Similarities and differences in the causes of the current global economic crisis and the Great Depression

Can Keynesian economic analysis provide solutions in the current circumstances?


Essay, 2009
9 Pages, Grade: A

Excerpt

The global economy is currently facing a severe recession with falling output, rising unemployment and a high degree of uncertainty.[1] Parallels can be drawn between the causes of the current crisis and those of the Great Depression of the 1930s. The most salient causes of the Great Depression were a speculative bubble, the resulting stock market crash of 1929 and misguided policy reactions by central banks and governments. Tight monetary policy and a fallback to protectionism led to the collapse of the international economy. This further created business uncertainty, which together with financial disintermediation and bank runs resulted in shattered confidence levels and a subsequent, hardly stoppable, downward spiral of economic activity. Similarly, the current economic crisis began with a speculative asset bubble crash, followed by a shortage of credit supply and extremely low confidence levels and high uncertainty. However, due to an improvement in the understanding of macroeconomics policy makers' toolkits have been enhanced. This has led to appropriate reactions by fiscal authorities and central banks providing liquidity to markets. However, specific circumstances are unique and errors were made nonetheless. To spare the world from "The Great Depression II" Keynesian fiscal stimuli in form of tax cuts targeted at liquidity constrained agents are necessary. Monetary policy can only be effective to stimulate aggregate demand when confidence is reestablished and the lending mechanisms start working again.

Similarities and differences between the causes of the Great Depression and the current global economic crisis

Both the current global economic crisis and the Great Depression were prompted by the burst of asset market bubbles. The Great Depression's origin can be traced back to the burst of the stock market bubble while the current crisis resulted from the collapse of the housing market.

From 1922 to 1929 the world witnessed a period of extremely rapid growth; the American Economy grew by 5.5% on average per year and unemployment decreased to 3.5%. The prevalent conviction that growth would be uninterrupted and the belief that the "secret to continual prosperity was found"[2] set the scene for the start of the Great Depression. During 1928 and 1929 confidence about future earnings, general optimism and an abundance of savings from the preceding and ongoing period of prosperity led to a speculative rally[3] at Wall Street.[4] Investors were buying securities based on the expectation of a continuation of rising prices. This caused the Dow Jones to rise by 30% within ten months prior to September 1929.[5] This "great speculative orgy"[6] had to come to an end sooner or later. After the hysteria to participate and profit in the bull market it was realized that industrial production had stopped growing[7] in June 1929 due to fairly tight monetary policy. As a result confidence plummeted, panicking shareholders began selling culminating in the stock market crash on Black Tuesday, October the 24th 1929.[8]

The current economic downturn began with the burst of the housing market bubble. In order to stay profitable and as a response to deregulation and increased competition with lower margins, investment banks started designing and distributing complex and highly leveraged derivative securities.[9] Since the capital requirements on investment banks were lifted in 2004, their capital ratios were allowed to decrease from 1/12 to 1/33 within a year.[10] Due to the complexity of the derivative products and an incentive problem[11] on behalf of the rating agencies (the rating agencies were paid by the issuer of the security) many financial products suffered from so called "ratings inflation"[12]. Prior to 2007 mortgage rates were continuously declining and housing prices were rising. As a result residential construction was stimulated immensely[13]. The massive mispricing of risk (too many funds being provided for subprime borrowers) and the burst of the housing bubble ultimately led to the crisis.[14] House prices started falling, residential construction contracted and subprime loans defaulted at high rates. Consequently lenders and investors became insolvent, institutions ceased to trust each other and financial institutions either failed (e.g. Lehman Brothers) or had to be bailed out (e.g. Bear Stearns, AIG).

After the stock market crash of 1929, there was a major swing from high to low consumer and business confidence.[15] This lack of confidence and increased uncertainty led to a decline in consumption and investment behavior as well as four episodes of banking panic.[16] Misguided and tight monetary policy[17] by the Federal Reserve allowed the quantity of money to decline by unprecedented levels. Financial disintermediation reduced aggregate demand through liquidity

[...]


[1] The only positive aspect of the recession is that the slow-down in economic activity will cut growth rates of greenhouse gas emissions.

[2] Christopher Dow (1998), Major Recessions - Britain and the World, 1920-1995, Oxford University Press, New York, USA p. 162

[3] The behaviour of the individual in a speculative bubble would have been rational if it had not beenfor thefact that others are behaving in the same way. This is the so called Fallacy of Composition - the whole differs from the sum of its parts. Kindelberger (1978), Manias, Panics, and Crashes, Basic Books Inc, New York p. 34

[4] John Kenneth Galbraith (1954), The Great Crash 1929, The Riverside Press, Cambridge, UK p.174-175

[5] Christian Saint-Etienne (1984), The Great Depression 1929-1938: Lessonsfor the 1980s, Hoover Institution, Stanford University, USA p. 20

[6] Christian Saint-Etienne (1984), The Great Depression 1929-1938: Lessonsfor the 1980s, Hoover Institution, Stanford University, USA p. 174

[7] ibid p. 20

[8] Eugene White (1990), Crashes and Panics-The lessons from history, New York University, New York p. 144-145

[9] Barry Eichengreen (2008), Anatomy ofthefinancial crisis, from The First Global Financial Crisis of the 21st Century Part ll June-December 2008 p.215

[10] Susan Woodword (3.1.2009), Recent Financial Crisis, 2009 American Economic Association (AEA) Annual Meeting

[11] Alan Binder (3.1.2009), Recent Financial Crisis, 2009 American Economic Association (AEA) Annual Meeting

"With dumb incentives in place, markets produce poor results"

[12] Marco Pagano and Paolo Volpin (2008), Credit Rating Failures: Causes and Policy Options, from Macroeconomic Stability and Financial Regulation: Key Issues for the G20

[13] Susan Woodword (3.1.2009), Recent Financial Crisis, 2009 American Economic Association (AEA) Annual Meeting

[14] Marco Pagano and Paolo Volpin (2008), Credit Rating Failures: Causes and Policy Options, from Macroeconomic Stability and Financial Regulation: Key Issues for the G20

[15] Christopher Dow (1998), Major Recessions - Britain and the World, 1920-1995, Oxford University Press, New York p. 160

[16] final quarter of 1930, March to June 1931, August to December 1931, last quarter of 1932, culminating in the Bank Holiday ofMarch 1933 as laid out in Karl Brunner (1981), The Great Depression Revisited, Martinus Nijhoff Publishing, Boston, USA p. 7

[17] Commitment to the Gold Standard, as some argue, was part of the reasonfor tight monetary policy of the Fed. However, this can be regarded as just another feature of the Fed's incompetence. For whatever reasons the Fed pursued tight monetary policy, it was misguided and deepened the recession.

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Details

Title
Similarities and differences in the causes of the current global economic crisis and the Great Depression
Subtitle
Can Keynesian economic analysis provide solutions in the current circumstances?
College
University of Otago
Grade
A
Author
Year
2009
Pages
9
Catalog Number
V189030
ISBN (eBook)
9783656129035
ISBN (Book)
9783656130062
File size
422 KB
Language
English
Tags
what, great, depression, keynesian, financial
Quote paper
Frederik Schröder (Author), 2009, Similarities and differences in the causes of the current global economic crisis and the Great Depression, Munich, GRIN Verlag, https://www.grin.com/document/189030

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