Describing the Mechanics behind Financial Crises Using the Great Depression of the 1930s - Essay Example

Describing the mechanics behind financial crises using the Great Depression of the 1930s. BY YOU YOUR SCHOOL INFO HERE HERE Describing the mechanics behind financial crises using the Great Depression of the 1930s Introduction There is a great deal of speculation regarding what specific mechanics served as the most influential factors leading to the Great Depression of the 1930s. It is speculated and theorised that the Great Depression was caused by the phenomenon known as debt deflation, radical declines in consumer confidence leading to banking runs known as deposit withdrawals, drop in demand for new housing construction, and a failure of the U.S. Central bank to inject liquidity into the banking system. Many of the factors that are speculated to have caused the Great Depression were paralleled by the 2008 recession which impacted the economies of the majority of the developed world. This essay attempts to illustrate the specific mechanics that drive financial crisis utilising examples from the Great Depression to define how such crises develop and become monumental problems. Debt deflation, consumer confidence and the housing market In the 1920s, productivity and output in emerging industries that were gaining economic strength as a result of modernisation and rising consumer incomes was dramatically increasing. This led to over-confidence in the credit markets and banking lending systems about the longevity and viability of industrial capacity and ability to pay back loans. By 1929, the start of the Depression, debt to gross domestic product (GDP) in the United States had reached levels of 300 percent, a situation unparalleled in history (Jerome 1934). This was due to the ability of industrial leaders to procure credit for industrial expansion and technological improvement in which banks were now holding monumental volumes of open commercial loans, leading to a situation of over-indebtedness. Concurrently, the central bank of the United States, in an attempt to curb the inflationary rates that were present in the nation prior to the late 1920s, initiated a monetary policy that increased interest rates. Suddenly, the incentive for industry to obtain loans was curbed as a result of sudden intervention by the country’s central bank. As a result, this credit-centric economy experienced a significant deceleration in lending, leading to substantial drops in money supply that was in circulation. In macro-economic theory, a decrease in money supply leads to deflation of the national currency (Boyes and Melvin 2005). Economists and investors in the capital market, upon witnessing that deflation was a legitimate phenomenon, began to lose confidence in the economic system in the U.S. and other nations that maintained the same monetary policies of increasing interest rates to control inflation. This lack of confidence led to a sharp and measurable reduction in demand for finished products produced by industry and led to a rapidly rising unemployment rate as a means of controlling costs in an environment where consumers were not purchasing nearly the volume of products that were once in high demand during the 1910s and 1920s. As a holistic result, a malicious spiral began to occur where prices of finished products were being reduced as a means to incentivise increases in demand which led to profit losses when prices dropped so dramatically that the costs of financing production efforts could not be offset through revenue production. Concurrently, the industrial repayment of debt remained at the previous price level before significant deflation and companies were no longer able to make a reasonable profit. With the inability to make profit as a result of debt deflation, businesses were forced to liquidate that could not identify alternative methods of improving their financial positions and banks, which now maintained a vested interest in their operations as a result of significant loan debt on behalf of these companies, were gaining corporate assets that had lost a significant amount of their value. To sell these assets at substantially lower prices only exacerbated the problem. What this led to was immediate credit restrictions for industrial leaders to procure loans as a result of having less money available to lend associated with asset value plunges. As a result, the banking system essentially collapsed as lending institutions maintained an illiquid position and could not raise demand for top performing loan generations. The 2008 financial crisis mirrored many of the factors that were aforementioned with the Great Depression of the 1930s. Between 2004 and 2007, there was a significant demand for housing loans (mortgages) and, in an over-confident economic environment, banks and other lending institutions were more than willing to remove credit restrictions in order to provide less-qualified buyers opportunities for home ownership at high interest rates. Significantly inflated interest rates were supported by the Central Bank which made loan guarantees for consumers highly attractive for immediate and substantial profitability, a situation that mirrored the economic conditions of the 1910s and 1920s. Prior to the year 2004, these high interest rate mortgages represented only eight percent of all mortgages currently in circulation (Simkovic 2011). By 2006, the volume of high interest loans were 20 percent of all mortgages, representing billions of dollars worth of bank and other lending institution debt holdings. This, again, was mirrored by the condition of the United States in the 1920s, in which new housing construction accelerated at a pace that was 25 percent above that of the population growth in the country at the time (Fisher 1933). As a result, demand for these houses fell and banks that held these properties were unable to regain profitability in an environment where credit restrictions were becoming increased and consumer demand (as a result of under-confidence in the economic state of the country) led to considerable profit losses. Banks, as a result, began to fail rapidly which was mirrored by the 2008 recession in which asset values and loan defaults were causing significant problems with bank institution liquidity. During the initial 10 months of the year 1930, a total of 744 banks were illiquid and failed (Ganzel 2003). Even in the 1930s, the inter-connectedness of U.S. banks and other banks in developed countries around the world made substantial, negative financial impacts that were quite paralleled with the situation occurring in 2008 with the recent global recession in which banking institutions around the world began to fail with high debt load and substantially reduced asset values on poor-performing loans. Concurrently, with news in capital markets that banks were experiencing a shortage of money, there was a significant run on banks to remove their deposits as part of under-confidence in the ability of the economy to rectify itself, leading to further bank failures. Debt deflation, as a result, was a primary driver of what caused the Great Depression of the 1930s. The role of the Central Bank It is the responsibility of the Central Bank of a nation to recognise signs and trends that are leading to banking problems and, subsequently, inject important and vital capital to stabilise these banks (Sullivan and Sheffrin 2003). Central Banks are monopolies that control money supply, monetary policy, and are considered the last resort lending entity to commercial banks in the event of insolvency problems. The Central Bank in the United States and Great Britain had moved quickly to establish lower interest rates to promote lending incentives and, rather than adjusting monetary policy and injecting vital capital into commercial banks, the U.S. Central Bank simply allowed banks to fail as a result of the indebtedness occurring as a result of deflation and asset value declines. This inaction was a result of the Real Bills Doctrine of 1928 which stated that currencies and securities only be provided if they are backed by other assets with equivalent value (Cunningham 1992). This policy established the foundation of asset-backed securities that was a primary cause of the collapse of many banks in the 2008 recession. Known as credit default swaps, these are modern agreements that occur between seller and buyer of derivatives which are backed by mortgages or a variety of different bond obligations. When default occurs, buyers gain receipt of a payment which was established to secure the swap and, once received, the contract becomes concluded (Deutsche Bank 2009). Banks, therefore, in 2008, experienced significant losses when buyers of derivatives were forced to make payment on the original credit default swap contract when default occurred. Banks in the late 1920s, forced into compliance for asset-backed securities legislation under the Real Bills Doctrine were similarly driven to insolvency. Conclusion As indicated, the financial crisis of the Great Depression was nearly parallel with recent situations that drove the 2008-2010 global recession. Central bank incompetency in establishing proper monetary policy, appropriate interest rate policy, and injection of valuable capital into commercial banking institutions led to the underpinning situation causing economic collapse. Coupled with debt deflation and significant losses occurring as a result of a declining housing industry, the Great Depression was essentially unavoidable and difficult to rectify. Banking failures, banking asset value reduction, and consumer under-confidence in the economy, coupled with the Real Bills Doctrine of 1928 were the primary drivers of the Depression that were comparable to the events leading to the 2008 recession. 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Competition and crisis in mortgage securitisation, Indiana Law Journal, 88, p.213. [online] Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1924831 (accessed 1 February 2014). Sullivan, A. and Sheffrin, S.M. (2003). Economics: principles in action. Upper Saddle River: Pearson Prentice Hall. Read More