Friday, October 3, 2008

Lessons from the Great Depression

Whenever times are turbulent, we are tempted to say that “things are different this time.” While there are aspects of the current financial crisis that are unique, they also have much in common with past recessions and the great depression.

In a moment of fear, we can begin to imagine that the current crisis won’t end and that we should all be buying bonds and gold in preparation for the breakdown of civilization. However, as the Canadian Capitalist explained with a 1932 Dean Witter quote, we should keep the faith in stocks. Our economy will either recover or there will be chaos. If there is chaos, then nothing will maintain its value. Even real estate will be worthless because titles will be insecure. The only sensible course of action is to plan for a recovery.

Another lesson from the great depression comes from the fact that the government of the time did not attempt a bailout of the type that US lawmakers are currently working on. It’s easy to argue against a bailout. Why should we use public money to help rich bankers?

As banks fail, the other institutions they owe money to will fail and there will be a cascading effect throughout the economy. As the Canadian Capitalist explained in Why Bailout Wall Street?, the first businesses to fail may be those most deserving of bankruptcy, but the pain will eventually spread to other businesses that had little or nothing to do with sub-prime mortgages.

So, it seems that the US government has little choice but to bail out Wall Street to try to contain the problem. I see two important questions to address in the aftermath of the bailout:

1. Why was there no effective government regulation to prevent this disaster?

2. Why are the boards of directors of public companies so completely unable to protect shareholders from CEOs who collect huge salaries and bonuses while driving their companies to ruin?

2 comments:

  1. Answers

    1) The Republicans are in charge. They love de-regulation and we see the consequences. Now they want extreme regulation. Too late.

    2)Because they do not understand that they work for the shareholder. They believe they should support the CEO. It's the old boys network - and that has nothing to do with the gender of the board or CEO.

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  2. Thanks for the links. It is almost certain that credit default swaps will be regulated going forward and require maintaining capital reserves. Too bad the authorities didn't see this coming or opted not to heed the warning signs.

    Shareholders deserve a big share of the blame for runaway executive compensation. Very few institutions are patient long-term owners these days. They buy stocks to hold for a few quarters and couldn't care less about agency costs. Generous stock option grants mean CEOs have a short-term orientation as well. Deferred bonus payments that you discussed before is part of this bailout package. Hopefully, shareholders would be demanding such arrangements in the future.

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