The results of the credit crunch - Essay Example

The results of the credit crunch Introduction The world economies have been through various business cycles involving contractions and expansions. Some of these can be described as normal while others are referred to as recessions and depressions. Depressions are seen as more extreme forms of recessions that may be triggered by variables such as stock market crashes and financial crises which result in more rapid declines and lengthy periods of contractions. The 20th century has seen the Great Depression of 1929 to 1933 which was prolonged until the beginning of the 1940’s. The fiscal expansion which came about as a result of World War 11 led to the end of that period of contraction. As some parts of the world are recovering from what has been described by many as the Great Recession, the debate is on as to whether or not the world went through a depression or a recession. Indeed there are some similarities with the Great Depression of the 1930’s but the official authorities have not characterised it as such. This paper defines recession and depression and explains the differences between them. It also looks at similarities and or differences leading up to the Great Recession which was triggered by the volatility in the stock market and a credit crunch in 2007, and those of the Great Depression which lasted from 1929 to 1933 and extended into the 1940’s. Definitions The Business Cycle Dating Committee (BCDC) at the National Bureau of Economic Research (NBER) defines a recession as a time when business activity is at its peak and therefore starts falling until it reaches its lowest level (“bottom out”) –a trough (Recession n.d.). A recession normally lasts for a year and is part of a regular business cycle which involves contractions (recession) and expansions. However, there are others which have lasted for up to two years. An example is the Japan’s economic slowdown in Japan in the 1990’s which lasted for 2 years to March 1999 can be considered as a recession since the largest peak to trough decline in GDP during that period was 3.4%. A depression on the other hand represents a slowdown in economic activity where GDP falls by more than 10% (Recession n.d.). It is characterised by rising unemployment, a sustained long term downturn in the economy and normally last for more than three years. The great depression which lasted from 1929 to 1933 and which was prolonged well into the early 1940’s with the “double-dip” is a prime example of a depression. During this period real GDP fell by 30% which is above the 10% benchmark. Unemployment levels soared to never before seen levels and a large number of families and single persons were losing there homes. Thousands of business closed there doors while others downsized. Differences between a recession and a depression The Economist (2009) quotes Saul Eslake, the Chief Economist at ANZ Bank as saying that the difference between a recession and a depression is more than just size and duration as noted in the definitions above. Eslake indicates that the cause of the downturn is also of importance (qtd. in The Economist, 2009). Eslake went on to state that a recession usually results from tight monetary policies while a depression is the result of a “bursting asset credit bubble”, a sharp decline in credit (contraction) and a fall in the general price level (The Economist 2009). Eslake further stated that during the Great Depression prices fell by approximately 25% and nominal GDP shrank by almost 50%. A depression Eslake suggested does not have to be as severe as in the 1930’s. They can either be mild or severe. Additionally, Eslake (qtd. in Economist 2009) indicates that the economic downturns (slumps) which followed on the heels of the collapse of the Soviet Union and the ones which characterised the Asian crises were not depression. The reason Eslake states is that inflation increased sharply. Eslake also suggested that the downturn in the economy of Japan which ended in 1999 may qualify as a depression even though it did not last for three years and was not of the size as stated in the definition above. Essentially, Eslake (qtd. in The Economist 2009) is saying that there are some other factors in addition to the duration and or the level or size of decline in GDP that differentiates a recession from a depression. Bloom (2008) appears to support Eslake when he indicates that the Great Depression started with a stock market crash – Black Thursday October 24, 1929 and a meltdown of the financial system which he likens to the credit crunch of 2008. According to Bloom (2008) during the Great Depression credit was withdrawn from both customers as well as between financial institutions, which is essentially a credit crunch. The Federal Reserve, which is the Central Bank of the United States tried to restore calm, however, this was unsuccessful. This credit crunch triggered a recession which led to significant declines in US GDP as mentioned above. The recession which was triggered in 2007 Bloom (2008) states was larger than every recession since Word War 11 combined. The similarities with the period 2007 to 2008 when Bloom (2008) wrote the article were that stock market volatility had increased by approximately 6 times since August 2007. This meant that this period had some similarities inclusive of the credit crunch and the stock market volatility as was seen in 1929. Bloom (2009) suggested that the increasing uncertainty and the collapse of the banking sector resembles the Great Depression and states that on the last occasion when the stock market volatility was persistently high as it was during the Great Recession of 2007 to 2010 was during the Great Depression of 1929 to 1933. According to Rosenberg (n.d.) even though there were some signs which would suggest otherwise the US economy was going through a “1930’s style depression”. Thus one writer points out that the prices of housing have fallen by 17% over the last two years and that number is send to decrease even further. The writer further pointed out that homeowners in the United States have lost approximately $2 trillion of equity during what he describes as the “worst housing slump since World War 11. Rittenberg and Tregarthen (2009) states that during the Great Depression real GDP fell sharply by approximately 30%, real per capita disposable income also fell sharply by almost 40% while over 12 million persons had lost their jobs. Rittenberg and Tregarthen (2009) also stated that the unemployment rate soared from approximately 3% in 1929 to approximately 33% in 1933 as a result of the failure of approximately 85,000 businesses and the downsizing of many others. The unemployment when added to the credit crunch at the time resulted in hundreds of families and single persons losing their homes and by 1933 almost 50% of all mortgages on urban owner-occupied houses went into delinquency. According to Rittenberg and Tregarthen (2009) while the economy began to recover from the Great Depression in 1933 an excessively large recessionary gap persisted and another downturn began in 1937 resulting in another trough thus the term “double-dip”. This pushed the unemployment rate back to 19% in 1938. Rittenberg and Tregarthen (2009) further indicates that the economy of the United States had never contracted so much and for such a long period and had also indicated that historical data suggests that 75 years before the Great Depression there had been approximately 19 recessions which lasted for an average of less than two years. The Great Depression lasted for more than ten years from 1929 to 1941 when World War 11 started. It is the duration and severity of the contractions that resulted in it being described as a depression. It was during that period that the Government’s of the US tax revenues increased for 10.8% in 1929 to approximately 17% in 1933. This higher tax rate reduced consumption even further. The recession that was triggered in 2007 in countries like the United States had begun much later in other countries and while the United States is suggesting that it is rebounding there are some countries that have not started to recover. Unemployment levels are still at an all time high. Even though the magnitude and severity is not as bad as in the Great Depression of the 1930’s the symptoms are much the same. Additionally, the length of this recession is much longer than the average seen since the Great Depression. According to the Economist (2009) the GDP of the USA declined by 6% (annualised) in the last quarter of 2008. However, it is not expected that the policies adopted during the period of the Great Depression would have been applied in this instance as policy makers are not expected to make the same mistakes. During the Great Recession which was triggered in 2007, the Government responded as soon as it became apparent and some financial institutions were bailed out while some were allowed to go under. During the great depression hundreds of banks failed without any intervention from the government. Between 2009 and 2010 the government did everything it possibly could to prevent the downturn from getting to the state of the Great Depression. Financial support was given to companies in the automobile industry in order to allow them to continue in business and therefore save jobs. A number of retail stores like Circuit City in the United States filed for Chapter 11 bankruptcy because of the decline in consumer demand and unemployment levels were above normal. Conclusion The same factors that triggered the Great depression of 1929 appear to be quite similar to those that triggered the Great Recession. The main factors being stock market volatility and a severe credit crunch. During the Great Depression the United States Government allowed the economy to operate freely without much Government intervention and so the recession got severe and lasted for quite an extraordinarily long time. The Government allowed hundreds of banks to collapse and thousands of businesses to go under. However, it was World War 11 that appeared to save the day and so Government expenditure that was incurred to fund the war resulted in increased employment and an expansion in the economy. This brought an end to the depression then. The period of the Great Recession is very different in how the United States Government dealt with it. While the government took some time to come to the realisation that there was a contraction of above-normal proportions in the economy, they responded as soon as they became aware. Significant sums of money were pumped into the economy in order to facilitate its expansion. Though a number of banks failed it was proportionately far less than had occurred during the Great Depression. The Obama Administration did not just sit and watched as happened in 1929. They acted and they did so swiftly. It was this swift action that resulted in less jobs being lost as would have been the case if things were allowed to work themselves out. The government did whatever it could to meet with automobile manufacturers and other business interests to prevent the industry for collapsing. This helped to save a number of jobs in that industry as well other industries that supplied them with raw materials and services. It should be quite obvious from the foregoing that the Great Recession was not as severe as the Great Depression of 1929 which lasted for more than a decade. Things could have been even worse if the response was similar to that of the 1930’s. What is therefore significant is that things were not allowed to run their course as happened in the 1930’s. While World War 11 appeared to have shortened the period of the Great Depression of the 1930’s, it was the intervention by the Obama Administration in the United States that prevented this from getting to the stage of the Great Depression of 1929. It is therefore important that it is clearly understood that the results of a situation is affected by the response mechanisms that are put in placed to deal with the situation. The response mechanisms that were put in place were different during the Great Depression of the 1930’s when compared with the Great Recession of the 21st century and so this lead to a somewhat different result. References Bloom, N. (2008). The Credit Crunch may Cause another Great Depression. Centre Piece: Spring 2008 Retrieved: http://www.stanford.edu/~nbloom/CreditCrunch.pdf Last Accessed 6 Marc 2011 Economist. (2008). Diagnosing a Depression. The Economist. December 30, 2008. Retrieved: http://www.economist.com/node/12852043 Last accessed 7th Mar 2011 Rittenberg, L and Tregarthen,T (2009) Principles of Macroeconomics. Retrieved: http://www.flatworldknowledge.com/pub/1.0/principles-macroeconomics/30015#web-0. Last accessed 9 March 2011 Rosenberg, D (n.d.) Economy Caught in Depression, Not Recession. Retrieved http://www.thecomingdepression.net/main-street/deindustrialization/economy-caught-in-depression-not-recession-rosenberg/. Last accessed 8th Mar 2011 Recession (n.d.). What is a Recession? Economic Recession Definition. Retrieved: http://recession.org/definition. Last accessed 5th Mar 2011 Read More