The Great Depression and the 2007-2009 Recession ... - SSRN papers

International Research Journal of Finance and Economics ISSN 1450-2887 Issue 59 (2010) © EuroJournals Publishing, Inc. 2010 http://www.eurojournals.com/finance.htm

The Great Depression and the 2007-2009 Recession: The First Two Years Compared Hamid Shomali Department of Finance and Economics, Golden Gate University Ageno School of Business, San Francisco, California, USA E-mail: [email protected] Tel: +1-415-442-6582; Fax: +1-415-442-6579 Gwendolyn R. Giblin Candidate, Doctor of Business Administration, Golden Gate University Ageno School of Business, San Francisco, California, USA E-mail: [email protected] Tel: +1-415-977-2220; Fax: +1-415-777-5189 Abstract The 2007-2009 recession was the most severe economic downturn since the Great Depression. However, most research regarding the Great Depression focuses on the entire decade of the 1930s. This paper compares the first two years of the Great Depression and 2007-2009 recession, including the: (1) causes; (2) severity; and (3) policy reactions. When viewed in this manner, it appears that the more recent financial downturn is not “another Great Depression.” While in some respects it was more severe than the Great Depression in year one, the two year data indicates that direct comparisons are not warranted. Keywords: Great Depression, financial crisis, recession, 2007-2009 recession, fiscal policy, monetary policy JEL Classification Codes: E65; E02; E63; E66

1. Introduction In the last few months, I have found myself uttering the words “worst since the Great Depression” far too often: the worst twelve month job loss since the Great Depression; the worst financial crisis since the Great Depression; the worst rise in home foreclosures since the Great Depression. – Christina Romer, Chair, Council of Economic Advisors (2009a) The 2007-2009 recession is, by most accounts, the most severe since the Great Depression. However, the term “Great Depression” typically refers to the economic hardships that persisted for the entire decade of the 1930s. Although the more recent financial downturn has been, in some respects, more severe than the Great Depression, data from the first two years indicates that such a direct comparison is not warranted.

Electronic copy available at: http://ssrn.com/abstract=1970641

International Research Journal of Finance and Economics - Issue 59 (2010)

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2. Comparison of the Causes With both the Great Depression and the 2007-2009 recession, significant asset inflation preceded the economic downturn. The economy grew quickly through much of the 1920s due, in part, to consumers taking on more debt. During that decade, the amount of outstanding real estate mortgages increased from $11 billion to $27 billion (Bernanke 1983). Installment debt also increased as consumer products became more widely available. Easy access to credit resulted in consumers significantly increasing their purchases of cars, household appliances, and other household items throughout the 1920s (Parker 2007, 2). This increase in consumer spending and debt concerned President Herbert Hoover and the Governors of the Federal Reserve. In addition, the stock market was reaching new heights. Thus, to curtail the “speculative excesses that were driving the stock market boom,” the Federal Reserve began its contractionary efforts in early 1928 (Parker 2007, 4). The 2007-2009 recession is also largely attributed to events in the housing and financial markets. In the late 1990s and early 2000s, developing countries invested large amounts of savings in the United States and other countries with well-established financial systems. The increased demand for “safe” assets caused returns on those investments to decrease. The low yields then caused investors to seek riskier investments with higher returns. As a result, innovative and higher risk investments became common. As Bernanke (2009) noted: To satisfy the enormous demand for investments perceived as safe and promising higher returns, the financial industry designed securities that combined many individual loans in complex, hard-to-understand ways. These new securities later proved to involve substantial risks – risks that neither the investors nor the firms that designed the securities adequately understood at the outset. The under-pricing of this risk contributed to the financial crisis that occurred once the investments began to lose value. The “influx of inexpensive capital” was also responsible for home building to increase to “wellabove historical levels” and for the inflation of existing home prices, according to the Council of Economic Advisors (2009a, 62). Mortgage financing changed as well. In the early and mid-2000s, there was significant growth in the number of subprime, interest-only, and adjustable rate mortgages. These mortgages made home ownership available to more people but, in many cases, loans were made to borrowers who presented higher credit risks. Another significant change in the mortgage industry was the securitization of mortgages. Traditionally, lenders kept the loans they originated, so the lender had an interest in making wise loan decisions. In recent years, however, many loans were packaged into mortgage backed securities that were sold to investors. Thus, the risk of default on the underlying mortgages was transferred to purchasers of the derivative securities. Because lenders no longer bore the risk, they became more willing to make loans to less credit worthy borrowers. This practice occurred throughout the mortgage industry, even by the government-sponsored entities Fannie Mae and Freddie Mac. The appreciation in home prices began to slow in 2005 and prices started falling in Q3 2007. As demand for residential construction slowed, the number of new housing starts also declined.1 The decrease in home values put some borrowers “under water,” i.e., they owed more than the market value of the home. Mortgage delinquencies increased significantly, particularly for adjustable rate subprime loans. As a result, the derivative mortgage backed securities lost significant value. Some major investment banks were highly leveraged, with leverage ratios reaching 25 to 1, so losses in the mortgage backed securities had serious repercussions. In addition, many investment banks relied on access to short term financing to service their debt, which became unavailable as the economic crisis intensified. Longstanding investment banking firms, such as Bear Sterns and Lehman Brothers, found themselves in a liquidity crisis. In many ways, the causes of both the Great Depression and the 2007-2009 recession are similar. Asset inflation and excesses in the housing market led to unsustainable economic conditions. 1

In 2005, housing starts averaged more than 172,000 per month. That number declined precipitously, with monthly averages of 150,000 in 2006, 113,000 in 2007, 75,500 in 2008, and 46,000 in 2009 (U.S. Bureau of the Census 2009). Electronic copy available at: http://ssrn.com/abstract=1970641

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Ultimately, the excesses reached a point where they could no longer be maintained and the economy had to adjust to a more tenable level. In both the Great Depression and 2007-2009 recession, this started a chain reaction of economic consequences that spread throughout the economy.

3. Comparison of the Severity By some measures, the first year of the 2007-2009 recession appeared to be as severe as the Great Depression. However, in the latter half of 2009, the economy diverged from the path of the Great Depression and, instead, showed initial signs of expansion. Prior to the Great Depression, the economy reached its peak in August 1929, according to the National Bureau of Economic Research (NBER) (NBER 2010). The October 1929 crash of the stock market often is referred to as the cause of the Great Depression. However, economists generally characterize it as one of many events contributing to the overall economic downturn. The October 1929 crash “mainly reversed a large run-up in stock prices that had taken place between June and August, and house prices declined only slightly. As a result, household wealth fell by just 3 percent between December 1928 and December 1929,” according to Romer (2009b). Similarly, former Federal Reserve Governor Frederic Mishkin (2008) has explained that: The tightening cycle that ended in August 1929 weakened an already deteriorating economy and paved the way for the collapse of the stock market in October. The Federal Reserve's mistake in attempting to burst the bubble directly was made worse by its refusal to change course rapidly after the market collapsed and the banking system got into trouble, thereby allowing deflation to set in, which raised real interest rates to extremely high levels and further depressed growth. Thus, while the 1929 stock market crash was undeniably an economic shock, asset inflation and large amounts of consumer debt set the stage for the events that followed. In 1931, two years after the start of the recession, the economy showed signs of continued decline. The unemployment rate of 3.2% in 1929 increased to 15.9% in 1931.2 The GDP of $103.6 billion in 1929 declined to $76.5 billion in 1931 – a 26% decrease.3 The more recent recession began in December 2007, according to the NBER. One year into the recession (i.e., December 2008), it appeared to be more severe than the Great Depression by some measures. The S&P 500 index was slightly above 1,500 in early December 2007, but declined more than 50% -- to a low of 677 -- in March 2009. The market volatility was much greater than that experienced during the Great Depression. Romer (2009b) explained that, “The variance of returns measured using the S&P index was more than one-third larger in the current episode than in the final four months of 1929." In addition to the decrease in stock values, housing prices fell by 9% in 2008. “All told, household wealth fell 17 percent between December 2007 and December 2008, more than five times the decline in 1929,” explained Romer (2009b, 2). However, by other measures, the 2007-2009 recession took a different path than that of the Great Depression. The Bureau of Labor Statistics reports that the seasonally adjusted unemployment rate, which was 5.0% in December 2007, increased to 10% by December 2009. Though that is twice the natural rate of unemployment, it is still much lower than the 15.9% unemployment rate in 1931. The decline in GDP also was not as severe as that experienced during the first two years of the Great Depression. GDP decreased in each quarter from Q1 2008 through Q2 2009, but increased in subsequent quarters (Bureau of Economic Analysis 2009). Again, while this data reflects a faltering economy, it presents a less negative situation than that faced in year two of the Great Depression. In addition, the significant deflation experienced during the Great Depression did not occur in the 2007-2009 recession. During the Great Depression, the Consumer Price Index fell by 4.6% in the

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Unemployment continued to increase in the following years, reaching 23.6% in 1932 and 24.9% in 1933 (U.S. Bureau of the Census 1975). Like unemployment, the decline in GDP continued beyond the first two years of the recession. GDP was just $58.7 billion in 1932 and $56.4 billion in 1933 (Federal Reserve Bank of St. Louis 2009). Thus, in the four year period from 1929 to 1933, GDP declined by 46%.


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first year and by 12.7% during the first two years.4 The 2007-2009 recession resulted in less consumer spending, but price levels did not decrease: the CPI increased 0.1% in 2008 and 2.7% in 2009. Therefore, comparisons between the first year of the 2007-2009 recession and the Great Depression have some basis. This is particularly true regarding the stock market’s volatility and the decrease in household wealth. However, in the second year of the Great Depression, the economy continued to decline. That was not the case in more recent recession, in which initial signs of expansion emerged in year two.

4. Comparison of the Policy Reactions During the 2007-2009 recession, effective monetary and fiscal policy prevented the economy from declining into another Great Depression. The Bureau of Economic Analysis (2009) reports that the GDP increased 2.3% in Q3 2009 and 4.7% in Q4 2009.5 Politicians and economists continue to debate whether more or different actions should have been taken by both Congress and the Federal Reserve. However, they generally agree that the economy would have been in worse condition had the Government not intervened. This did not occur during the Great Depression, where the initial economic shocks were exacerbated by what most economists characterize as severe policy misjudgments. 4.1. Monetary Policy When the economy began to decline in 1929, the Federal Reserve did not actively manage the situation. Because the Federal Reserve did not act, the money supply decreased, and prices continued to fall. Economists generally agree that the Federal Reserve’s decisions during the Great Depression were ill-advised. However, hindsight provides the benefit of analyzing the Federal Reserve’s decisions with full knowledge of the ramifications. Several prominent economists note that the Federal Reserve was working within context of the gold standard and, perhaps, simply failed to consider that alternatives may have existed. As Ben Bernanke once explained: When the British went off gold in 1931 the story is that the Chancellor of the Exchequer, while taking a bath, was informed of the abandonment of gold and he said something to the effect of “I didn’t know we could do that.” Of course he could do that. The United States didn’t do that because the US, like France, had accumulated large gold reserves . . . As a result, the pressure on the dollar never reached the stage where essentially there was no choice but to abandon the gold standard. (Bernanke, quoted in Parker 2007, 59) In fact, most countries “did everything they could and only when institutional factors like financial crisis, banking problems or just the pressure of the external drain became severe enough they found themselves forced to abandon the gold standard,” according to Bernanke (quoted in Parker 2007, 59). Thus, “it was a problem of paradigm and not a problem of decisions within a paradigm (Bernanke, quoted in Parker 2007, 59).” Other economists, including Allan Meltzer, have provided a similar explanation: [T]hey did what many so-called sensible people at that time would have done. . . . They were acting in the way that most people acted at the time. The Federal Reserve Act was written to create a passive institution. That is, they were not supposed to engage in countercyclical policy. That's something that came later, and they didn't think that was their responsibility. (Federal Reserve Bank of Minneapolis 2003) Indeed, abandoning the gold standard in favor of more expansionary policy-making was not possible as a practical matter. Economist Peter Temin once said that those who suggested doing so were “ridiculed by the orthodoxy” because “when you’re on the gold standard then the central bank 4 5

At its lowest point in 1933, the CPI had declined by 27% compared to August 1929. While this paper focuses only on the first two years of the recent recession, the GDP has continued to grow throughout 2010 as well.

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preserves the exchange rate. That’s what the Fed did in 1931 . . . in the midst of a very bad recession (Temin, quoted in Parker 2007, 38).”6 This hindsight has guided the actions of the Federal Reserve during the 2007-2009 recession. In an interview conducted prior to the financial crisis, Romer stated that economists learned important lessons from the Great Depression. “If we are ever hit with a major depressionary shock . . . you step on the gas any way you can. And I think the lesson from the Great Depression is that it will work (Romer, quoted in Parker 2007, 136).” Romer added that, “We could easily face very big shocks, but our tools, even though they are imperfect, are good enough. I think we are smart enough now that we would use them (Romer, quoted in Parker 2007, 137).” That is, in fact, what has happened during the 2007-2009 recession. The Federal Reserve adopted expansionary monetary policies, such as reducing the federal funds rate to a historically low level. The effective rate of 4.66% on December 1, 2007 was reduced to 0.13% as of December 1, 2009. The low federal funds rate had a ripple effect throughout the economy, resulting in lower interest rates for home mortgages and items bought on credit. Another difference between the Great Depression and the 2007-2009 recession was the institutional knowledge of the Federal Reserve, which has greatly increased during the past century. The Federal Reserve was established in 1913, so it was a relatively young organization in 1929. Benjamin Strong was Governor of the Federal Reserve Bank of New York “and the de facto equivalent to a Fed Chairman today,” Bernanke (2002) explained. Strong died in October 1928. Following Strong’s death, “the Federal Reserve no longer had an effective leader or even a well-established chain of command” and “what power there was accrued to men who did not understand central banking from a national and international point of view, as Strong had,” said Bernanke (2002). Today, the Federal Reserve has a well-established system of Governors and District Banks. In addition, the Federal Reserve has the benefit of decades of research, including methods of econometric analysis that did not exist in the 1930s. Furthermore, today’s bank customers are protected by federal deposit insurance that did not exist during the Great Depression. A repeat of the “bank runs” in the early 1930s did not occur because customers knew that deposits of up to $100,000 were insured by the Federal Deposit Insurance Corporation (FDIC). That amount was temporarily increased to $250,000 in October 2008 to further build consumer confidence in the banking system (FDIC 2008). In 2008 and 2009, 165 banks failed (FDIC 2009).7 However, these failures occurred “with barely a ripple felt by depositors” because FDIC insurance “short-circuited a channel through which the financial crisis could have mushroomed,” said Romer (2009b). Romer (2009b) added that, "The FDIC’s ability and willingness to insure the issuance of debt by larger banks was also a key factor [in] containing the crisis.” By comparison, more than 9,000 banks suspended operations during the Great Depression, resulting in depositors losing most or all of their money. Thus, bank customers during the Great Depression had good reason to quickly withdraw funds upon any indication of trouble at a bank.8 In addition, the central banks of countries around the world are working together to implement monetary policy to stimulate the global economy. Interest rate changes in the United States and other large economies often affect foreign interest rates. Some argue that the near-zero fed funds rate in the United States has caused dollars to flood into China, thereby starting to create new asset bubbles and undermining the global recovery. Nonetheless, a general spirit of cooperation exists among the world’s central banks. International leaders held a series of meetings to discuss efforts to strengthen the world

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The connection between maintenance of the gold standard and the length of the Great Depression has received much attention from scholars since the 1980s. Bernanke (1995, 15) noted that between 1933 and 1935 “the money supplies of gold-standard countries continued to contract, while those not on the gold standard expanded.” More than 135 additional banks failed in the first ten months of 2010, according to the FDIC. Granted, to some extent, comparing the numbers of failed banks in the 1930s and today can be misleading. In the 1930s, banks typically had a single branch or a small number of branches. Today, banks tend to be larger and have more branches. A bank’s collapse counts as only a single bank failure regardless of how many branches it has. For example, the failure of Washington Mutual in September 2008 counted as a single bank failure though it had thousands of locations.


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economy and to prevent similar crises in the future. The G-20 also discussed the effectiveness of the policy responses taken by member countries and strategies for coordinating their efforts.9 The Federal Reserve’s actions during the 2007-2009 recession were dramatically different from those taken (or more accurately, not taken) during the first few years of the Great Depression. The NBER determined that the more recent recession ended in June 2009. This indicates that the Federal Reserve’s expansionary monetary policy contributed to the economy not declining further. 4.2. Fiscal Policy During the Great Depression, politicians focused on balancing the federal budget rather than adopting expansionary fiscal policy. As a result, the Government took actions that exacerbated the economic problems. For example, Congress passed the Revenue Act of 1932, which increased taxes for many middle and lower income taxpayers. Efforts to balance the budget also precluded the Government from spending on social programs that may have stimulated the economy or, at least, provided social services to those adversely impacted by the recession. A vicious cycle ensued due to reduced consumer spending and high unemployment, which further reduced the tax revenues received by the Government. Lower tax revenues then made it even more difficult to balance the budget. The Government’s response to the 2007-2009 recession was markedly different. Congress enacted two significant measures related to the financial crisis. First, in October 2008, Congress passed the $700 billion Troubled Asset Recovery Plan (TARP). TARP provided the Treasury Department with funds to stabilize and/or bail out financial institutions. TARP’s objective was to prevent the collapse of the financial system by permitting the Treasury Department to purchase troubled assets. Then, in February 2009, Congress passed the $787 billion American Recovery and Reinvestment Act (ARRA). The ARRA stimulus was divided among tax cuts, assistance to states to help those affected by the recession, and Government investments in infrastructure, health information technology, and other areas. The Council of Economic Advisors reports that $63 billion in tax cuts had been made as of August 2009 (Council of Economic Advisors 2009b). Another $128 billion in government spending was “obligated” to projects, i.e., the funds were set aside for payment as expenses are incurred and projects are completed (Council of Economic Advisors 2009b). It is estimated that the Government’s fiscal stimulus efforts increased real GDP by 2-3% in Q2 and Q3 2009 (Council of Economic Advisors 2009b). Another significant difference between the Great Depression and the 2007-2009 recession was the use of automatic stabilizers that did not exist in 1929. Romer (2009b) noted that, “we have a larger tax system and a social safety net that leads automatically to higher government spending in a recession. The result is a budget that naturally swells in a severe downturn.” During the Great Depression, social welfare programs to protect the unemployed did not exist. Unemployment Insurance was established in 1935 and the first food stamp program did not begin until 1939. The unemployed had no Government safety net. Today, a variety of automatic stabilizers take effect when expansionary fiscal policy is needed. Tax policies are “the most important” automatic stabilizers, according to Krugman and Wells (2006, 302). In addition, increased transfer payments in the form of unemployment insurance, foods stamps, and similar programs boost Government spending while also helping those in need. The Government’s failure to implement expansionary fiscal policy contributed to the length and depth of the Great Depression. Having learned from history, the Government responded to the 20072009 recession by enacting TARP and ARRA, as well as providing additional benefits for the unemployed. By all indications, the Government’s active involvement in economic stimulus proved to be a better course of action than that taken during the Great Depression.

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The Group of Twenty Finance Ministers and Central Bank Governors (the G-20) consists of finance ministers and central bank governors from European Union and 19 countries.

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4.3. International Trade Policy Both the Great Depression and the 2007-2009 recession were international in scope. However, the U.S. Government has taken a very different approach to international trade this time. The difference in international trade policy is one reason why the economy is recovering, whereas it continued to decline in the 1930s. The economy’s downward spiral during the Great Depression is attributed, in part, to the Smoot-Hawley Tariff Act. The Act imposed tariffs of more than 40% on thousands of imported goods. Retaliation by other countries brought trade between the United States and much of the world to a halt, which further slowed the United States economy and prolonged the Great Depression. Paul Krugman has noted that, “Most people, even including the senators who voted for Smoot-Hawley, soon realized that protectionism had gone too far (Krugman 1994, 288).”10 The consequences of Smoot-Hawley continued well after the end of the Great Depression. “The United States began trying to negotiate tariffs down again as early as 1934, and after World War II both the political and the economic environment were very favorable for trade liberalization,” according to Krugman (1995, 288). However, Krugman (1995, 288) explained that international trade “had been shattered” by SmootHawley and “trade among industrial countries didn’t regain its 1914 level until 1970." Today, the United States’ tariff rates are among the lowest in the world due, in part, to free trade agreements made during the past decade. In the 2007-2009 recession, countries around the world took a more coordinated approach to the economic crisis. Most industrialized countries, and many emerging countries, implemented forms of economic stimulus. The Council of Economic Advisors reports that the countries adopting larger fiscal stimulus packages generally fared better than the countries initiating smaller ones. Countries did not engage in protectionist actions, which allowed international commerce to continue, albeit at a reduced level. Furthermore, countries worked together to reach agreements to keep the international markets open to trade and investment. Both the Great Depression and the 2007-2009 recession reflect international economic downturns. However, by seeking international cooperation, and not taking protectionist actions, the Government created an environment in which the international economy could start to recover.

5. Conclusion The United States economy is still experiencing many effects of the 2007-2009 recession. Yet the comparisons to the Great Depression are overstated because the economy did not sink to the same depths. To be sure, the economy remains in an undesirable state from the perspective of many individuals, companies, and society in general. The impact of the recession will be felt long-term, particularly because it will take time to reabsorb the unemployed into the active workforce. However, two years into the recession, the economy showed signs of turning around, which was not the case in 1931.

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Bernanke, B. 1983. "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression." American Economic Review, 73(3), 257-76. Bernanke, B. 1995. "The Macroeconomics of the Great Depression: A Comparative Approach." Journal of Money, Credit, and Banking, 27(1), 1-28.

The Smoot-Hawley tariff was not enacted in response to the recession. Eichengreen and Irwin (2009) explain that, “The basic structure of the tariff rates was set by the House Ways and Means Committee in early 1929, well before the peak of the business cycle.” Accordingly, they argue that is “difficult to view the tariff as an anti-depression measure.” Regardless of the rationale for the law, the timing of the tariff’s enactment in 1930 had unfortunate consequences.

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