Christopher James Liebetrau
G08L2114
Tutor: Candice Hittler
Period 1
The Differences Between the great depression and the Current Global Financial Crisis
Economics 202 Essay 1
29 April 2009
Abstract
This essay sets out to distinguish the differences and similarities between the Great depression of the 1930’s and the current global financial crisis. It is an important discussion as a depression should not have happened again after learning from the mistakes of the past. The current crisis and great depression were compared on the basis of their causes and effects and it was subsequently concluded that both recessions were preceded by large credit booms and following uncertainty by investors.
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Introduction
This essay sets about critically analysing the differences between great depression of the 1930’s and the current global financial crisis. In this essay the relevant theories of the causes of each recession will be looked at; including high and low interest rates, the stock market, unemployment, aggregate demand and the distribution of wealth. The effects that each recession had on the economy of that respective time and on the welfare of people globally will also be considered and discussed in the essay. With the current recession originating in the United States of America the majority of this essay will be analysed from the American point of view for consistencies sake.
The Essay on Great Recession Vs Great Depression
The Great Depression and Great Recession has had an outstanding impact in our nation’s history and is well known to the When President Barack Obama was inaugurated in January 2009, he inherited a horrendous economy. But was the economy back then really worse than it was during the Great Depression? Obama said in 2009, “The economy was on the verge of a great depression. In some ways, actually, the ...
The great depression
“A depression is a severe economic downturn that lasts several years” (Amadeo, 2009: 1).
There are a number of contributing factors that resulted in the Great Depression that occurred in the 1930’s and despite the crash of the stock market triggering the great depression there were many other domestic and foreign problems that fuelled the greatest economic crisis that had ever been seen thus far. (Kelly, 2009: 1).
“The two major components of the financial collapse were the loss of confidence in financial institutions, primarily commercial banks, and the widespread insolvency of debtors” (Bernanke, 1983: 258)
The 1920’s was a decade of high economic expansion as there was great demand for products including cars and radios, however during the decade there was increasing economic uncertainty. This uncertainty was due to the increase in international currency fluctuations as well as trade policies such as tariffs that had been introduced by many countries. There was also uncertainty arising due to restrictive monetary and fiscal policies that had been introduced to ensure that the currencies remained on the gold standard. (Parkin et al., 2005: 717).
In 1929 the stock market in the United States of America crashed and the economic slowdown that resulted from this only heightened the uncertainty. This slowdown led to a drop in exports, which subsequently caused a drop in aggregate demand. This can be illustrated by figure one where there is a leftward shift in the Aggregate Demand Curve from AD1 to AD2. To some extent the decrease in aggregate demand was reflected in the labour market and thus caused the money wage rate to fall, which consequently caused the Short run Aggregate supply curve to shift leftwards from SAS 1 to SAS 2, ultimately resulting in GDP and the price level both falling. (Parkin et al., 2005: 717).
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Other factors that led to the uncertainty about the economy included the misdistribution of wealth among the nation’s people. The misdistribution of wealth was caused by a huge increase in demand for goods such as cars and radios and firms replied to this demand by raising their productivity. The productivity per worker had now increased by four times the amount that the wage rate was increased. This meant that firms were greatly increasing their profits and could produce even more, however this resulted in an oversupply of goods by the industries as the working-class citizens could no longer afford to buy goods due to their real wages increasing by such a small margin in comparison to those high up on the corporate ladder. (Gusmorino, 1996: 3)
“For an economy to function properly, total demand must equal total supply. “In an economy with such disparate distribution of income it is not assured that the demand will always equal supply” (Gusmorino, 1996: 2).
There was a great demand for goods, but as explained earlier the majority of the public could not afford these goods and the really wealthy were only interested in spending small amounts of what they were earning. Thus the economy became reliant on luxury spending by the rich, and credit sales of goods. This caused uncertainty as you cannot always rely on luxury spending by the rich as if there is the slightest doubt in their mind as to losing money on an investment, money hoarding will take place. This will not pose a problem as long as prices and wages drop instantly in order to reflect the lower amount of money in circulation. (Harless, 2009: 1) “If a country has a gold standard, then hoarding money can make the money supply drop dramatically since a gold standard makes the quantity of money difficult for the government to control” (Harless, 2009: 1).
According to Bernanke (1995: 4) “Countries that left the gold standard were able to re-inflate their money supplies and price levels, yet other countries, including America, persisted with the gold standard and recovered much slower from the depression.”
Many economists agree that the stock market crash in 1929 signalled the beginning of the great depression as it triggered off a snowball effect of the economic crisis. “From early 1928 to September 1929 the Dow Jones Industrial Average rose from 191 to 381” (Gusmorino, 1996: 5).
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It is clear here that the profits that could be made by trading shares was promising and sparked many investors to plough money into the stock market. Company profits were no longer the primary concern of investors and as long as their shares were appreciating in value, they were happy and confident. During this time investors were taking advantage of their ability to trade with shares on margin. Buying shares on margin is much like buying any other good on credit, and involves the investor taking a loan from the broker and settling the debt with the return made from the share trading. This led to huge return possibilities and sparked an investing spree and thus drove the market to ridiculously high levels. Midway through 1929 the loans owed to brokers was worth over $7 Billion and the brokers by this stage had started charging interest of over 20%. This boom in the stock market was all based on confidence, and similarly, fear was responsible for the stock market crashes. (Gusmorino, 1996: 2).
Prices in general had been decreasing since September 1929, but still people were confident in their ability to make large returns by trading shares. However on October 21 1929 prices fell drastically and resulted in investors selling their shares quickly, which only made the collapse happen faster. By October 29 1929 there was a complete lack of confidence in the stock market and no one was willing to invest at even the cheapest share prices. (Gusmorino, 1996: 2).
The stock market crashes of 1929 acted as a trigger to the already unstable United States’ economy. As discussed earlier, due to the misdistribution of wealth the economy during these times was highly dependent on confidence and the stock market crash resulted in total lack of confidence by any investors. There was a chain reaction that followed and started off with the rich halting there expenses on luxury items and investments. The middle and lower classes stopped using credit facilities out of fear of not being able to settle the debt and the interest. This forced industrial production to decrease and subsequently unemployment began to increase and people were unable to settle their debts. Goods that had been bought on credit were now being returned and repossessed which caused stock-piles of inventory in factory warehouses. The car and radio industries were now obsolete, which in turn meant that without cars there was no longer a need for tyres or fuel, and those without radios demanded less electricity. Internationally, there were no longer loans to foreign countries and in an effort to protect local businesses the United States Federal Reserve imposed trade barriers, known as the Hawley-Smoot Tariff resulting in foreign countries completely discontinuing buying American products. This only meant that more jobs were lost and more stores, banks and factories were all forced to close. (Gusmorino, 1996: 2).
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During the 1930’s banks were failing at an alarming rate and huge responsibility could be placed on them for the panic that investors were experiencing. Banks were not maintaining adequate cash reserves, making risky investments and loaning to people who were un-creditworthy. (Neal, 2005: 40) “The use of banks for depositing personal savings and weekly paycheques had been placed upon the assumption that funds would be available when there was a need for them” (Neal, 2005: 40).
Thus when the banks were beginning to fail there was a mad rush by investors and depositors to collect there money. The banks reserves were quickly exhausted and the banks became insolvent. (Neal, 2005: 40).
Unemployment grew to 5 million in 1930 and up to 13 million in 1932. The economy had spiralled out of control, the great depression had begun.
The Current Global Financial Crisis
Since the Second World War the rate of profit in America had been decreasing. (Moseley, 2009: 3).
The Federal Reserve thus decided to try and raise profits and hence, monetary and fiscal policies were introduced to raise corporate profits. The American government wanted to increase aggregate demand by raising profits and a number of strategies were introduced by firms to do so. Strategies of the firms included: lowering money wages or increasing the prices more than the money wage, (both having a decreasing effect on the real wage rate) cutting back on health and medical insurances, speeding up labour intensities and outsourcing manufacturing to countries with cheaper labour. (Moseley, 2009: 3).
The Term Paper on Bank Marketing Financial Institution
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It is thus obvious that the increase in corporate profits has been at the expense of the workers. Many workers in America are forced to work harder and longer for less pay in order to keep their jobs and provide for their families. (Moseley, 2009: 3).
The increased corporate profits meant that there were many institutions that had money to loan others but due to the fact that the working class had less money to buy goods their motivation to borrow was significantly higher. Interest rates had also been lowered in an effort by the Federal Reserve to recover from the recession that was experienced in 2001. (Wallison, 2008: 1) Thus “financial corporations increasingly focused on workers as their borrower-customers” (Moseley, 2009: 4).
This factor along with the record low interest rates and a strong economy fuelled a housing boom in America. (Swann, 2006: 1).
The borrowing initiated and houses were bought all over. People were borrowing as much as possible as their expectations were that prices would only go up indicating that buying a house was considered an investment by the purchaser. (Pickard, 2005: 1).
“At the early stages of the US housing boom, rising prices were balanced by falling interest rates, leaving affordability largely unaffected. (Pickard, 2005: 1).
Banks were granting loans without seriously considering their debtors’ credit-histories and the housing market became flooded. Recently however mortgage rates have been on the increase along with the housing prices although at a much slower rate. As the housing prices levelled off and with raised interest rates, people began to default on their mortgage payments and this sparked fear in investors and their response was to hoard money. Banks were flooded with people trying to get their money out and soon their reserves were exhausted and similar to the great depression there was a major decrease in money supply.
Banks major source of income are loans, and thus with no money to lend the income made by granting credit dried up. At this stage many banks filed for bankruptcy, and some were lucky enough to be bailed out by the government. (Patrick, 2008: 1) “The idea behind the bailout is to give banks the opportunity to lend more money in order to create money and stabilize the economy” (Patrick, 2008: 1).
The Term Paper on A Comparison of the Great Depression and Our Current Financial Crisis
A comparison of the Great Depression and our current financial crisis Brandon Gilbreath HIST-410 Al Campbell The Great Depression, an event that happened 70 years ago still conjures images of families waiting in soup lines and thousands of men looking for work. In October of 1929 the American economy came to screeching halt and would not see growth for the next three years. This was a major event ...
This can prove to be a very effective solution to the problem as long as lenders are sure of their debtors’ ability to settle their loans. “The decline in U.S. productivity growth and in housing prices did not provide a particularly favorable backdrop for withstanding a credit contraction” (Reinhart and Rogoff, 2008: 8).
There was a similar housing boom in South Africa as prices of houses were raising and interest rates were dropping. There was however a difference in that the credit-rating of borrowers was thoroughly checked before granting loans and thus loan defaults were a far less occurrence in comparison to the United Stated. “The South African industry continued to perform well in spite of pressures exerted by the global financial crisis that had seen growth in the global industry shrink to 1.3% last year” (Financial 24, 2009: 1).
The effects of the American crisis were very similar to that of the Great Depression and the Graph seen in figure one is relevant in that there was a decrease in aggregate demand and a decrease in Short Run aggregate supply, resulting in the GDP and the price level both to fall. With reference to Figure 2 this can be illustrated by a leftward movement along the production function from point A to point B which represents a decrease in Output from (Y1 to Y2) and a decrease in employment from (N1 to N2).
(Froyen, 2009: 64)
Similarities and Differences between the Great Depression and the Current Recession
The current recession shares two major similarities with the great depression in that the periods preceding these recessions there was a “credit-fuelled” bubble, in which the public began borrowing large sums of money to buy goods and secondly that there were Government intervention policies implemented in both in order to prevent falling asset prices. An example of a policy used in both times were the banning of selling shares short. (Patel, 2009: 1)
There are a number of differences between the current recession and the great depression. The first noted difference is that there is an absence of a gold standard in the current economy. This means that the Federal Reserve is far less restricted in the amount of money they can create compared to back then. The second main difference is that the United States was not as “debt-ridden” back then as it is now. Blame for this can be largely placed upon credit cards, as they are a relatively new introduction and are an easy way of granting credit. Thirdly the debt now is largely owned by foreigners now and this causes problems in that the countries owning the debt can devalue the dollar by selling treasury bills or dollar reserves. The final difference is that all major currencies are now “Fiat” currencies and the US Dollar is the World reserve currency. This helps in that as central banks inflate their money supply to maintain parity the US is able to export its inflation. (Patel, 2009: 1)
Conclusion
Although speculation can arise as to the cause of the current recession and how it is similar to the Great Depression, it is difficult to comment on whether this depression is as bad as the great depression as it is not over at this stage. There have been monetary and fiscal policies implemented but whether these measures are successful or not will remain to be seen. Some of the differences however indicate that this could be an even worse crisis than the Great Depression as there are many areas which are worse off and that could potentially turn sour.
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