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What the Great Depression Did That This Recession Won't

By Morgan Housel - Updated Apr 6, 2017 at 5:03PM

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How bankruptcy will prevent a generation of worry.

One of the most important things about the Great Depression was not how bad it was, but how long it lasted. The downturn itself was 10 years long, but the impact it had on how people lived lingered for decades. Well after the Depression ended, households shunned debt, loved saving, and were wary of risk -- a mentality that lasted until the 1980s, when those who lived through the Depression retired.

It's still too early to tell how the recent recession has altered how we manage our finances, but the early indicators give us some clue: Unlike after the Great Depression, not much has changed. The personal savings rate jumped sharply in 2009, but has already drifted back to a pitiful 3.5%. Consumers are shedding debt, but they're doing it almost entirely by defaulting on it -- credit card debt has declined by over $100 billion since 2009, but banks wrote off over $180 billion of bad credit card loans over that period, meaning consumers were actively racking up new debt. A recent Fannie Mae survey shows that 60% of homeowners say a major reason they bought a home is because they think it will make a good investment. Legions of homebuyers are lining up at the Federal Housing Administration for mortgages with paper-thin down payments.

Not much has changed.                                                                   

I've been thinking about why this is -- why, after seeing their wealth decimated and jobs disappear, households haven't been scared into saving more and borrowing less, as they were after the Great Depression.

Maybe it's because the past four years paled in comparison to what took place during the 1930s. But I think there's more to it than that. For a while, I thought it had to do with stimulus packages and monetary policy, or maybe a newfound view of American exceptionalism that makes U.S. consumers unwaveringly optimistic.

But then I found this chart, which may explain it better than anything else:

Source: Federal Reserve.

Note that this isn't the total number of bankruptcies, but bankruptcies per 1,000 people, making it a true apples-to-apples comparison over time.

What it shows is clear: Personal bankruptcy during the Great Depression was virtually unheard of; today it's an everyday occurrence. About the same number of people were awarded bachelor degrees last year as filed for personal bankruptcy (1.6 million).

The effect that has is tremendous. During the Depression, those with too much debt largely dealt with it the hard way -- by selling assets, depleting savings, finding extra work, seeking help from relatives, or other ways of being shackled to the figurative debtor's prison. Today, a trip to bankruptcy court and a few years with a tarnished credit rating suffices for millions of Americans. And keep in mind, household debt as a percentage of net worth was about the same in the early 1930s as it is today.

It's hard to say exactly why bankruptcy has gained so much popularity. One likely reason is that bankruptcy was more ruthless in the past than it is today. Personal bankruptcy in the early 1930s usually meant an obliteration of financial well-being that left debtors virtually unable to live. As one firsthand account notes, debtors "threatened judges in bankruptcy cases; in one case a mob dragged a judge from his courtroom, beat him, hanged him by his neck till he fainted -- and all because he was carrying out the law." Going through a bankruptcy could be so damaging that people would collude to soften the blow. A family member or friend would often purchase assets in bankruptcy liquidation auctions and return them to the former owner the next day.

The laws have since changed dramatically. In 1938, after most of the carnage of the Depression had already taken place, the Chandler Act created bankruptcy options other than liquidation, such as debt reorganization, making it easier to go through personal bankruptcy. An even bigger change came in 1978 with the Bankruptcy Reform Act, which many argue made bankruptcy more appealing and sent filings through the roof.

Another reason bankruptcy has grown may simply be cultural. One study by Rafael Efrat of California State University, Northridge, found "a noticeable shift, beginning in the 1960s, in public attitudes toward individuals filing personal bankruptcy." Defaulting on debt simply lost its stigma.

Efrat explained: "[P]eople began to ascribe more sympathetic feelings toward the bankrupt. This sympathetic mind set was largely due to a shift in societal attribution of fault for financial failure." Not surprisingly, many came to view lenders, not borrowers, as responsible for consumers' debt loads -- a point reinforced by the recent Occupy Wall Street protests and the rising acceptance of walking away from underwater homes.

Whatever the reason, bankruptcy is far more common today than it was during and after the Depression. What that means going forward, no one knows. It's not hard to argue, however, that it could mean consumers don't need to save like they did in the past, don't need to avoid debt like they did in the past, and can accept risks that used to be off limits -- all rationally. The ironic truth is that those who levered up on debt during the bubble and then reneged on their promises ended up in a better position than many of those who played the game prudently. As long as that's the case, consumer behavior may not swing conservative like it did after the Depression.

Is that a good thing? You tell me in the comments section below.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

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