Comparison between the Great Depression and the Great Recession - Coursework Example

Comparison between the Great Depression and the Great Recession In 2008, the world economy was faced by one of the most dangerous crisis since the Great Depression that took place in the 1930s. The great recession also occurred because banks created too much money through the creation of loans. This paper will make a comparison between the Great Depression in 1930s and the Great Recession in 2008. To make the comparison, the paper will discuss the major causes of the Great Depression and the Great Recession, how political economic leaders solved the two crises, what political economic leaders learned from the Great Depression crisis and the causes of the subprime crisis. Prime are the loans that are normally offered to borrowers who have good credit histories and those that carry lower interest and lo rates as compared to the subprime crises. Subprime are those loans that are normally offered to borrowers who have bankruptcies, late payment histories and defaults. The subprime mortgage crisis also known as "mortgage mess" came to the attention of the public when there was a steep rise in home foreclosures in 2006 which then spiraled seemingly out of control in 2007 and this triggered a national financial crisis that went round the year within a period of a year (Phillips, 2009). Before 2006, the US housing market was highly flourishing as a result of the facts that it was so easy to obtain a home loan. Individuals were taking subprime mortgages as they had expectations that the home price would continue rising and that they would be in a position to refinance their home before the higher interest rates. The peak of the subprime boom was in 2005 and at this time one out of every five mortgages was subprime. However, the housing prices and the housing bubble burst prices had reached their peak and were on the decline phase. Identification of housing bubbles is done after market correction and this took place in the US in 2006. Home prices were overvalued in 2007 and any necessary correction would last for years with trillions of dollars of home value being lost in the process. Bubble bursts that took place in between 2004 and 2006 as a result of the increase in interest rates were responsible for the subprime mortgage crisis (Laxer, 2009). The Federal Reserve Board had raised interest rates up to 17 times in a period of 2 years from 1% to 5.25%. It, however, stopped rising interest rates simply because of the fears that this could accelerate downturn in the housing market hence undermining the whole economy. Slumping sales and prices in the housing market as in August 2006 resulted to a free fall in the housing sector which then derailed the rest of economy resulting to the Great Recession of 2007. The housing bubble was one of the major causes of the subprime mortgage crisis in the market. The meltdown started with the bursting of the US housing ‘bubble that had started in 2001 and that reached its peak in 2005. A housing bubble is defined as the economic bubble that normally occurs in global and local real estate markets and normally occurs as a result of increased valuation in real estate property until unsustainable levels are reached in relation to affordability indicators and incomes. This results to a decrease in home prices and makes mortgage debts higher that the values of the properties. Many economists believe that historically low-interest rates were one of the causes of the US housing bubble (Phillips, 2009). The housing bubble was fundamentally endangered by the real long-term interest rates decline. There is a connection between higher home values, lower interest rates, and the increased liquidity brought about by higher home values. Mortgage rates are normally set in relation to 10 year Treasury bond yields which are in turn affected by federal funds rates. Prices of houses are highly influenced by interest rates the and the housing market in some countries happens to be a key channel in the transmission of monetary policy. The rise in subprime lending also led to the subprime mortgage crisis. Subprime borrowing resulted to the increase in home ownership rates as well as the demand for housing during the years of the bubble. There was an increase in the US ownership rate from 64% in 1994 to 69.2% in 2004. The increased demand fueled the rise of housing prices as well as consumer spending and also created unheard of increase in the values of the home of 124% between 1997 and 2006. Some of the homeowners took advantage of the property value increase to refinance their homes with very low-interest rates and took a out a second mortgage against the added value to use them for consumer spending. This led to a percentage rise of 130 percent of household debt as a percentage of income in 2007, 30% higher than the average amount noted earlier in the decade. The contagion of the Great Depression crisis began in 2007 when the sky-high home prices in the US finally turned decisively downward and spread very quickly to the whole of the US financial sector after which it spread to the overseas markets (Phillips, 2009). That is, the Great Recession quickly metamorphosed from the bursting of the housing bubble in the US to the worst recession ever witnessed in the world of a period of six decades. The housing bubble was the major cause of the subprime crisis as well as the broader economic crisis in 2007. The By the end of 2008, the economic crisis had worsened off leading to the crash in the stock markets around the globe, and this also made the stock markets quite vulnerable. The financial crisis happened because banks were quite unable to create too much money and in a quick way, and the banks used the crisis to push up the house prices and in speculation on financial markets. The global economic crisis that began in July 2007 with the crust crunch, when there was a loss of confidence by the US investors in the value given to sub-prime mortgages leading to the liquidity crisis. The collapse of the Lehman Brothers in September 2008 marked the start of a new phase in the global economic crisis. The collapse of Lehman Brothers made risk loving banks as well as investors all over the world to reverse all their perceptions. Due to the complexity that arises from mortgage-backed securities, banks and investors were quite unaware of the extent of the liabilities that are associated with the deterioration of the US housing sector. As a result, liquidity dried up faster to an extent of almost bringing up the global financial system into its knees (Phillips, 2009). That is, the rapid increase in the mortgage bonds securitization was not an ordinary housing bubble, and this exposed both domestic lenders as well as global investors to the stability of the US housing market. Government from all over the world highly struggled in rescuing the financial giant institutions as fallout from the stock and housing market collapse worsened. Many institutions continued facing serious financial liquidity issues. The increase in interest rates by the Federal Reserve resulted to the rise in the delinquency rate on home loans. The rise in the bad loans resulted into the failure of a significant number of US mortgage lenders. In 2007, the hedge funds were hit hard by the defaults as well as the subsequent unwinding of the sub-prime market. The US financial institutions started hoarding liquidity in the mid-2007 leading to a freezing of the market for asset-backed commercial paper. The credit crunch had started. This led to a further increase in the risk perceptions as well as a decrease in lending which then exacerbated the failure of the Lehman Brothers in September 2008, an event that almost imploded the financial system. The great recession also occurred because banks created too much money through the creation of loans. This resulted in a double of the total amount of debt and money in the economy within a period of 7 years. This money was used in pushing up house prices and in the speculation on the financial markets. Eventually, the debts ended up becoming unpayable. This is because lending of large amounts of money into the property market pushed up the prices of houses along with the level of personal debt and interest also increased making loans unpayable resulting to global economic crisis. The Great Depression was the period that was characterized by the unprecedented decline in economic activities and occurred between 1929 and 1939. The following are some of the major causes of Great Depression: The Great Depression was caused by underlying weaknesses that were prevalent as well as imbalances within the US economy that had been as a result of boom psychology as well as the speculative euphoria of the 1920s. The depression fully exposed all those weaknesses as well as the inability of the nation’s financial and political institutions to cope with the vicious downward economic cycle that was set in 1930. Before the Great Depression, different governments took little or no action during the times of business downturn and also relied on impersonal forces in the achivments of the required economic correction (Mian and Sufi, 2014). Howver, market forces proved that they cannot be achieved to acquire the desired recovery during the early years of economic Depression. Stock market crash of October 1929- During this period, few firms had posted quite disappointing results that caused a fall in share prices. The decline in prices turned into crash, and this is after the share prices fell. What followed was a panic that spread all through the stock exchange as people were unloading their shares. Confidence evaporated and then problems spread to the rest of the financial system. Share prices continued to fall even more in 1932 with the deepening of the depression. Fall in share prices resulted to a collapse in consumer wealth and confidence. Spending, therefore, fell, and the decline in the confidence led to the desire for savers to withdraw all the money they had saved in the banks. Political factors- The cataclysmic collapse of the world trade contributed to the length and severity of the great depression. The imposition of trade barriers on imports with high hopes of increasing the demand for domestically produced goods and to raise revenue from tariffs was a major cause of Great Depression. There was a plummation of 29% in the international trade in 1929. During this time, there were more logistics, communications as well as financial barriers that needed to be overcome. The loss trade was quite devastating and had ripple effects that are unlike bank failures. The increase in tariff rate and the decline in imports resulted to the loss of revenue as well as domestic unemployment. Under the political thinking, tax timing was implemented by pursuing a balanced budget. With the plummeting of tax revenue along with economic activities in the period, it was natural to raise taxes to cover up the mushrooming effect. This resulted to the rise in marginal income tax rates resulting to the decrease in aggregate demand for services and goods as well as the incentive to earn (Soros, 2009). Bank failures- the first 10 months of 1930 saw around 744 banks go bankrupt and savers were loosing their savings. As part of the banks desperate moves to raise money, the banks tried calling in their loans before the savers had time to repay them. With the banks going bankrupt, the demand for savers to withdraw their money from the banks increased. The authorities were not bake to stop the bank runs as well as the collapse in the confidence in the banking system. The failure of the banking system was one of the most powerful causes of economic depression. The Great Recession and Great Depression have similar economic phenomenon and only differ in few aspects. Each of the two periods is followed by the massive run-up of asset prices which are followed by a tremendous deflationary pressure that has since sent both equity and debt markets into turmoil. The Great Recession and the Great Depression have similar origins even though the policy response to the Great Recession was different from the response by Fed during the Great Depression. Unemployment rates were also high during the two periods with the unemployment rate being 25% during the Great Depression and 10% during the Great Recession. The two periods also consisted of huge waves of bankruptcies, defaults, and bank runs. The two periods were also characterized by halted credit liquidity which was quite massive. The political economic leaders in both the Great Depression and Great Recession solved the crisis in the following ways: During the Great Recession, Governments across the globe recognized the severity of the financial/economic crisis of the Great Recession as well as the urgency to intervene as a way of avoiding a catastrophic collapse of the real economy and the financial markets. Their responses included cutting down of interest rates to stimulate investment and borrowing and injections and bailouts of money into the financial system, to maintain the flow of credit. These measures were aimed at preventing further economic deterioration and to keep workers in their jobs as well as to help in the creation of new jobs to create employment opportunities for the people who were unemployed. This response by the political-economic leaders greatly helped in the aversion of the most severe downturn even though the effectiveness of the measures varied across countries. To solve the crisis of the Great Depression, the then President Herbert Hoover believed that the US government should monitor its economy and also encourage counter-cyclical spending to ease the downturn from the global crisis. President Roosevelt created a large-scale temporary jobs program as a way of solving the high rate of unemployment that was created by the Great Depression. President Franklin Roosevelt created the new deal in 1933 as a program of dealing with the financial illness that had led to economic paralysis of the nation. Through the deal, the president had directed the Secretary of the Treasury to draft an emergency banking bill. The new deal was aimed at doing away with laissez-faire capitalism and going back to the regulation and reform legislation. The new deal enabled the government to moderate its currency inflation enabling the country to move upward in terms of commodity prices. However, regardless of how comprehensive the new deal looked, it terribly failed in ending the depression. In 1939, unemployment rates were still as high as 19 percent, and it only reached pre-depression levels in 1943. The massive spending that was brought by the entry of the Americans to the Second World War resulted to the ultimate cure of the economic woes resulting from the Great Depression. The key lesson was that governments needed to run deficits to stimulate economies during periods of recession. Political, economic leaders learned a lot from the Great Depression crisis. Looking back at the recovery from the Great Depression crisis from a comprehensive perspective, one will find that despite all the returns to positive growth in late 2009, most of the advanced economies are still in a situation which is economically vulnerable and this is more so from the workers welfare standpoint. This clearly shows the fragile nature of the recovery process, which the political-economic leaders learned which were in their minds during the Great Recession crisis. State and Federal governments also subsequently reformed the financial system regulatory structure to prevent the occurrence of similar cataclysmic credit crunches. Those reforms that political-economic leaders had learned from the Great Depression formed the foundations of the countries financial system until 1980s and the 1990s, when the regulatory changes eased all the restrictions on the financial institutions behaviour in the hopes of increasing economic efficiency and the improvement of capital allocation. There are however some unheeded lessons from the Great Depression, which made world political-economic leaders to repeat the same mistakes during the Great Recession. Despite having gone through the Great Depression, political-economic leaders did not learn on how to heed warning signs of the occurrence of a crisis and this resulted to the worst effects of the banking crisis during the Great Recession. The fact that the Great Depression was successfully averted enabled the policy makers to declare that they were able to go back to the normal policies before it was the reality. For example, the political-economic leaders failed to consider the factors that led to Great Depression hence resulting to Great Recession (Cynamon, Fazzari and Setterfield, 2012). The Federal Reserve raised interest rates in 1929 after it had kept them low in the 1920s which then resulted to a boom. This choked off investments and halted entrepreneurship. The failure to heed the lesson from the Great Depression saw this rescue in the Obama government. This is because the seeds of the Great Recession were planted in the government as early as in the 1990s, but the political-economic leaders did not see it coming. The government started pushing for home ownership even to people who were uncreditworthy, and this made the mortgage loans toxic. The government also increased its federal spending similar to the period of Great Depression. Just like in the case of the Great Depression the political-economic leaders talked about balancing of a federal budget, but instead resorted into massive federal spending resulting to an economic crisis, a clear indication of unlearned lessons. In conclusion, there are similarities and differences between the Great Depression and the Great Recession. Each of the two periods is followed by the massive run-up of asset prices which are followed by a tremendous deflationary pressure that has since sent both equity and debt markets into turmoil. Both have similar origins even though their responses were different. The two periods are characterized by high unemployment rates as well as huge waves of bank runs, defaults and bankruptcies. References Arestis P and Karakitsos E, (2013). Financial Stability in the Aftermath of the Great Recession. Palgrave Macmillan Berberoglu B, (2014). 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