Economic Crises in the World - Essay Example

The Great Depression vs. Economic Crisis of 2008 Economic crises, have always involved large and persistent declines in levels of output and employment. The crises have been like puzzles especially in developed countries whose economies typically function at high levels. The analyses and comparison of the Great Depression to the 2008 recession is done mainly because of the magnitude and significance of the two recessions to many of the highly developed world economies. The Great depression is a like a story with a mythic luster for most of the Americans alive today. Even those who were already born during this period may not remember much about it. Despite this, it is clear that Americans cannot escape the foundational legacy left by the Great. At the very least, it is known that during that period, times were really bad because the Great depression is the standard by which economists, historians and journalists measure most of other potentially bad times that followed. Liberal and Conservative economists still argue over the cause of the depression but the fact remains that it happened and in the process scarred the lives of millions of Americans while at the same time changed the course of United States politics. The parallels between the Economic Crisis of 2008 and the Great Depression have been subject to many comments. The current economic crisis is believed by some economists to be as bad as the Great Depression but this point highly disputable. As economists and historians continue with their debates, the effects of the 2008 recession are still felt all around the globe. Introduction Depressions lead to large and persistent declines in economic activities of a nation. They feature a major crime whereby an economy is leveled. There are always a number suspects who possibly contributed to the depression. The most fascinating aspect of depressions is that they manage to remain a mystery. They are mysterious when looked at from the perspective of standard economics. This is so particularly in countries that are highly developed such as the United States, Britain, Australia that ideally should not have them because of their relatively efficient institutions and well functioning economies.1 This then begs the question as to what makes such economies go bad. This paper will assess the features of crises and depressions, with a focus on the Great Depression and the recent economic recession of 2008. Though these crises initially occurred in the United States, their magnitude was felt all over the world. In the United States, the effects of the systemic crisis are easily seen due to the recent political, economic, and ideological developments. Output and employment levels in the U.S. gradually fell at a great speed that had never been seen for many decades with the situation getting worse to a point that forced the government to introduce bailout plans to rescue some of the economic sectors. General Motors and Citigroup which were two of the largest corporations in the US, one a symbol of the manufacturing prowess of the US and the other the largest bank became insolvent. Policies that had previously been effective in overcoming past financial recessions and crises such as institutional bailouts and expansionary monetary policies were not capable in stemming the 2008 crisis.2 Comparisons: The Similarities It is important to note that in terms of real economic decline as measured by unemployment, real GDP or Industrial Production, the Great Recession was relatively minor. In the period between 1929 and 1933, the real GDP of the US fell by close to 30 percent. On the other hand, between 2007 and 2009 the real GDP fell by slightly over 5 percent. In 1933, unemployment in the U.S. peaked at 25 percent whereas in 2009 it was slightly above 10 percent.3 The United States Bureau of Labor Statistics places the unemployment rate at 8.2 percent as of March 2012.4 Though this rate is still high, it cannot be compared to the rate that prevailed during the 1930s. Secondly, both the 2008 financial crisis and the Great Depression affected economies globally.5 The origin of the crises was in the US but due to the globalization effect, other economies were also affected. A third similarity is in the nature of the recoveries that followed the recession. In both cases, the recoveries were sluggish in terms of expansion of the real economy. The recovery that occurred after 1933 was rapid but not sufficient enough to completely reverse the downturn that preceded it. One explanation as to why recovery in the 1930s was incomplete that the New Deal NIRA policy impeded the process by attempting to cartelize the markets for both goods and services.6 The current recovery is also sluggish in nature just as the 1930s one was. Another similarity is that asset price busts and boom episodes were experienced in both occasions. In the 1920s, an episode of the housing boom and bust was witnesses followed by the Wall Street boom and crash in 1929.7 In the 2008 crisis, the bursting of the subprime mortgage related housing boom in 2006 is believed to have triggered the crisis. In addition to this, in both cases, the government introduced interventionist policies to prevent asset prices from falling. For instance, bans were instituted in 2008 to prevent short selling which was similar to what was done when the Great Depression began. In both cases, the stimulus packages were used as a remedy to the crises but they appear to be unsuccessful now just as they were back then. The weakening of the dollar and its instability has been witnessed a lot since the 2008 financial crisis began. Currently, there is a serious debate on the sustainability of the dollar as a world reserve currency. Several countries including China which is a growing world economic power house have called for an alternative world reserve currency since the start of the economic recession. Comparisons: Differences The main difference between the two crises lies in the nature of the banking crisis that was faced then compared to the recent one. The 1930s financial crisis was the old fashioned liquidity based crisis that was as a result of the federal bank failing to play its role as the lender of last resort. On the other hand, the recent crisis was a solvency driven crisis. The economic crisis of 2007-2008 just like 1929-1933 crisis, was caused by the bust of an asset price boom. The subprime mortgage market collapse led to panic in the non regulated and non covered shadow banking system. These institutions which had greatly expanded due to the repeal of the Glass Steagall Act had much more leverage compared to traditional banks.8 Their proneness to risk was also much higher. Another difference is the lack of a gold standard in the current financial system. The gold standard was used to restrict money supply since all money in the 1930s had to be backed by gold. The devaluation of the dollar relative to gold during the Great Depression led to attempts in circumventing the restrictions placed with regard to money supply.9 This restriction on money supply is no existent today. Also during the great depression, America did not have as much debt as it has now even in relative terms. Items such as credit cards did not exist. The national debt and deficit financing was significantly lower. In the 1930s much of the public debt of the US was owned by the locals. This is not the case today as much of America’s debt is owned by foreigners. Currently, the US dollar serves as the world's reserve currency which was not the case during the 1930s. This has somehow helped the United States to export its inflation, something that was not possible during the Great Depression. The Response to the Crisis Lessons from Friedman and Schwartz derived from the 1930s banking panics on the importance of implementing expansionary open market policies in order to deal with liquidity problems were well learnt by the Federal Reserve. During the recent financial crisis, the Federal Reserve adopted highly expansionary policies beginning end of 2007, and from late 2008 to now. The Fed adopted a highly cautious policy approach during the first to the third quarters of 2008. This was evident in the high real interest rates charged and the flat growth in the monetary aggregates. However after the onset of the last quarter of 2008 the Fed policy became highly expansionary. It pushed the rate for federal funds almost to zero and an aggressive policy that called for quantitative easing was embarked on.10 Based on the view by Bernanke (1983) that the banking collapse in the 1930s led to the failure of the credit allocation mechanism, a plethora of extensions were developed to lengthen he discount window.11 This action was taken by the Fed in conjunction with the Treasury. This was referred to as credit policy whose purpose was to virtually encompass every kind of collateral so as to unclog the credit markets. Another aspect of the 2008 crisis that was not present during the Great Depression is that the Fed together with other monetary authorities in the US participated in a series of bailouts involving incipient and insolvent firms that people deemed to be too connected to fail. Some of these firms included Bear Stearns (March 2008), Freddie Mac and Fannie Mae (July 2008) and AIG (September 2008). The Lehman Brothers was allowed to fail on grounds that it was insolvent while at the same time it was not as important as the others. It was later stated that the Fed did not have legal authority to bail it out. The greatest problem experienced during the recent crisis was insolvency and not illiquidity as was the case in the 1930s depression. The difference between now and then is that the too big to fail doctrine developed in the 1980s meant that the monetary authorities had to bail out large financial firms that were insolvent but were deemed to be too connected to fail. This is a serious departure from the Bagehot’s Rule that calls for the provision of liquidity to banks that are illiquid but solvent.12 This issue became a major concern causing a lot of debate. It led to the passing of the Dodd Frank Wall Street Reform and Protection Act, in July 2010 which is still in its implementation stages to date. The Act seeks to establish a Financial Stability Oversight Council comprised of members from the treasury, the Federal Reserve Board, the securities and Exchange commission and other financial agencies in an attempt to address the too big to fail problem. The experience of the Great Depression was an important lesson on policy response by use of aggressive monetary policies. This was a great help in attenuating the impact of the financial crisis on the economy. The difference was the sources of systemic risk in that back then it was due to a contagious banking panic as opposed to an insolvency driven risk problem that was experienced recently. The authorities were slow in realizing that insolvency was the main problem. Once they realized it, the institutions that were deemed to be too big to fail were bailed out. In the 1930s, this doctrine was not applied in the U.S. During that time Bank of United States, which was among the largest banks in the US was left to fail after it became insolvent.13 Conclusion In order to understand the issues regarding both the Great depression of the 1930s and the economic recession of 2008 is developing theories that can account for the causes and drivers of these depressions. History has shown that periodically, capitalism undergoes a crisis that is systemic in nature. The institutional form of capitalism varies depending on the period. An economic system may be effective through running a social structure of accumulation or an institutional form of capitalism. These systems may for some time lead to high profits and economic growth but eventually, the contradictions associated with these forms of capitalism will undermine the continual of its operation and lead to a systemic crisis.14 The Great Depression was an economic crisis that rapidly developed with much more severe implications compared to than the crisis of regulated capitalism of the 1970s and other subsequent crises. This indicates that there is a possibility that an economic crisis due to liberal capitalism may in general tend to develop at a more rapid rate and be more severe than a crisis of resulting from regulated capitalism. The recent experience with the 2008 economic crisis is consistent with this proposition.15 The economic crisis of 2008 has provided lessons and comparisons in economic history. Most of these lessons are derived from the Great Depression. It is generally observed that historical lessons were influential in designing the policy responses applied in dealing with economic crises. The two depressions had obvious parallels such as the unusual sharp drop in prices of assets, a sharp drop in output, and the failure of financial institutions. This is usually followed by a general financial distress. The 2008 crisis, just like the 1930s crisis, was not confined to the United States only but affected global economies thereby becoming a global financial crisis. The decline in industrial production globally at the beginning of spring in 2008 is closely similar to the decline that followed the 1929 summer peak.16 This analogy legitimates certain responses with regard to the collapse of financial and economic activity in the United States while delegitimizing others. It legitimizes the notion that the federal government needs to have an aggressive response in crises so as to prevent the collapse of investment funds and avoid financial failures. This reflects the interpretation given by Friedman and Schwartz with regard to the Great Depression that the Great Depression was great because of inadequate response by the federal government. The economic crises have taught Americans how to be resilient during hard economic times. It is easy to see that history can repeat itself if the same mistakes are made over and over again. The lack of proper mechanisms to deal with the problems that arose during the Great Depression meant that Americans had to cope with the problems for a very long time. The same issue continues to happen since the economic crisis of 2008 began. Slow reaction and poor implementation strategies have meant that Americans still suffer the effects of the crisis to date. The American economy continues on a downward trend with an ever increasing foreign debt. It is clear that financial crises are bound to occur because economic systems are not perfect. The main issue of concern should be on how to deal with such a crisis when it occurs. Clear cut policies on how such a crisis should be handled need to be developed. This will save many Americans the pain and suffering they undergo during such crises. It would also be good to try and avoid situations that are likely to lead to an economic crisis as prevention will always be better than cure. It is very costly to deal with economic crises. The recent crisis has demonstrated this. The massive bailouts that are yet to fully bear fruit are evidence of this. In order to safeguard the welfare of American citizens, the government should be keen on solving the current problems in order to relieve the people of stress caused by such crisis. This is essential if the country is to fully recover from the economic downturn caused by the recession. Works Cited Bernanke, B.S. “Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression,” American Economic Review, 73, (1983): 257–76. Print. Bordo, Michael, and John Landon Lane (2010), “The Lessons from the Banking Panics in the United States in the 1930s for the Financial Crisis of 2007-2008”, NBER Working Paper No. 16365. Print. Bordo, Michael, and Joseph Haubrich (2011), “Deep Recessions, Fast Recoveries and Financial Crises: Evidence from the American Record”, Federal Reserve Bank of Cleveland (mimeo). Print. Cole, H.L. and Ohanian, L.E. ‘The Great Depression in the United States from a Neoclassical Perspective’, Federal Reserve Bank of Minneapolis Quarterly Review, 23 (1999): 2–24. Print. Chandler, Lester V. America’s Greatest Depression, 1929-1941. New York: Harper & Row Publishers. 1970. Print. Crotty, James. 2008. 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