Housing Was at the Root of the Great Depression, Too

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By Evan Soltas

The U.S. economy slips into recession. The stock market takes a tumble as heady expectations for future growth cool. Interest rates fall as the Federal Reserve quickly trims the discount rate in hope of cushioning the business cycle.

The low interest rate environment sets off a massive wave of home construction and an asset bubble in real estate. By the time the Federal Reserve takes action, the boom is completely out of control. Bank balance sheets and household savings have become dependent on the profound mispricing of real estate and other equity holdings.

The heedless extent of leverage makes the financial system extremely vulnerable to capital losses. As the housing bubble implodes, it pushes the economy into a long, deep recession.

This is the economic story of the last decade -- and of the 1920s.

After a sharp deflationary recession at the end of World War I, the newly created Federal Reserve slashed interest rates, setting off a housing bubble of such an incredible scale that it dwarfs its recent counterpart. When the bubble ended, what seemed to be a calm and contained contraction turned violent, culminating in the macroeconomic implosion of the Great Depression.

Milton Friedman and Anna Schwartz famously pinned the Great Depression on passive tightening of monetary policy, and Fed Chairman Ben Bernanke and other scholars highlighted the role of the gold standard and the collapse of international monetary order. But economists and commentators have largely overlooked the role of housing in the causation and intensification of the Great Depression.

After an encore performance of macroeconomic calamity, this long-standing oversight deserves correction.

A graph of the interest rates of the 1920s shows a U-shape. After curbing the inflationary excesses of World War I with a discount rate of 7 percent at the Federal Reserve Bank of New York, the Fed brought interest rates to 3 percent and below by the middle of the decade.

As expectations of growth returned, the persistence of low interest rates directed investment into real estate. Facilitated by a massive boom in mortgage financing, prices soared. In New York City, the value of real estate rose 80 percent in real terms, with even larger increases for higher-end speculative properties, according to one study.

The magnitude of the 1920s bubble was even more impressive in terms of construction. Housing starts more than doubled, as did the real value of residential construction. That is four times as large as the housing boom of the 2000s.

The culture of the 1920s also emphasized home ownership and home improvement, a grim precursor to sentiment in the last decade. Following a surge of interest, the magazine Better Homes and Gardens was founded in 1922, taking its name from a now-forgotten public policy initiative, the "Better Homes Movement." No fewer than three presidents -- Warren Harding, Calvin Coolidge and Herbert Hoover -- encouraged home ownership and investment through public campaigns.

Government support led to increases in residential investment well beyond new construction. Responding to new demand, shipments of all of the items that go into home renovation -- such as wood flooring, bath tubs and kitchen sinks -- rose to tremendous heights.

The stories of the 1920s and the 2000s are parallel even in the way the bubbles popped. In both instances, the housing market cooled early but gently, transferring speculation into stocks. The broader economy overheated and then fell into contraction, leading to sharp markdowns in real estate asset values, which precipitated true crisis. And in both cases, interest rates were forced to the zero lower bound as problems in the housing market disrupted a key component of the transmission mechanism of monetary policy.

The similar role played by housing in the Great Depression and Great Recession is remarkable. How is it, after all, that housing was a key player in the two largest recessions of the modern era? The connections merit new inquiry.

(Evan Soltas is a contributor to the Ticker. Follow him on Twitter.)

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-0- Sep/25/2012 13:29 GMT