Comparing and contrasting the Great depression and the 2007-2009 Financial Crisis


Kyle Gray

Econ 2020

Many references to the Great Depression have been made when discussing the 2007-2009 Financial Crisis (also known as the Great Recession and the Housing Crisis). Though it is true that this is the worst economic crisis to befall the United States in the last 70 years, on a macroeconomic level the Financial Crisis relatively tame in comparison to the Great Depression. Though the exact business cycle has yet to be determined, the Financial Crisis lasted around 20 months; which is markedly longer than any recession in recent history, yet it was less than half as long as the Great Depression.  The loss in GDP in the Great Depression was ten times more profound and the unemployment was over two and a half times higher than the recent crisis. This paper will examine the causes of both of the Crises, the responses of the Federal Reserve to them, and the effects of international cooperation.

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(Wheelock, 2010)

Causes of the Great Depression and the Financial Crisis

The causes of both the Great Depression and the Financial Crisis were rooted in the use of outdated nostalgic economic policies that oversimplified reality. Both were preceded by expansions with people that were unaware of the risks they faced. With growth and prosperity, people were more willing to take risks, which led to their respective economic downturns.

The Great Depression was characterized by the Gold Standard, a 19th century economic theory pioneered by David Hume. Hume explained how currencies valued in gold would maintain stable values relative to each other. An economic shock in one country causing decreased exports would result in an outflow of gold and decrease prices in the exporting country. Lower prices would then encourage exports, resulting in an inflow of gold and stability. (Temin 2010)

This theory was very successful in the 19th century, but in the postwar 1920’s world, rising oligopolies, monosphonies, unions and strikes gave way to a complexity that Hume’s theory did not address. When both Germany and the United States faced recessions, prices could not fall with sufficient speed due to the ratchet effect to equilibrate markets causing the recession spread to other economies and grew. (Temin 2010)

The housing boom in recent decades was nourished by the ruling economic theory “The Washington Consensus.” This theory was an adaptation of the gold standard to current conditions indicating stable exchange rates, responsible fiscal policies, and deregulation. The Washington Consensus was designed to reduce risks and recreate old prosperity in this economy. Banks and businesses used this reasoning to create new assets known collectively as derivatives. Derivatives were a way to benefit from the fact that only a few homeowners at a time would default on their mortgages. Banks divided these mortgages up into varying levels of risk without knowing which ones would default. When the housing market failed and defaults did not turn out to be random, the derivatives showed to be more risky than once thought and investors refused to buy any of them and markets seized up, resulting the in first stages of the Financial Crisis. (Temin 2010)

 

Comparing responses of the Federal Reserve

President Obama credited the Federal Reserve’s response to the financial crisis was what kept the United States from economic freefall. The Federal Reserve initially responded in early 2007 to the housing market collapse by providing liquidity to keep financial markets operating as confidence began to decline and investors were beginning to withdraw. Financial strains eased in October 2007, but were revived in November. As the market strain continued into 2008, individuals and firms continued to have difficulty acquiring loans. The Federal Reserve invoked section 13 of the Federal Reserve act “which permits the Federal Reserve to lend to any individual, partnership, or corporation “in unusual and exigent circumstances” if the borrower is “unable to secure adequate credit accommodations from other banking institutions.” This was created in 1932 out of concern that widespread bank failures made it difficult to obtain loans, was not used again until 2008, and was a very important tool in limiting the financial crisis. The Federal Reserve again used Section 13 was to loan 29 billion dollars to facilitate the acquisition of Bear Stearns by JP Morgan as its investments in mortgage-backed securities began to fail. The Federal Reserve chairman Ben Bernanke justified this action with this statement:

“Allowing Bear Stearns to fail so abruptly at a time when the financial markets were already under considerable stress would likely have had extremely adverse implications for the financial system and for the broader economy” (Bernanke, 2008a)

Both of these loans were broad departures from the typical strategy of only lend to financially sound institutions with good collateral. This theory highly contrasts with the Federal Reserve’s response to the great depression. The effectiveness of this strategy was later demonstrated when the Federal Reserve refused to make a loan to rescue Lehman Brothers, the failure of this firm triggered widespread withdrawals from other money funds, this worsened the impact and extended the duration of the recession. (Wheelock, 2010)

Though there is plenty of criticism of the Federal Reserve’s response to the financial crisis, it was notably more aggressive than the response to the great depression. The Federal Reserve Bank of New York acted swiftly in the October 1929 market crash by lowering its discount rate and lending heavily to banks, but the fed largely ignored banking failures and panics in 1930-33 and did little to stabilize price and output declines. (Wheelock, 2010)

Comparing international cooperation

A failure of large-scale international cooperation broadened the great depression in the 1930’s and set the stage for World War II. The high point of international cooperation was supposed to be the 1933 London World Economic Conference with the goals to increase currency stabilization and reduce trade barriers. Governments were unwilling to make sacrifices that would lead to greater short term cost even if it meant long term stability.With the failure of the conference and currency stabilization imminent, participating countries looked for scapegoats not unlike an international dramatization of the board game “clue”. (Bordo 2009)

The lesson of the importance of cooperation was apparent during the financial crisis, despite some countries adopting protectionist measures the G-20 meetings in 2008 and 2009 produced several anti-protectionist agreements. This laid the foundations for quick recovery in international trade after the aforementioned collapse of Lehman Bothers.

Reminiscent of the 1930s, plenty of blame and accusations have been placed in the wake of the financial crisis. China is accused of rigging its currency to drive exports, Europe complains that the United States is using quantitative easing to drive down the dollar, and the US accuses the EU of using the euro troubles to drive down the exchange rate. Worse is that southern European countries suspect the single currency system in the EU as a mean for Germany to maintain export advantages. Though these accusations appeared in the most vulnerable time of the crisis, international leaders assured themselves that international cooperation was working splendidly. (Bordo 2009)

Central banks in many countries worked together to ease the strain on the respective economies and encourage currency flow. On December 12, 2007, the Federal Reserve announced the establishment of reciprocal currency agreements known as swap lines with the European Central Bank and Swiss National Bank to provide a source of dollar funding in European financial markets. Over the next 10 months, the Fed established swap lines with a total of 14 central banks. (Wheelock, 2010)

In conclusion, there are many similarities between the Great Depression and the Financial Crisis. Some lessons from the past were learned in the response to the Financial Crisis, but it seems we did not learn from the underlying causes of both. Or perhaps it is inevitable to have a collapse after an economic boom.

Sources

David C. Wheelock (March 2010) Lessons Learned? Comparing the Federal Reserve’s Responses to the Crises of 1929-1933 and 2007-2009

Retrieved from: http://web.ebscohost.com/ehost/pdfviewer/pdfviewer?sid=f982646a-6bde-401bb4e8-6e98c7a602da%40sessionmgr110&vid=6&hid=105

Michael D. Bordo Harold James (December 2009)THE GREAT DEPRESSION ANALOGY

Retrieved from: http://www.nber.org/papers/w15584.pdf?new_window=1

Peter Temin (January 2010) THE GREAT RECESSION AND THE GREAT DEPRESSION

Retrieved from:http://www.nber.org/papers/w15645.pdf?new_window=1

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