The Great Depreciation of the 1930s and the Lessons from It - Essay Example

The Great depreciation of 1930s and the lessons from it Name Course Instruction’s Name 23rd April 2010 Executive Summary The financial and economies across the world fluctuates resulting in numerous consequences such as the great depression. Some of the sectors that were affected by great depression includes banking and agriculture, and its impact is commonly associated with banking polices and technological advancement. Great depression lasted for long period because of governments’ introduction of policies to support local productions. The financial causes of great depression include crash of stock market, easy credit policies, deflatory policies on gold standard, inequality in wealth and income increased debts and inflations, and forces of money. Some of the lessons learned include requirement of bigger fiscal expansion, increase supply of money can accelerate recovery, provision of stimulus, financial and real recoveries occur concurrently, and the need for global expansionary plan. Table of Contents Table of Contents 3 Introduction 4 Sectors most hit by the depression 4 Why the depression took longer period to quell 5 Financial causes of the depression 5 Lessons learned and used in recent global financial crisis 9 Conclusion 12 References 13 Introduction The great depression occurred prior to the World War II and it affected worldwide economies. The great depression lasted for almost ten years beginning in late 1920s and ending in the early 1940s. The origin of the great depression is said to be United States of America where the stock markets crashed in the late 1929 (Romer, 1994). The spread to other countries was very drastic. The effects of the depression were felt in both poor and rich countries. The depression had both economic and social effects. For instance, many people lost their jobs and United States of America recorded a high of 25% in unemployment (Christina, 2009). The prices of goods and services dropped, little revenue was collected by tax collectors and the overall individual income dropped. Construction and farming were greatly affected with huge drops in the prices of crops with some places recording a high of 60% reduction in prices. Recovery from the depression was seen from mid 1930s until the beginning of the World War II. Sectors most hit by the depression The agricultural and the banking sectors were the most affected. There was overproduction of crops, which resulted in the slumping of prices of the produce. This was due to new technologies and farming methods, which were used at the time (Romer, 1994). These were detrimental to countries, which could not add value on these produce, which in most cases was the major foreign exchange earner. As a consequence, the foreign reserves of most countries, which depended on primary produce for foreign exchange earner, dropped drastically and many became bankrupt. Latin America was one of the victims, which depended on primary produce as a means of foreign exchange (Calomiris, 1993). The banking sector experienced a crisis during this period. This was compounded by bad policies in place, which resulted in reduced cash supply and contracting economies. Some countries such as Germany had large debts from United States of America. During the depression, the debts were recalled by the US banks. This resulted in the collapse of the banking system in German (Snowden, 2009). Why the depression took longer period to quell Many governments imposed high tariffs on imports to balance the diminishing export market. Many economists argue that this drastically reduced the trade and enhanced the spread of the depression (Rothermund, 1981). Another action taken by the governments of the day was reduction of expenditure. This enhanced fall in the consumer demand and therefore reinforced the depression (Christina, 2009). The interest rates were too high for individuals or businesses to borrow. The withdrawal of US funds from Europe enhanced the spread of the depression through major collapse of the banking institutions (Eichengreen, 1996). Financial causes of the depression The main causes of the great depression are still contested among economist though it is widely agreed that the crash of the stock market was the cause of the depression (Romer, 1994). During the depression fall in prices of assets and commodities, decline in credit and demand and overall disruption of major trade was experienced. This resulted in impoverishment of many people due to the rise in the rate of unemployment. Theories, which try to outline causes of the depression, are classified as orthodox classical economics (Christina, 2009) and structural theories. The orthodox classical theories base their explanation on the money supply, decisions by central banking and the availability of gold. It is also explained in terms of dynamics of the population during that period. There are various theories, which are based on this school of thinking. Examples include economics theory, gold standard theory, monetarist theory and neoclassical theory (Calomiris, 1993). Structural theories on the other hand are based on the Keynesian principle (Calomiris, 1993). According to Austrian theory, the great depression occurred as a result of easy credit policies, which were in place in the 1920s (Bernanke, 1983). According to these policies, private banks received overnight credits, which had strict reserve conditions. The shortcoming of the policy was that the rates of the reserve and those of interest rates were decided centrally and their application were uniform across all banks (Snowden, 2009). Thus, banks that had poor policies in lending accessed credit easily. Thus according to this theory, the expanded money supply in the 1920s, which led to a boom that was driven by credit, was the key cause of the depression since this could not be sustained in the long run. This theory lays blame on the Federal Reserve as they failed in their work (Bernanke, 1983). The gold standard is based on the deflationary policies, which were enacted after World War I. After the war, the gold was valued at the value prior to the war and this resulted in deflation. This increased the initial shocks of the great depression (Romer, 1994). Many nations in the Europe stopped using gold standard after the war due to large costs of the war. This caused inflation due to increased currency in circulation. Thus, it is argued among economists that the gold standard system is responsible for the spread of the depression. Those countries that stopped using the gold standard system experienced reduced deflation and recovered quickly (Christina, 2009). Another theory that was put forward by Catchings W. and William T.F. argues that the inequality in the income and wealth among population was the cause of the great depression. They argue that there were a lot of produce than could be consumed (Romer, 1994). They stated that wages increase was too far lower than what was being produced. Thus, huge profits were realized but were channeled into stock market rather than being converted into purchasing power. This theory is of the idea that the reduced purchasing power was the cause of the depression (Rothermund, 1981). Another theory put forward by Irving F. attributes the occurrence of the depression to increased debts and deflation. He argues that poor credit policies in place during that period led to increased debts, which in turn resulted in the decline in the prices of assets (Christina, 2009). Defaults in the payment of the debts resulted in the collapse of banks and subsequent losses in the assets’ value. This led to slowed capital investment and decline in construction. Few banks, which were still surviving, increased their capital reserves and few loans were transacted. As a consequence, there was intensification in the deflationary pressures. Thus, the recession was transformed into a depression (Calomiris, 1993). Monetarist theory was put forward by Milton F. and Anna S. The theory is based on the importance of the forces of money. They argued that monetary policies were vital and that the Federal Reserves only put in place wrong monetary policies and as a result, the great depression occurred. They stated that the Federal Reserve failed to use correct policies that could have stopped the recession from transforming into the great depression (Christina, 2009). This theory was however rejected by some economists who viewed monetary factors as symptoms and not the causes of the depression (Rothermund, 1981). Nonetheless, this theory gained strength in the 1980s and was considered by some economists in the Japan’s financial crisis of the 1990s (Bernanke, 1983). Poor monetary policies are some of the probable causes of the recent financial crisis that have rocked many economies. Milton and Ann argued that if the Federal Reserve could have suspended the conversion of deposits into currency as was done in the 1907, then the depression could not have happened (Rothermund, 1981). They argued that such action could have prevented the banking panic of the 1930s (Calomiris, 1993). Thus from monetary point of view the decline in the supply of money was the cause of the great depression of the 1930s. They argued that restriction in the supply of money resulted in the decline in the employment, income and in the prices of commodities (Romer, 1994). Milton and Ann stated that during the depression people held back money by spending less and this led to reduced employment, which in turn caused decline in the production due to inflexible prices. Thus the Federal Reserve failed by not detecting the problems and acting accordingly. According to Keynesian concept, a decline in interest rates is not an automatic boost for the investments to increase (Bernanke, 1983). According to economists who adopt this theory, many investments are profit driven and hence long-term decline in demand is an indicator of lower sales in the future. Thus, few investors will be motivated to invest just because the interest rates have fallen. Thus, an economy can enter into a depression in such cases as argued by Keynesians. According to Keynesian economists, this is what happened during the great depression. The bankruptcy, which rocked many economies, was a deterrent to investment by investors who used to analyze trends in the future demands. Some economists attribute the weaknesses in the banking system as one of the causes of the depression. Farmers who had mortgaged their land could not keep up with the increasing rates of interests charged by the banks as their produce fetched low prices. Thus, most farmers defaulted paying their loans (Christina, 2009). As a consequence, many small banks that were agricultural based collapsed. Other banks failed to maintain enough reserves, invested in stock markets, and offered loans, which were too risky. Thus, the Wall Street Crash depleted these banks’ investments. This crash is said to be the cause of the depression since it dimmed future investments and expectations. Another school of thought attributes the breakdown in the international trade as one of the causes of the depression. According to this theory, many European countries owed United States of America’s banks large debts at the end of the World War I (Hollingsworth & Tyyska, 1988). The debtors wanted to be forgiven the debts in the 1920s, which the US government did not honor but instead its banks loaned more money to European nations (Rothermund, 1981). High tariffs charged on imports by US, weakened economy made the Europe countries to be unable to sell their goods, and hence they defaulted in the payment of their debts as their economies crumbled. Some economists view protectionism by countries as a contributing factor to depression. Protectionism was used to change monetary policies, which were constrained by the gold standard (Romer, 1994). Countries were unable to float exchange rates due to the gold standards since they feared running out of gold. Lessons learned and used in recent global financial crisis Even though the recent recession was severe, it was not as bad as the 1930s depression where up to 25% of Americans lost their jobs as compared to recent recession where a high of 8.1% was recorded (Christina, 2009). In addition, the decline in GDP experienced in 1930s was about 25% in comparison to recent drop of about 2%. Just like the 1930s depression, the recent downturn had some origin in the collapse of asset prices as well as the collapse of financial institutions (Christina, 2009). The decline in the asset and stock market prices resulted in increased savings while in the 1930s the decline in the wealth resulted in bankruptcies. One of the greatest lessons from the 1930s depression is that to avert a financial depression or to recover from it requires bigger fiscal expansion (Christina, 2009). In the 1930s, the fiscal policy failed mainly due to small emergency spending commissioned by Roosevelt’s administration. This caused the deficit to rise for up to 1.5% of the GDP in the mid 1930s and had very minimal effect on the economy. This lesson was taken up by Obama’s administration in handling the recent recession. This was through the passage of the American Recovery and Reinvestment Act (Christina, 2009). This was intended to increase the fiscal expenditure. It allowed about $800 billions to be injected into the economy as a stimulus for growth through tax cuts and increased investment. This was also intended to be used for aiding those most hurt by the recession. This stimulus was intended to reduce decline in employment and job losses (Snowden, 2009). Another major lesson from the 1930s recession is that increase in the supply of money can accelerate recovery from a recession or depression even if the interest rates fall (Christina, 2009). During depression, fixed exchange rates were used mainly due to use of the gold standard. There was increased supply of money in the early 1930s and since the interest rates were too low they could not be lowered by this but instead it broke the deflation. This changed the investing and borrowing costs (Christina, 2009) which were advantageous to the behavior of firms and consumers. This resulted in increased spending especially on long term assets with less expenditure on services due to fixed interest rates. Thus monetary policy can prevent expectation of deflation and encourage expenditure even if the interest rates are too low (Hollingsworth & Tyyska, 1988). The third lesson from the great depression is that provision of the stimulus need not be withdrawn within a short period of time. During mid 1930s both fiscal and monetary policy turned contradictory (Christina, 2009) and this resulted in an increase in GDP deficit by about 2.5%. This also led to banks increasing their reserves, which resulted in increased lending rates. Thus, this had adverse effect on the economy with the rate of unemployment hitting a high of 19% by the end of 1930s (Rothermund, 1981). Therefore the reversal of the monetary and fiscal policies in the mid 1930s delayed the recovery from the depression and thus policy makers need to know that the stimulus should at least last longer for economy to recover fully from a recession or depression. Another lesson from the depression is that financial and real recoveries occur hand in hand (Christina, 2009). During the 1930s financial recovery that was put into effect by Roosevelt’s administration was short lived even though it stabilized the economy (Hollingsworth & Tyyska, 1988). The financial recovery was witnessed only after the real recovery occurred. Thus when the real economy is strengthened, the financial systems become stable. This is a lesson that has been put into practice by the current administration through the Financial Stabilization Plan. This is aimed at increasing lending and evaluation of the capital required by the financial organizations (Rothermund, 1981). In addition to the lessons above, the need for global expansionary policy is another lesson from the great depression (Christina, 2009). This allows sharing of the disadvantages of the depression and advantages of the recovery. It is widely agreed among economists that the increase in the supply of money in the US in the 1930s helped in the recovery of many economies worldwide. This is because increase in the money supply helps interest rates to drop and be beneficial to many countries. Thus, in the recent recession it was argued among economists that increasing money supply and fiscal expansion would be beneficial worldwide (Christina, 2009). This was put into effect by china, which expanded its fiscal policy while the European countries reduced their interest rates. This action was expected to pave way for the end of the recession. Conclusion The great depression was worthy learning from. Many people lost their wealth and employment as many were impoverished. From the discussion above, many lessons learned from the depression have been very instrumental in averting the effects and the spread of the recent recession in addition to shortening the time that it occurred. The fiscal policy and the monetary policy as seen from the discussion have been very vital in addressing the spread and effects of the recession. References Bernanke, B. 1983. Nonmonetary effects of the financial crisis in the propagation of the great depression. The American Economic Review, 73(3), pp. 257-275. Calomiris, C. 1993. Financial factors in the great depression. Journal of Economic Perspectives, 7(2), pp. 61-85. Christina, D.R. 2009. Lessons from the Great Depression for Economic Recovery in 2009. Washington: Brookings Institution. Eichengreen, B. 1996. Golden Fetters: The Gold Standard and the Great Depression, 1919-1939. New York: Oxford University Press Hollingsworth, L. & Tyyska, V. 1988. The hidden producers: women’s household production during the great depress. Critical Sociology, 15, pp. 3-27. Romer, P. 1994. The origins of endogenous growth. Journal of Economic Perspectives, 8(2), pp. 3-22. Rothermund, D. 1981. The great depression and British financial policy in India, 129-34. Indian Economic Social History Review, 18, pp. 1-17. Snowden, N. 2009. Depression economics before he General Theory: the order in Cole’s Chaos. Oxford Economy Paper, 61, pp. 425-439. Read More