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Despite the gloom and doom from those ignorant of financial history, the current crisis is similar to the many financial crises that we have experienced in the past. We had an asset bubble followed by a bust. Our leaders were too slow to understand the gravity of the situation. Financial institutions that lent too much money to the wrong people got burned, and their failure threatened to cause a chain reaction.
However, the Great Recession will not turn into Great Depression 2.0. Our leaders have taken most of the right steps to prevent a collapse of the financial system and restore economic growth. They have been careful to avoid the biggest mistakes of the Great Depression, such as letting the banking system fail and the money supply collapse. History shows that these panics burn themselves out. After the excess inventory is worked off, businesses find themselves too lean and start hiring again. Economic growth resumes. Financial markets are already signaling that the panic phase is over.
Yes, we have many long-term challenges: We must deal with the aging of our population, dependence on foreign energy, global climate change, and the instability of global politics. But we also have many long-term advantages. We have a well-educated, hard-working, and innovative population capable of rising to these challenges. Our legal and political institutions, although not perfect, are basically sound and provide a climate conducive to economic growth.
Have we dodged another Great Depression? For sure. Are we out of the woods? Not by a long shot.
The best we can say at this point is that the economy is getting worse more slowly than it was before. Real gross domestic product fell at a 6.3% annual rate in the last quarter of 2008; it was falling at a 5.5% rate in the first quarter of this year, and, if forecasts prove correct, it will decline only 1% to 2% in the second quarter. So the economy may start to grow again soon, but the expansion will likely be anemic, with a real risk of a “double dip” recession—that is, recession followed by a modest short-term improvement that quickly lapses into recession again.
What is missing is any plausible source of economic demand. After 2001, the housing bubble fueled consumer spending, construction, and growth. This time around, consumers, anxious to rebuild their balance sheets, are poorly placed to take the lead.
The federal stimulus package fell far short of plugging the projected output gap, and fresh cuts at the state and local level will neutralize much of the package. With the rest of the world following us into a deep recession, the prospects for export-led growth also appear dim.
The biggest problem, though, remains the labor market, where unemployment will quickly top 10%. Even if the official recession ends this year, the last two recessions and their "jobless recoveries" suggest it will be two to three more years before the labor market begins to tighten again.
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