The Great Depression Essay Example for Free

The big(p) Depression EssayA macroscopical amount of literary productions including research and text books, exist on the subject of the Great Depression. It is considered by many economists as the worst economic crisis in the Statesn History. Statistics suggest that from the condescension cycle peak in 1929 to the trough in 1933, the received Gross Domestic Product (GDP) contracted by 39%. From 1929 to 1933, the unemployment rate rose from 3. 2% to 25% any may who had jobs were only able to work part-time. By 1933, 50% of American banks had failed. From 1929 to 1933, the consumer price business leader (CPI) fell by -25%. The Dow Jones industrial just fell -89. 2% among September 1929 and March 1933. Net enthronement was electronegative from 1931 to 1935 and the economy experienced a sharp decline in sum total real income, then there were massive defaults and bankruptcies by business and households (Bernanke. S, 2004, White, 2009). But what ca employ the great low g ear? Or rather, why did the street corner of 1929 turn into a depression? Calomiris (1983) remarks there is still very little consensus amongst economist on this question.Before Maynard Keynes (1936) General Theory of Employment, Interest and Money, economist relied on the Classical approach some(prenominal) to manage and beg off the Great Depression. However, the classical theory could non explain a lot of the data at the time for instance, it could not explain the lengthy unemployment (Keynes, 1936). This signified the acquire for a new theory of macroeconomics. Such a theory was provided by Keynes. The essence of Keynes theory is contained in the simple aggregate hold model.Keynes identified the collapse of the return in the 1920s as part of the problem. In his opinion, the collapse of growth led to a diminution in investment opportunities and a d professward shift in investment demand. The unprecedented levels of unemployment could in any case be explained by the colla pse of aggregate consumption. Keynes along with Irvin Fischer (1933) also identified the pecuniary markets as important sources and propagators of economic decline during the Great Depression (Calomoris, 1983).However, the exact nature of this connection is still a hot topic of debate, and this is where much of the literature on the great depression can be found. correspond to Keynes theory of aggregate demand, monetary policy had no causal role in the Great Depression (Mishkin, 2007). Mishkin (2007 p 588) argues that this assumption was based on three pieces of evidence. He states that during the Great Depression pertain rate on U. S treasury securities were extremely low (Below 1%).To the proto(prenominal) Keynesians, the low nominal interest rate meant that the monetary policy was easy expansionary (Hamilton, 1987). The second assumption was under(a)pinned by the lack of experiential evidence on the co-movement between nominal interest rates and investments spending. Whi le the third assumption was based on the fact that surveys by macroeconomists carried on business community indicated that their decision to invest was not influenced by market interest rates (Mishkin, 2007).In 1963, Friedman and Schwartz published the Monetary History of the United States in which they outlined a theory implicating silver supply as the major cause of the Great Depression. In their opinion, what transformed the recession of 1929 into a depression were the imprudent policies by the federal official conquer, which led to the stock market crash and to the kinks of banking failures which reduced the money multiplier and the money stock (Bernanke, 1983a Friedman and Swartz, 1963).The figure 1 below shows the close correlational statistics between GDP and the money stock. Friedman and Swartz countered the Keynesians argument that interest rates on U. S. treasury securities and high grade corporate bonds were low was countered by the observation that interest rates on lower grade bonds rose radically during the peak of contraction (between 1930-1933) this indicated that monetary policy was tight (Mishkin, 2007).The second reason why the Keynesian assumptions were regarded as misleading on the question of the tightness of the monetary policy during the depression was that in a period of deflation the important interest-rate transmission mechanism is through the real interest rate and not the nominal interest rate, hence low nominal interest rates do not necessarily mean that constitute of borrowing is low and that monetary policy is easy since public expectation of a reduction in price levels can increase real interest rates (Hiuzinga, 1986 Summers, 1984).A good example of how the real-nominal interest rate relationship affected the U. S. economy during the Great Depression was seen in the housing celestial sphere. Wheelock reports that even though the nominal value of mortgage dept peaked in 1930, deflation caused a raise in the real value o f big mortgage dept up to 1832. Thus the outstanding mortgage dept burden increased sharply during the contraction phase of the depression (Wheelock, 2008). Researchers also criticized the use of Structural Model evidence by Keynesians.Mishkin (2007) argues that the quality of this face of evidence is dictated by the goodness of the model used. Friedman and Swartz narrative on the Great depression was that the original trigger of the Great Depression was the, 1928, Federal Reserve attempt to contain inflated sh atomic number 18 prices at Wall Street which they attributed to speculative activity. To accomplish this, they raised the policy interest rate. This depressed interest-sensitive spending in atomic number 18as such as construction and Motor industry.This in turn induced a drop in production and investments, which led to reduced hiring of workers by companies. The fasten of the monetary policy through the recession which begun in August 1929 precipitated the October 1929, s tock market crash (Hamilton, 1987, Bernanke, 2002b). The stock market crash eroded the nations accumulated savings, leading to a reduction in aggregate demand. From 1930, the contracting economy triggered successive waves of widespread banking panics (Calomiris etal, 2003 Hamilton, 1987 Chandler, 1970).Bank failures and hoarding of cash increased some(prenominal) the currency deposit ratio and the reserve deposit hence a decline in money stock this added to the deflationary pressures (Bernanke, 2007b White, 1984). They asserted that failure by the Fed to reverse the decline in money stock with open market proceedings and loans to banks through discount windows added further pressure to the economy (Friedman, 1963). According to them, the 1937 -1938 recession was triggered by the Feds attempt to stimulate lending by doubling of the required reserve ratio, this had the opposite effect.Mishkin (2007) writes that the importance of this theory to more or less economists is that it opened a whole new connection between the fiscal sector and the macroeconomy. Another important contribution was that it suggested new research agenda Calomiris (1993) summarized them thus 1) Can the reduction in money stocks from 1930 to 1933 explain the bank failures or did they restrain a separate origin? 2) Was the demand for money stable tending(p) the low nominal short term interests rates in the 1930s or was there a liquidness trap 3) Could nominal price and employ rigidity offer an fit explanation for the persistent stagnation during the 1930s?4) Were policy failures by the Fed actions acts of omission or commission or did they comprise the practical application of the old classical theories to new circumstances? 5) Were open market operations by the Fed, unaccompanied by reforms in the monetary and bank regulations, satisfactory in reversing the 1930-1933 stagnation? Following the publication of the Monetary History, economist focused either on confirming Friedman and Swartz assertions or in researching the implications of their findings. For two decades, the focus was in the main on the first three questions.Unfortunately, economists restricted there inquiries within the framework of the sticky-price, IS-LM paradigm. This approach severely limited the search for alternative transmission mechanisms between financial markets and the macroeconomy (Bernanke, 1983). Support for the Monetarist theory has come from formal statistical tests which examined the correlations between money and aggregate spending (Mishkin, 2007) a number of researchers found that there was no liquidity trap during the 30s therefore, money supply shocks could have had an important effect on aggregate output (Meltzer, 1963 Temin, 1989).Field argued that the pre-depression stock market miraculous food increased money demand and that this was not offset by corresponding increase in money supply. This resulted in increases in the interest rates and in deflation (Field, 19 84). Evidence corroborating Friedman-Swartz illiquidity possibleness as the trigger of the bank failures came from data on bank suspensions aggregated at topic or regional level, this data show a correlation between bank failures and turning points in indices of industrial production, the money supply, the money multiplier, interest rate, and deflation rate (Friedman, 1963 Wicker, 1980).According to White (1984, p 138), the first bank failures in the 1930 were not unique rather, it was a continuation of the banking failures of the 1920s. Recently studies by Calomiris and Joseph (2003) have revealed a strong correlations between the characteristics of banks, the economic environment in which they operated and their chances of survival. The thesis that banks failures were not panic induced, but were a continuation of the bank failures of the 1920s, which were linked to bank overbuilding suggested a lesser role of bank failures as a transmission mechanism. new(prenominal) critics adv ocated additional exogenous expenditure shocks to explain the cause of the depression noting that the real money stock had not contracted during the early stages of the depression (Temin,1976 Bernanke,1983 ). At the resembling time, some scholars argued that the reduction in money stocks during the initial stages of the depression was not large enough to trigger the depression (Meltzer, 2003) In short, economists realized that money shocks entirely could not have transformed the recession into a depression.Thus, additional link were needed between the financial markets and the macroeconomy. Bernanke captured it this way in his 1983 research paper whiz problem is that there is no theory of monetary effect per se on the real economy that can explain prolong non neutrality. Another is that the reduction of money supply in the period seems quantitatively insufficient to explain the subsequent fall in output (Bernanke, 1983, p257) The new paradigm shift came with the application of theoretical models of credit allocation under asymmetric information in imperfect markets to the Great Depression.Mishkin was the first to apply this model in his study of the furbish up of changes in household balance sheet and consumer spending during the Great Depression (Mishkin, 1978). He argued that in the 1930s, the depressive effect of aggregate wealth reduction on outlay was compounded by the dept deflation which in turn reduced aggregate consumption demand. Using empirical evidence, Bernanke research suggests that the efficiency of credit allocation was reduced under imperfect market conditions of the 1930s and that aggregate demand was reduced by the resulting higher personify and reduced availability of credit (Bernanke, 1983).This process, in his opinion, can broadsheet for he protracted length of the great depression. Taken together, this new paradigm was not a rejection of Friedman and Swartz thesis, it merely showed that the monetary shock and other events in the early phase of the Depression prolonged the Depression through there effect on the institutional structure of the credit markets and the balance sheet of borrowers (White, 1984 Romer,1989).In short, macroeconomists have cogitate that the tendency of banks to respond to deposit outflows and increased risk of loan defaults by freezing credit can aggravate recessions, magnifying declines in investment, production and asset prices (Calomiris, 2008) The focus on deflation and financial collapse throughout the world also suggested ways through which the depression was channeled to other countries.Currently, economists agree that the sumptuous standard compete an important role in transmitting the economic decline in America to the rest of the world (Campa, 1990 Bernanke, 2002b) under the gold standard trade imbalances gave rise to international gold flows. In his analysis of international transmission of the American Depression, Kindleberger reasoned that that the stock market collap se and deflationary shocks triggered a liquidity squeeze, a reduction in bank lending and the international financial collapse of the 1930s i. e.the lack of access to credit forced less-developed countries to use up their gold and foreign exchange reserves this forced them to sell old quantities of primary products at reduced prices (Kindleberger, 1973). He also noted that the depression was more protracted in countries which stuck to the gold standard The countries that abandoned gold pursued independent monetary policy and were able to rebound faster. International studies correlating adherence to the gold standard, deflation and move economic decline have confirmed this argument (Bernanke and James, 1991 Eichengreen, 1992).Economists also believe that the enactment of The Smoot-Hawley Tariff which was supposed to protect American Farmers triggered a counterproductive wave of protectionist measures around the world, which worsened the depression (Draghi, 2009 Hamilton, 1987, Mel tzer, 1963) Although most of these debates occurred after the Great Depression, scholars now agree that both inept fiscal and monetary policies transformed a chemical formula business cycle into a depression. Since monetary contraction was part of the problem during the Depression.Currency devaluation and monetary expansions had to play a leading role in the recovery process. A number of commentators have shown that the American money supply increased by 42% between 1933 and 1937 and worldwide monetary expansion led to a lowering of interest rates and easy access to credit (Mishkin, 1991). Economists argue that since fiscal expansion can reduce expectation of deflation, they can reduce the cost of borrowing (Romer, 2009). Keynes theory that government spending, tax cuts, and monetary expansion are essential in countering recession can also be justified in light of historical evidence.Economists reason that the massive government spending, such as the New deal program specifically Work Progress Administration (WPA) and agrarian Adjustment Administration (AAA) reignited the economy (Calomiris and Mason 2003, Romer 1989, Temin 1989). In fact, the general consensus among scholars is that the economy American economy began to recover with a new monetary expansion and spending in preparation for war (White, 2009b). Concerning Banking sector reform, the view on the Bank Holiday is that it was a dramatic and effective remedy.The other reforms have also cadaverous support from Great Depression scholars (Blinder, 2008 Gapper, 2007 White, 2009b). These reforms saw the creation of a number of regulations and institutions, Banking Act of 1933 (commonly known as Glass Steagall Act) the act prohibited commercial banks from underwriting of dealing in corporate securities. Insurance of bank deposits by FDIC was designed to prevent depression type bank runs. SEC regulated investment and Federal berth Loan Bank (FHLB) guaranteed Residential mortgage loans.Collectively, sc holars now believe that these regulations insulated Americas banking system from the booms and busts of the financial markets (Russell, 2008). Bernanke (1983 p2) argues that only with the rehabilitation of the financial system in 1933-35 did the economy begin its slow emergence from the Great Depression. The 2007 Economic recession The economic literature on the current recession is still limited, however adequate amount of literature exist on the impact of the down turn on the U.S. economy. The Economic Report of the President Jan, 2009 gives a comprehensive coverage of how the recession started where it started and what is to be done. A large amount of literature can also be found on the causes of the crisis. among others. In terms of impact, the reports from the Bureau of Economic psychoanalysis (BEA) indicates that from Dec 2007 to May 2009, America has had 57 bank failures the unemployment rate has increased to 8. 9% the economy has declined by 3.3% from the second take up 2008 first quarter of 2009 from Sept 2008 to may 2009, the federal government has increased the money stock by 125% and over the same period the biggest fall in the Dow Jones industrial stands at -53. 8%. The outlook is equally dire most analysts have predicted a recession that may last up to two years (Roubini, 2009) dingys Investors Services (MIS), while further job losses are also expected have predicted increased foreclosures, while further job losses are also expected. But the impact has not been limited to America.The International Monetary Funds (IMF) World Economic Outlook published in Jan 2009 particoloured a bleak picture of the world economy in general They predict that the real global growth will be close to zippo in the same report, growth in advanced world economies was projected at -2%. In his report, presented to the V Symposium on International Trade (Feb 20, 2009) Cline reported that the economic crisis in America has triggered a highly synchronized global rec ession, which has seen a contraction in all economies (see the Graph below showing global growth over 3 decades (Cline, 2009).Figure, 3 Showing the Synchronization of Global Recession Taken together, commentators are unanimous that, in term of gruesomeness, this recession is still kooky vis-a-vis The Great Depression. Shiller (2009) writes that a lot of the upheavals in the economy have not been seen since the Great Depression. He cites the stock market volatility, the bank failures, the housing bust, the crack-up in mediation, and the near zero interest rate.Besides the statistical comparisons, the current debate and research effort is focused on how the how the crisis started. The proximate consensus is that the mortgage warrantor backed housing boom in America it to blame and that the origination and distributions of this paper assets is at the heart of the problem (Markus 2008 Grotty, 2009 Bernanke, 2009 Gapper, 2009) at the same time, researchers maintain that the crisis in the banking sector, was not independent, but resulted from distortions and incentives created by past policy actions.Blundell-Wignall, etal (2009), in there paper presented at a Reserve bank of Australia conference, averred that the current financial crisis is caused by global macro policies affecting liquidity and by very poor regulatory frame work. More specifically, economists recognize that any theory of causality, must, among other things, explain how the housing boom started, describe the factors behind the explosion of the residential mortgage backed securities (RMBS), how the banking crisis was triggered and the policy distortions that made it possible (Tett, 2007 Rajan 2009 Grotty, 2009).The findings of a number of researchers who have analyse the causes of the current financial crisis in America conclude that the policy distortions started with gradual undermining of the Glass Steagall Act, from the 1980s and the rise of the neo-classical theory of free markets (which a dvocates markets deregulation) Shiller (2005, p 43) argues that business cycles in the financial markets would not have been a major problem had banks been kept off the asset markets.The same argument is advanced by Summers (2008) who asserts that the deregulations in the banking sector exposed the banks to the bubbles and bursts of asset markets. Wray (2009) traces the poor regulatory framework in the U. S to the New Financial Architecture (NFA) which he claims is represented by a globally networked system of giant bank conglomerates and shadow banking system of investment bank, hedge funds and bank created special investment vehicles (SIV).In short, most scholars agree that the Riegle-Neal interstate banking and Branching efficiency Act of 1994 and the repeal of Glass Steagall Act in 1999 through the Gramm-Leach-Bliley Financial Act played a crucial role in laying the foundation which led to this crisis (Mishkin, 2009, p 268 Grotty, 2009). Atkinson, Wigall, and Lee (2009) have als o concluded that the Basel II accord on international bank regulation also opened an arbitrage opportunity for banks which led to the acceleration of off-balance-sheet activities.In the same paper, they claim that SEC 2004 decision to allow investment banks to manage there own risk was a major policy blunder. Soros puts it this way. Since 1980, regulations have been progressively relaxed until they have practically disappeared. authorities could no longer calculate their risks and started relying on the risk charge methods of the banks themselves (Soros 2008) At the same time, scholars have concluded that the other root cause of the problem is traceable to the easy availability of credit. Diamond, etal (2009, p 615) argue that the policies affecting liquidity availed a lot of funds to the banks.The 1% federal interest rate, the % interest rate in Japan, the fixed exchange rate in china and large reserves of sovereign wealth funds are listed in his paper as sources of cheap credit wh ich fueled the economic boom in America led to an inflation of prices around the world. The claims that interest rates were low are supported by statistics which indicates that real short term interest rates were negative from mid 2001 to mid 2005, given the modest values of inflation (Yellen, 2008) The low interest rates, in turn, ignited a housing boom.Fig, 3 shows the Case-Shiller house index from 2000-2008. According to Grauwe (2009), the doubling of US house prices from 2000-2006 was not underpinned by real changes in the U. S economy. In the same survey, he reports that between July 2006 and July 2007 the value of Dow Jones and the SP vitamin D rose by 30% while GDP increased only by 5%. Taken together, researchers have concluded that the collapse of the real terra firma market in 2006 was the origin of the crisis. The rising foreclosures turned the credit boom into a bust.however, economist have at the same time stated that the severity of the housing market bust has been c ompound by the weakness inborn in the financial system (Calomiris, 2008 Rajan 2009 Bookstabber, 2007) namely use of bank deposits for speculative activities- this operation was made possible though special investment vehicles (SIV) sometimes called shadow banking new financial innovations derivative products like Credit Defaults Swaps (CDS) and Collateral Dept Obligations (CDO) they have been exposit as complex and overly opaque failure of rating agencies to properly calculate the risks embedded in this instrument and failures by regulators and supervisors.Some have added that the formulas used to compute the level of risk in this instrument was questionable and that the development of riskier higher order CDOs tended to magnify the systemic risk (Volcker, 2008 Veneroso, 2007 Soros, 2007 Rajan 2009 b). Sorros (2008) argues that the new types of mortgage-backed securities primaeval to the boom were too complex and opaque to be priced correctly. Grotty (2009 p 40) also argues that these instruments encouraged fraud since most investors did not even know what they were buying. That when the risk inherent in these products became apparent in 2007, investors pulled back from structured products in general, banks had to re-absorb the losses incurred by their off balance entities SIV, straining there balance sheets in the process. moralistic hazard problems and adverse selection worsened with time lending to a credit freeze which led to a slow down in economic activities around the world (Mishkin, 2007, Folkman etal, 2007 Dornbusch etal, 2000) Concerning solutions, most policy makers agree that to reverse the recession, there is need for closely coordinated intervention at global level and that efforts must focus simultaneously on fiscal, monetary and financial stability policies. The underlying assumption is that restoring confidence in the prospects for employment and income and returning to balanced growth are the only way out of the recession (Draghi, 2009). Strong expansionary fiscal policies, with measures to support demand and safeguard banking and financial system have been instituted throughout the western world.The $ 800 billion dollar stimulus plans in America has been seen as bold policy initiative, although many economist are worried about its repercussion on the national dept. The proponents of this plan see it as the best way to either create jobs or prevent job losses (Romer, 2009). At the same time, most central banks around the world have rapidly lowered there interest rates. Draghi (2009) argues that in the initial stages of a crisis, rapid disinflation should not be allowed to turn into a deflation. To keep the banks afloat, central banks have injected large quantities of money into the system in some instances, they have bought corporate dept to keep financial institution afloat.Russell (2009) notes that reactivating financial intermediation is also essential since capital requirements cannot be satisfied by the state alone. To achieve this goal, economists agree on three basics steps. The need to guarantee liabilities to hold on bank runs taking the banks through a stress test to identify the banks with solvency problems and ring-fencing the problematic securities or transferring them to separate entities such as bad banks followed by recapitalization (Wheelock, 2009 White, 2009, Draghi, 2009) are possible ways of unfreezing bank lending. At the same time, economists agree that a solution to the housing crisis is necessary.Lastly economists have pointed out that there is a need to reform securitization, credit rating agencies, poor risk modeling and underwriting standards, as well as corporate governance lapses (Krugnall etal, 2008). Some economist has also concluded that massive failure in corporate governance in some companies reflects poor incentive structures for decision, thus bank reforms should be extended to corporate stipend practices (White, 2009 Blinder, 2008, Crotty, 2009) Referen ce Bekaert, G, Harvey, C. R. , 2005, Market Integration and Contagion, Journal of Business, Vol. 78, (No. 1), pp. 3996. Bernanke, B. S. , 1983. Nonmonetary effects of the financial crisis in the propagation of the great depression.American Economic go off 73, 257276. Bernanke, Ben (2002). On Milton Friedmans ninetieth Birthday, at the Conference to Honor Milton Friedman, University of Chicago, Chicago, Illinois, November 8. www. federalreserve. gov. (accessed on May, 10, 2009) Blinder, Alan, 2008. What Created This Monster? , New York Times, 23. Bookstabber, R. , 2007. The next financial crisis starts here, Financial Times, August 23. Calomiris, W. C. , Mason, J. R. , 2003. Fundamentals, panics, and bank distress during the depression. American Economic Review 93 (5), 16151646. Calomiris, C. W. , Financial Factors in the Great Depression. The Journal of Economics Perspectives, Vol 7 (2) pp 61-85.