immigration fell to half of its level over the previous five years. Increasing immigration would increase the demand for housing and raise home prices. And note that the benefit would be immediate. Home prices -- and the value of subprime obligations -- would rise in anticipation of a higher population base. The U.S. particularly needs highly skilled workers. These workers not only would purchase homes, but would generate higher living standards for all Americans.
Will we duck a depression? We will if the principles of economic growth -- increasing the incentives to work and save, promoting competition, and fostering economic openness -- are maintained. This is the most important lesson we learned, the hard way, from the 1930s.
Mr. Ohanian is a professor of economics at UCLA and director of the Ettinger Family Program in Macroeconomic Research.
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