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Why did we think the economic boom would last forever?

A kind of inebriation—irrational exuberance—was driving the economy. When people are drinking too much, they don’t realize it, so they need someone to intervene. As William McChesney Martin, the Federal Reserve’s longest-serving chairman, once said, “The important thing for the government to do is to take away the punch bowl just as the party gets going.”

But few experts foresaw the recent crash. Why?

Economic theory has become abstract and mathematical, relying on statistical procedures for analyzing data. And economists use recent data, usually covering the last 10 years. So they exclude the Great Depression and are not going to catch an event like this. To see the parallels you need the mind of a historian, which is hardly the same as the mind of an econometrician.

What do economists overlook?

Human psychology. Economists assume people are rational actors, though human nature is obviously more complicated than that. That’s what my book Animal Spirits is about: taking account of a theory of mind, recognizing what people are thinking. You have to remember that people are willing to change course if they perceive a situation has changed. For example, we know, at least at some intuitive level, when we’re in a bubble and when we’re in a crisis of confidence. But bubbles and confidence are not part of macroeconomic theory.

Is this the Great Depression part 2?

The situation is similar to the 1930s. Our banking system is like Humpty Dumpty— seriously damaged—and our basic confidence in the system—the eggshell—is broken. Because of what happened back then, we do think this can be fixed. But people don’t have a positive outlook and don’t trust each other. Ironically, that’s one thing that isn’t normally measured in the Confidence Index: trust.

Why is trust important?

During a boom, we tend to view successful people as geniuses. But when booms go bust, trust starts to decline. We view each other as manipulators, potential crooks. In that way, the system is seriously broken, because that’s more than the government can quickly fix. Part of the “animal spirits” that drive the economy is our view of ourselves and how we fit into the world, what kind of person each of us wants to be, what kind of people we admire. How much do we want to be part of society, or how much do we want to stand apart and be winners, is something that changes with the times.

How do changing self-images relate to the economy?

During the recent boom a Wild West attitude proliferated: We all wanted to play the game and win, like in Texas Hold ’Em. It’s adversarial: I don’t need to be taken care of, I’m gonna win. Unfortunately, a lot of that attitude is still around, and accounts for the anger being expressed about the bailout.

What happens when confidence vanishes?

You don’t spend any money, because that would be reckless—you might really need it. If you’re a business – person, you don’t hire anybody, because you’ll probably just have to let them go. If you’re an entrepreneur, you don’t start a new business, because there isn’t much chance for success. This becomes a self-fulfilling prophecy. That’s what’s happening now, which reinforces the crisis.

How does this crisis differ from the Great Depression?

The New Deal set up permanent agencies and institutions like the Federal Deposit Insurance Corporation. In the Depression, banks failed, and people lost their life savings, which was very confidence destroying. It got so bad that in 1933, the banking system and stock market had to be shut down. That created a much stronger sense of crisis than today’s. So the government has benefited from the New Deal and taken other steps, often based on Rooseveltera innovations.


In the 1930s, Congress passed a law saying, “In unusual and exigent circumstances, the Federal Reserve can lend to non-banking businesses.” They’ve been invoking that act to justify what they’ve been doing, like the Troubled Asset Relief Program.

What are the immediate dangers?

Our recent markets had a tendency toward speculation even stronger than in the 1920s, in the sense that it involved a bigger fraction of the population. There are more stock market investors, and there’s much more speculation in the housing market, which affects everyone. So our economy could be even more volatile than in the Great Depression. Right now, it looks like it won’t be as bad. We have to thank our government stabilization policies for that.

What’s your take on Obama’s regulatory proposals?

He’s trying to create some new governmental infrastructure, some of which would implement things I’ve been advocating. The Consumer Financial Protection Agency would introduce simple financial contracts for consumers that would protect them—something I’ve stressed in my books. It’s a simple job, but it seems we need government leadership to do this on a big scale.

What about fears of too much intervention?

In the 1920s, some savings and loan associations started experimenting for the first time with mortgages that were 15 or 20 years long. It never caught on, even though it was a great idea, until FDR created the Homeowners Loan Corporation, which mandated that all of their mortgages run 15 years. That changed everything: To this day, most of our mortgages are long term.

Is tackling health care part of trying to rebuild trust?

To me it is. We have 47 million people without health insurance. That must weigh on people’s sense of well-being. And it weighs on their sense of injustice. The irony is, we have Medicaid for really low-income people. People above the cutoff are supposed to be able to buy their own, but they don’t seem able to afford it. It’s a crazy idea that people who have jobs and are doing a little better are the ones without insurance. The risks to all of us, in terms of physical and financial costs, are huge.

What about the risks of socialism?

Obama is proceeding very deliberately, whereas FDR, who was also accused of socialism, had an impulse to experiment and move very fast. Obama’s proposals are more about creating an intellectual infrastructure that I hope will lead to substantive changes and a better 21st-century version of capitalism.


Look at the risk problem. Why did this crisis get so bad? Risks weren’t managed well. Individual homeowners took highly leveraged positions in the real estate market: They borrowed 90 percent or more to buy a house, putting their whole life savings into one market. All it takes is a decline of 10 percent in the market and they’re wiped out. That’s what happened. So it’s natural to say, let’s create institutions to manage that risk and not let that happen again.

How long will this downturn linger?

In recent recessions, notably in 1990- 91, even after the recession ended, we had a weak economy for several years. That’s likely to be even truer this time. A recovery isn’t months away, as some people say. We have deep and fundamental problems that will weigh on us for years.


Originally published in the October 2009 issue of American History. To subscribe, click here.