The Worst Crisis Since the Great Depression?

How did the United States hide the severity of its financial difficulties in the mid-1970s and early 1980s? We allowed financial institutions to keep their books at historical cost. Where that didn’t work, we instituted regulatory accounting principles that kept savings and loans from having to recognize their dire situation.

The fact is that, at the end of 1981, every major bank in the United States was, on a mark-to-market basis — that is, under our present accounting standards — insolvent and significantly so.

The U.S. savings and loan industry as a whole was not simply insolvent. It had negative equity of 20% of its total assets, but we hid it with accounting standards and really didn’t face up to the savings and loan component of it until the late 1980s.

On this occasion, mark-to-market accounting is forcing much more timely recognition of losses.

Indeed, I think mark-to-market accounting has actually exaggerated to a significant extent the losses that are likely if we could calm the situation now.

That is not in all respects bad. In contrast to what happened in previous episodes, major financial firms have been forced to go out into the market and raise additional capital, diluting the position of their existing shareholders.

So a cost is being paid. Is there a bailout? Absolutely! But in the past, the bailout often used to come almost entirely under the table because the Federal Reserve would cut interest rates and keep them low.

That would reduce the income that all of us citizens earned on our assets, reducing the cost of funds to the banks and others, and filling up their balance sheets, again at our expense under the table.

Well, this time, they’re being forced, at a much earlier stage, to actually recognize the losses that were taken as a result of their previous poor investment decisions — and that is not a bad thing.

I think it’s also not a bad thing that the American people seem to be really peeved at the prospect of getting a big bill to clean up this mess.

That will provide the impetus for a much more serious consideration of reforms going forward. Moral hazard is undoubtedly being created in the episode of this bailout.

But I think actually less so than in previous episodes, where we did not face up to the problems at an early stage. And if you think we were bad, you can consider what the Japanese did in concealing their financial problems for six years during the 1990s.

In conclusion, we are in the midst of a period of stagflation: inflation is still uncomfortably high but is probably coming down.

Growth is slowing — the U.S. economy is probably in recession or will be soon by any reasonable definition. But I don’t think we are yet looking at a steep recession on the order of what we saw in the 1970s and 1980s.

I think that by the middle of next year, the financial crisis will probably subtract about 1% from the level of U.S. GDP and that foregone output between 2008 and 2010 will cumulate to 2.5-3% of GDP — which is plus or minus $300 billion in lost output.

That’s not a trivial amount. It is not, however, the Great Depression.

Editor’s Note: This feature is adapted from a speech the Peterson Institute’s Michael Mussa gave at the 14th semiannual meeting on Global Economic Prospects on September 26, 2008. Copyright 2008 Peterson Institute. Reprinted with the permission of the Peterson Institute for International Economics.