How close did we come to a depression? Pretty close according to Newsweek.
"Depression" is a term of art. It’s more than a serious economic downturn. What distinguishes a depression from a harsh recession is paralyzing fearâ€”fear of the unknown so great that it causes consumers, businesses, and investors to retreat and panic. They hoard cash and desperately curtail spending. They sell stocks and other assets. A devastating loss of confidence inspires behavior that overwhelms the normal self-correcting mechanisms (lower interest rates, inventory resupply, cheap prices) that usually prevent a recession from becoming deep and prolonged: a depression.
We came pretty close to that last year.
Thus traumatized, the economy might have gone into a free fall ending in depression. Indeed, it did go into free fall. The anniversary of Lehman Brothers’ bankruptcy in September inspired much commentary that saving the investment bank wouldn’t have averted crisis. True. But allowing Lehman to fail almost certainly made the crisis worse. By creating more unknownsâ€”which companies would be rescued, how much were "toxic" securities worth?â€”it converted normal anxieties into abnormal fears that triggered panic.
As credit markets froze, stock prices collapsed. By year-end, the Dow Jones industrial average was down 23 percent from its pre-Lehman level and 34 percent from a year earlier. Financial panic poisoned popular psychology. In September, the Conference Board’s Consumer Confidence Index was 61.4. By February, it was 25.3. Shoppers recoiled from buying cars, appliances, and other big-ticket items. Spending on such "durables" dropped at a 12 percent annual rate in 2008’s third quarter and at a 20 percent rate in the fourth. With a slight lag, businesses canned investment projects; that spending fell at a 20 percent rate in the fourth quarter and a 39 percent rate in 2009’s first quarter.
So why didnâ€™t the economy keep tail spinning out of control?
That these huge declines didn’t lead to depression mainly reflects, as Romer argues, countervailing government actions. Private markets for goods, services, labor, and securities do mostly self-correct, but panic feeds on itself and disarms these stabilizing tendencies. In this situation, only government can protect the economy as a whole, because most individuals and companies are involved in self-defeating behavior of self-protection.
Government’s failure to perform this role in the early 1930s transformed recession into depression. Scholars will debate which interventions this timeâ€”the Federal Reserve’s support of a failing credit system, the TARP, guarantees of bank debt, Obama’s "stimulus" plan and bank "stress test"â€”counted most in preventing a recurrence. Regardless, all these complex measures had the same psychological purpose: to reassure people that the free fall would stop and, thereby, curb the fear that would perpetuate a free fall. Confidence had to be restored so that the economy’s normal recovery mechanisms could operate. That seems to have happened. By September, the Consumer Confidence Index had rebounded to 53.1. Housing prices had stopped falling. By the Case-Shiller index, they’ve increased for three months.