An Analysis of the Causes of the Great Depression and the Great Recession

Categories: The Great Depression

The Great Depression and Great Recession were events that caused economic turmoil in the United States. With that said, the magnitude and severity of each event is something that is up for debate and often time politicized. Fed Chairman, Ben Bernanke said, “September and October of 2008 was the worst financial crisis in global history, including the Great Depression.” However, not everyone agrees with that sentiment. Regardless of which economic crisis was worse, they both put millions out of work and led to a decline in economic growth.

We think the focus should be placed not on the severity of each event, but the root causes. Identifying the causes of each economic disaster, can allow us to learn from these mistakes and avoid this type of event from happening again. By comparing and contrasting these two events, we can get an understanding of the root causes and identify a solution to prevent this.

In this paper, we have identified two root causes of each event and have identified comparative policy lessons for each event.

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Through extensive research, we have concluded that the two main explanations for the Great Depression are the monetarist approach and Bernanke’s debt deflation approach. The Great Recession theories we have decided on our monetarist approach and a Keynesian approach. From a stand point of comparative policy, we learned that focusing on asset pricing, done during the Great Depression should be avoided. Additionally it was concluded that the Fed not being a lender of last resort had serious implications for the Great Recession.

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This report will proceed as follows. The next section will give an insight into the severity of each event with descriptive statistics. This will be followed with the two causes of the Great Depression, followed by the Great Recession. A section touching on comparative lessons will follow. Lastly a concluding section will wrap up the report.

Statistical Comparison of the Great Recession and Depression

The Great Recession and Great Depression are two examples of major economic crises in the United States. The Great Depression spanning from 1929-1933 and the Great Recession ranging from 2007-2009 were periods of huge economic downturns. Both periods were very challenging for citizens of the United Sates, but the depth of these two events varied greatly. This section will be dedicated to a brief overview of different statistics regarding the two events. Below is a table of a few macro statistics for the great recession and depression. The first statistic is the length of each event in months. The Great Depression lasted more than double the time of the Great Recession, with 43 and 20 months respectively. The three other stats are economic indicators for the robustness of the economy. The statistics show that the Great Depression led to harder time. Real GDP declined in the Great Depression by 36.21%, which is over 10 times as much as the 3.66% GDP decrease seen in the Great Recession. Also, the maximum unemployment is nearly 16% higher during the depression. Lastly and perhaps most intriguing, the CPI’s varied greatly. CPI decreased by 27.17% in the Great Depression and CPI increased by 2.76% during the Great Recession.

The Data table above shows three more in depth statistics of the two events. Bank failures in the Great Depression totaled nearly 9100. This is approximately 50% of the banks. The Great Recession only saw 57 banks fail or less than 1%. The Great Recession numbers are biased downward because of the bailout packages. There was also a huge disparity in the Fed’s increase in money supply. Lastly the Great Depression saw a bigger stock market decline when compared to Great Recession, which fell by 89 and 54% respectively. The data indicates that these were two different events, which led too different impacts on the economy.

Theoretical Explanations of the Great Depression

There are a huge number of popular theories that attempt to explain the Great Depression. Of these, the two that will be examined in more detail below are the monetarist explanation and Ben Bernanke’s debt-deflation theory, which is partially based on the work of Irving Fisher. According to monetarist theory, the Great Depression was ultimately the result of inaction by the Federal Reserve. Before and during the 1930’s, the Fed had been pursuing monetary sales on the open market, in order to reduce the money supply and stem speculation which had been occurring throughout the late 20’s. The Fed pursued this strategy in part because of the adoption of “real bills doctrine”, which required all money in the United States be backed in real goods. This policy had been enacted in 1928, after the death of the Fed chairman Benjamin Strong.

After the stock market crash of 1929, decreased consumer confidence and a failure of many banks to meet their obligations led to a run on the banks. This bank failure was exacerbated by the restricted money supply, and the Fed did not change its monetary policy in the early 30’s. As a result of this, over a third of banks in the United States closed from 1929-1933. This led to reduced consumer confidence, lowered consumption and lowered investment, all of which contributed to the reductions in GDP during the time period. The monetarist perspective on the depression was initially proposed by Milton Friedman and Anna Schwarz. They argued that while the Federal Reserve could not have necessarily prevented an economic downturn from taking place, it was the failure of the Fed to conduct significant open market purchases and reflate the economy which resulted in the Great Depression.

Additional evidence from this theory comes from Ben Bernanke’s gold standard international comparisons. Bernanke found that when making international comparisons from the time period, countries which left the gold standard and regained autonomy over their money supplies were able to reflate their economies more quickly and experienced faster recoveries. Ultimately, there is good reason to believe the monetarist version of events which caused the Great Depression. In many ways, one could call Ben Bernanke a monetarist, and his theories on the depression certainly find their roots in the work of Friedman and Schwarz. However, there is one major piece of the puzzle which Bernanke adds, his debt deflation theory. According to Bernanke, a large reason the Great Depression took place is debt deflation which occurred during the time period.

How did this occur? Bernanke asserts that after the stock market crash and the run on the banks which followed, debtors found that deflation in the economy meant their real burdens became increasingly costly. Some economists believe this wouldn’t be a problem, since typically such an issue is a “harmless” transfer from debtor to creditor, and the economy remains balanced overall. However, Bernanke argued that this was not the case, and that the increasing burden on debtors led to a much more severe economic downturn.

Bernanke’s first argument in support of this deals with asymmetric information. As he put it: “to the extent that potential borrowers have unique or lower—cost access to particular investment projects or spending opportunities, the loss of borrower net worth effectively cuts off these opportunities from the economy.” In other words, people and businesses frequently take out loans in order to take advantage of asymmetric information. However, when their real rate of interest significantly increases due to a contracted money supply (as explained in the monetarist approach), they are no longer able to make the investments they initially planned. As a result, the benefits of asymmetric information go unmet. This set of conditions partially contributed to the severity of the Depression, in Bernanke’s view. However, it is not just the borrowers that suffer the effects of debt deflation, according to Bernanke. In fact, creditors can be affected as well, and the likelihood of this increases as the economy worsens.

As debtors were continually unable to pay off their increased real burdens, creditors were often forced to take back their loans in the form of asset collateral. This is not ideal for banks, since these collected assets have little liquidity. Furthermore, since the economy is already in a downturn, these assets become worth significantly less, and the creditor often still takes a loss. This results in an environment with few if any willing lenders, which leads to what Bernanke called a “credit crunch”, where credit becomes extremely difficult to attain regardless of the interest rates at hand. The contracting money supply had made nominal interest rates irrelevant, increasing the real rates for debtors heavily. While there are enough Great Depression theories to fill several books, the combination of Friedman’s monetarist approach with Ben Bernanke’s debt-deflation addition appear to provide at least some degree of explanation for the crisis. Next, we will turn to the Great Recession of the twenty-first century and examine potential causes therein.

Theoretical Explanations of the Great Recession

The Great Recession that began near the end of 2007 and lasted until 2009 was a complex event with many theories behind its origin. It is difficult to pinpoint one particular cause, so the commonly accepted belief is that many intertwined factors are to blame. Many analysts point to the housing bubble, its conception and eventual burst, which is thought to signal the beginning of the recession. Bubbles are not particularly uncommon, so what sets this one apart? Unlike others, many denied the existence of this bubble from the beginning, including instrumental policymakers and the chairmen of the Federal Reserve. Many believe there were numerous signs of a bubble, but there are three objections to this. Namely, that it’s not possible to foresee a bubble until it breaks, that the Fed lacks the tools to deflate a bubble without doing more harm, and that it’s costlier to prevent a bubble than it is to deal with the after math of one.

The causes of the housing bubble are not certain, but theories include loose monetary policy, the failure of financial markets, and the global imbalance thesis. In “Interpreting the Causes of the Great Recession of 2008,” Joseph Stiglitz places the central blame on the failure of the financial markets. He attributes this failure to factors such as poor regulation by the government and short-sighted, profit-seeking incentives within the industry. Many market fundamentalists believed that there was no need for regulation in the financial market, suggesting that they function well when self-regulated. Stiglitz, however, argued that regulation was needed to prevent the actions of one party’s decision from effecting the wellbeing of others. Even if one party assesses their own risk accurately, the ramifications for a system as a whole are not typically considered.

Regulation would keep the wellbeing of the entire system in mind. He also argued that regulation would provide protection to investors from things such as predatory lending. According to Stiglitz, there is a long history of failure in the financial market which the government has been negligent in addressing. The incentives that Stiglitz also credits for the financial market failure are referred to as “faulty” and “perverse.” He argued that within the financial industry, there is an incentive structure that focuses on making profits in the short term. These incentives led to the standard of lending falling and individuals who normally wouldn’t have been seen as a good investment were being considered for the sake of greed and profit. This predatory lending failed to accurately assess risk, so in combination with low standards there was a growth in sub-prime loans.

When poor regulation of the financial industry is combined with the incentives for short-run profits, poor lending practices run rampant. The growth of the housing bubble is directly linked to these poor practices. Opponents to the theory of the financial market failing often draw attention to what they believe are government program failures, such as the CRA. The Community Reinvestment Act was and effort by the government to encourage more lending to minorities and communities that were not credit worthy. Stiglitz argues that the blame can’t be shifted to acts such as the CRA because the magnitude of lending is too small. He also points out that default rates are typically lower under CRA lending. Another widely accepted theory that Stiglitz draws attention to is loose monetary policy. This theory brings consideration to what was occurring in the time period leading up to the recession. After the issues with the bursting of the “dot.com” bubble the U.S. was left with the possibility of a recession in 2001.

Policy makers responded by “aggressively” reducing the policy interest rate. In “The Great Recession of 2008-2009: Causes, Consequences and Policy Responses,” Verick and Islam argue that this lowered interest rate was successful in ensuring that the 2001 recession was insignificant in magnitude and short in length. While successful in preventing a devastating recession in 2001, the policy interest rates effectively set the tone for the 2007-2009 crisis. Verick and Islam go as far as to suggest that these monetary policies in the U.S. failed to deal with the growing bubble in the housing market and contributed to the rapid growth in sub-prime mortgage lending.

The two theories discussed both lead back to the reasons that housing bubble grew so significantly. Stiglitz suggests that anytime time a bubble bursts it reeks “havoc” on the economy. This assumption is no different in the bursting of the housing bubble and the resulting great recession. When interest rates started to rise again in 2006, the consequences of the poor lending practices became evident. Many people were unable to pay the higher interest rates and delinquencies grew at an exponential rate. As a result, many lenders began to fail. With the failure of the mortgage lenders, the amount of investment spending would decrease. This decrease in investment spending would lead to a decrease in GDP. We have now examined theoretical explanations of both the Great Recession and Great Depression. Both of these crises had major impacts on the United States economy and people who comprise it. For this reason, it is worthwhile to spend some time comparing policy lessons learned from each event.

Depression and Recession: Comparative Policy Lessons

Given the parallels between the causes and impact of the two crises, there are similar lessons to be learned from each event. Stephen Cecchetti in, Understanding the Great Depression: Lessons for Current Policy, argues that “the Federal Reserve played a key role in nearly every policy failure” during the Great Depression. He states that some of the most important changes in the aftermath were the centralization of the Federal Reserve, deposit insurance and stronger bank regulation, the separation of commercial and investment banking, and unemployment insurance and social security. Cecchetti draws two important lessons from the Depression. The first is that central bankers cannot let changes in asset prices distract them from focusing on output and inflation. According to the author, the Federal Reserve was concerned that stock prices were becoming too high.

The Fed raised interest rates dramatically in an attempt to stem the rise in asset prices. He states that the Federal Reserve’s focus on the level of equity prices resulted in “a disastrously contractionary path for policy.” The second lesson is that the Federal Reserve must act as a lender of last resort by supplying reserves to banks when asset prices plummet, as they did in 1929. The Fed failed to do this, causing thousands of banks to fail through lack of liquidity. Similarly, the Fed has been criticized heavily for allowing the investment bank Lehman Brothers to fail during the Great Recession, due to an insufficient amount of collateral required to secure a large enough loan to keep the bank alive. Another frequently cited article is From Great Depression to Great Credit Crisis: Similarities, Differences and Lessons, by Almunia, Benetrix, Eichengreen, O’Rourke, and Rua, it is pointed out that aggressive rate changes were enacted shortly after the onset of both crises. In late 2008, the Bank of England and the Federal Reserve both cut rates significantly.

However, in the early 1930s, several countries raised interest rates in an attempt to defend their currencies. The authors also point out differences in fiscal policy, noting that the government in 1929 had no choice but to run a deficit due to the collapse of revenue. By 2008 however, there was a much greater willingness to run a deficit, likely to decrease taxes and stimulate consumption Even in the early months of the Great Recession, there were several similarities to the Depression. In Lessons from the Great Depression for Economic Recovery in 2009, the author, Christina D. Romer, uses examples of policy responses to the Great Depression and argues their effectiveness for the Recession that had recently began at the time of writing. One of the key lessons she takes from the 1920s is the effectiveness of monetary expansion, even with interest rates near zero. David Wheelock, in Lessons Learned? Comparing the Federal Reserve’s Responses to the Crises of 1929-1933 and 2007-2009 states that monetary and fiscal policies are widely credited for limiting the impact of the financial crisis on the overall economy.

Unlike the Depression, aggressive policies were enacted to insulate the global economy from the effects of the Recession. After the stock market crash of October 1929, the Fed quickly lowered its discount rate and began lending heavily to banks. However, from 1930-1933, the Fed largely ignored banking panics, and did little to prevent deflation. Conversely, in September 2008, the Fed made several large purchases of U.S. Treasury and agency debt, causing the monetary base to more than double and significantly reducing the risk of deflation.

Conclusion

The purpose of this paper was to provide a new look at the Great Depression and Great Recession, through a comparative analysis of the two events. First, some statistical background information was provided on the two events. Following this was our analysis of the Great Depression, which examined the event through the lens of the monetarist and Ben Bernanke’s more recent theories. The Great Recession was also explained, with a monetarist and Keynesian approach being taken primarily. Finally, we examined some comparative policy lessons from each event, and attempted to compare and contrast the two. It would be impossible to write any exhaustive report on two of the most important financial crises in American history, but hopefully this survey has provided some clarity.

Works Cited

  1. Almunia, Miguel, Agustín Bénétrix, Barry Eichengreen, Kevin O’rourke, and Gisela Rua. “From Great Depression to Great Credit Crisis: Similarities, Differences and Lessons.” (2009). Web.
  2. Bernanke, Ben. Essays on the Great Depression. [electronic Resource]. N.p.: Princeton, NJ: Princeton UP, C2000., 2000. Ebrary Leased.Cat00024a. Web.
  3. Cecchetti, Stephen. “Understanding the Great Depression: Lessons for Current Policy.” (1997). Web.
  4. Christiano, Lawrence, Roberto Motto, and Massimo Rostagno. “The Great Depression and the Friedman-Schwartz Hypothesis.” Journal of Money, Credit & Banking (Ohio State University Press) 35.6 (2003): 1119-197. Business Source Complete. Web. Mar. 2016.
  5. Fridman, Gerald. “Bad History Makes Bad Policy: Friedman, Schwartz, and Bernanke on Great Depressions.” Dollars & Sense 283 (2009): 9-10. Alternative Press Index. Web. Mar. 2016.
  6. Fridman, Gerald. “Bad History Makes Bad Policy: Friedman, Schwartz, and Bernanke on Great Depressions.” Dollars & Sense 283 (2009): 9-10. Alternative Press Index. Web. 31 Mar. 2016.
  7. Romer, Christina D., Lessons from the Great Depression for Economic Recovery in 2009 (December 1, 2009). Wheelock, David C. “Lessons Learned? Comparing the Federal Reserve’s Responses to the Crises of 1929-1933 and 2007-2009.” ICPSR Data Holdings. Web.

Cite this page

An Analysis of the Causes of the Great Depression and the Great Recession. (2021, Sep 28). Retrieved from https://studymoose.com/an-analysis-of-the-causes-of-the-great-depression-and-the-great-recession-essay

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