I’ve been noticing that there are questions lately about what caused the Great Depression and whether we’re at risk of something similar in 2020.
The short answer is: No, I don’t think we’re at risk of another Great Depression.
For context, I asked this exact same question in October 2008 at the start of the Great Recession. I ended up examining the prior 12 US recessions going back 136 years to determine how companies survived during those times.
I documented those findings in my book The Recession-Proof Business.
Now, let me elaborate on why, despite coronavirus, a drastic drop in many consumer sectors, and stock market values plummeting, I don’t think we will have another Great Depression.
First, economic cycles are normal. It’s normal for an economy to grow and normal for it to shrink.
Many recessions are triggered by a collapse in asset prices. In the case of the Great Depression, Black Monday 1987, and the Great Recession of 2008, the assets in question were stock market prices.
If 25% to 35% of your wealth disappears overnight, you feel poor. You spend less money and that impacts everyone else in the economy even if they didn’t lose money in the stock market (businesses have fewer sales, they do layoffs, workers have less money then spend less money as consumers).
So, in all recessions, there’s a decline in demand in some part of the economy that then has a domino effect on the rest of the economy.
This is how most recessions unfold.
This was also true during the Great Depression. However, there was another factor at play during the Great Recession that made it particularly severe.
It’s something known as “systemic risk.” Specifically, it was banks failing and banking systems collapsing.
The way a banking system works is that people make deposits to a bank and the bank lends out those deposits to others in the form of a loan.
As long as everything is stable, this works just fine.
In the Great Depression, once a few banks failed, their customers lost their life savings because no deposit insurance existed. People started freaking out that they could lose all their money, so everyone rushed to withdraw all of their savings.
The thing is, when you make a deposit in a bank, the money is not actually in the bank. It’s lent out. So, when everyone went to withdraw their money, a few were successful and the rest were told, “Sorry, we don’t have it.” These banks promptly went bankrupt because they could not fulfill their depositors’ withdrawal requests.
This is known as a “run on the bank.”
50% of banks failed during the Great Depression and their customers typically lost their life savings in the process.
When half the country literally loses their life savings, they don’t spend money in local businesses. Those businesses become unprofitable and lay off workers. Laid-off workers also don’t spend money at other local businesses. Those businesses fail, and so forth.
There are a few reasons why a Great Depression is unlikely to occur again.
The simple reason is: Deposit Insurance & The Federal Reserve Bank
Let me explain.
Let’s say, hypothetically, that every customer at Bank of America asks to make a withdrawal (similar to what happened during the Great Depression). Bank of America does not have that kind of cash on hand. One hundred years ago, it would simply go bankrupt and prompt depositors to rush to withdraw money from their banks.
However, the process is different today.
If this were to happen today, Bank of America would contact the Federal Reserve. The Federal Reserve is a bank’s bank. The Federal Reserve Bank is known as “the lender of last resort.”
Bank of America says, “We need $10 billion in cash fast.” The Fed, as they’re known, says, “We will wire it to you within the hour.”
In addition, the Federal Government insures bank deposits. You might have noticed that your savings and checking accounts are “FDIC Insured.” This means that if the bank goes bankrupt, you will get your money back.
Because of these two changes, bank runs have not happened.
We were extremely close to a great depression in 2008. This time it wasn’t commercial banks that were the problem, it was investment banks.
It used to be that mortgages were issued and kept by banks. Now, banks issue the loans, then sell them to Wall Street investors to collect payment over the next few decades. The mechanism to sell mortgage loans to Wall Street did not exist when the original consumer banking regulations were developed.
When there was a collapse in the mortgage industry in 2008 (too many borrowers couldn’t make their mortgage payments), it hit the investment banks.
Bear Stearns and Lehman Brothers both collapsed within months of each other.
As this happened, Wall Street professionals quickly did their calculations and had what I call an “Oh sh*t” realization.
You see, Wall Street investment banks all do billions and billions of dollars worth of deals with each other.
If Goldman Sachs needs a billion euros today, it might buy them from Morgan Stanley.
These kinds of simple transactions take place in just a few seconds. They are very straightforward.
However, in 2008, many of the banks had more complex transactions, called derivatives.
Unlike simple transactions that were open, closed, and settled within a few seconds, derivates were open-ended contracts that would ultimately be closed and fulfilled years or sometimes decades later.
Derivatives are predicated on the other party (known as a counter-party) still being in business ten years later.
So, if I’m Morgan Stanley and I do a deal where Bear Stearns will pay me $500 million five years from now, when Bear Stearns abruptly no longer exists, I’ll realize, “Oh sh*t, that’s $500 million that I won’t be getting.”
Every investment bank had derivative contracts with every other investment bank in the world. The total dollar value of these transactions was in the trillions of dollars — not just one or two trillion dollars, but $600 trillion in contracts. (This is about ten times more than the entire global economy of that single year.)
As you might intuitively gather, every investment bank in the world had extremely high financial dependencies on every other investment bank in the world. If Bear Stearns is no longer able to pay Morgan Stanley $500 million and Morgan Stanley fails, then they can’t pay Goldman, which causes Goldman to fail, who’s then unable to pay Credit Suisse.
In a matter of weeks, every investment bank in the world is bankrupt.
This is called “systemic risk.”
(Incidentally, Warren Buffett calls derivates “financial weapons of mass destruction” for a reason… and now you can hopefully see why.)
For the current economic situation with COVID-19, there will be a significant drop in demand in certain parts of the economy. The demand drop so far is mainly from consumers in the restaurant, entertainment, airline, and hotel industries.
But, there doesn’t appear to be any systemic risk of the financial system itself. In other words, people will lose money through the financial system, but the financial system itself is not in jeopardy.
From an economist’s point of view, this is a hit on the economy, but a temporary one.
Note: One lesson from the past 12 US recessions is that the level of psychological fear and panic at the start of the recession is extraordinarily high. It always seems like an unmitigated disaster that will never end.
The Panic of 1907. The oil crisis of the 1970s. The post-9/11 recession. It always seems like the end of the world as we know it.
And it’s actually true. Life as we know it usually changes quite dramatically. What’s difficult to see in advance is what life will look like after the recession. The psychological presumption is that, because we can’t anticipate that answer, there must be no life afterward. This is not true. It’s simply difficult to tell at the start.
Now, let’s look at 2020 from an economic and medical history perspective and discuss why I think a depression is extremely unlikely. Believe it or not, there is still some debate about this amongst economists, in part because the economy is so big and diverse.
Most consumers only know the part of the economy they see — in this case, restaurants, bars, airlines, and hotels. These sectors have been hit hard by the coronavirus, but our economy is quite large.
First, China has already turned the corner on COVID-19, showing that it’s possible to get under control. They will be slowly allowing workers back into the factories and have developed a rapid-response process. If there is a local outbreak, they will have the infrastructure to do a better job containing it.
Second, the development of a vaccine for coronavirus seems likely, though probably in 12 to 18 months. Other infectious diseases have caused major losses of human life in history, and vaccines have been developed to prevent much of those losses.
So, from an economic and medical history point of view, socially and economically, it’s going to stink for one to two years, and the problem that caused all of this will be under control, or at least we will be able to turn the corner and see the light at the end of the tunnel.
There have been many precedents for this:
- In 1916, the polio epidemic terrified Americans. In one summer, 2,000 people died in New York City alone. Today, polio is nearly eradicated.
- In 1980, measles killed 2.6 million people globally. In the United States today, you rarely, if ever, hear the disease mentioned.
- From 2005 to 2012, the HIV/AIDS Pandemic killed 36 million people.
To paraphrase Warren Buffett, 2008 was far scarier (economically) than 2020.
2020 is far scarier from a societal and humanitarian perspective but not from a systemic, economic-risk perspective. He doesn’t see a risk of a banking system collapse. I don’t either. The Fed is there. Stress tests were developed in 2009 to ensure that banks had more financial reserves.
There’s a long history of failing to do bailouts on the banking system and suffering dearly for it (Great Depression), and a history of doing it successfully (Great Recession).
So, long story short, from a historic, economic perspective, this crisis sucks, but it poses much less systemic risk than prior stock market and economic declines.
In other words, this too shall pass.
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