вЂњThe Great Recession of 2007-2009 and The Great Depression of the 1930s: Similarities, Differences, and Policy ResponsesвЂќ Jason E. Taylor Professor of Economics Central Michigan University April 14, 2010: Governmental Affairs Conference Great Depression versus Great Recession: A Question of Magnitude вЂў Great Depression of the 1930s в–« Unemployment ranged between 14-25 percent between 1931 and 1940. вЂў Great Recession of 2007-2009 в–« Unemployment peaked at 10.2 percent. Great Depression versus Great Recession: A Question of Magnitude вЂў Real Gross Domestic Product fell by 26.7 percent between 1929 and 1933. вЂў Real Gross Domestic Product fell by 3.7 percent between late 2007 and mid-2009. Great Depression versus Great Recession: A Question of Magnitude вЂў The Overall Price Level fell 24 percent between 1929 and 1933. вЂў The Overall Price Level rose modestly, around 2.5 percent, between late 2007 and mid 2009. Great Depression versus Great Recession: A Question of Magnitude вЂў Dow Jones Industrial Average fell from 381.2 in September 1929 to 41.2 in July 1932вЂ”a fall of over 89 percent. вЂў Dow fell from 14,164 in October 2007 to 6,543 in March 2009вЂ“ a fall of 53.8 percent. What Caused The Great Depression? What Caused the Great DepressionвЂ¦ Really Three Separate Questions вЂў What initiated the downturn? вЂў What made the downturn so steep (a вЂњDepressionвЂќ)? вЂў What made the downturn so long (вЂњThe Great DepressionвЂќ)? Stock Market Crash of 1929 вЂў Unparalleled optimism in the 1920sвЂ¦ a вЂњNew EraвЂќ perceived to be upon us. вЂў A classic stock market вЂњbubble.вЂќ (More later.) In October 1929, the bubble pops. вЂў Many lose significant portions of their wealth. Confidence in the вЂњnew eraвЂќ is shattered. Four Phases of the Great Depression Phase One: Oct 1929-Oct 1930 вЂў Stock market crash (Oct 29) causes jump in unemployment rate from around 3 percent to 9 percent in December 29. вЂў But things settle down and unemployment falls to 6.1 percent by Oct. 1930. вЂў Sharp recession, but things are looking up. Phase Two: November and December 1930. вЂў Unemployment jumps from 6.1% in October to 14.4% in December. We have a вЂњDepressionвЂќ on our hands. вЂў Primary Cause: The Banking вЂњPanic of 1930.вЂќ Major banks fail including вЂњThe Bank of the United States,вЂќ a private bank in New York with a very official sounding name. Phase Three: The Banking Crisis Continues, 1931-1933 вЂў Unemployment steadily rises from 14 to 25 percent over these two years as banks fail en masse. By 1933, around HALF of all banks in the United States had failed. вЂў The Smoot-Hawley Tariff raised duties on imports (protectionism). Trade war resulted in which other countries responded in kind. This contributed to the world-wide Depression. Phase Four: WhereвЂ™s the Recovery? Putting the вЂњGreatвЂќ in Depression вЂў Unemployment fell from its 1933 peak of 25 percent to around 14% in 1937. вЂў Then unemployment rose back to 20 percent during the вЂњdepression within the DepressionвЂќ of 1937-38 вЂў World War II. Unemployment finally fall back to single digits in the 1940s. A (Very) Brief History of the Fed: Created in 1913 вЂў Banking Panics: 1873, 1893, 1907. Panics occur because of вЂњcontagion effect.вЂќ If people hear of a failure, they may fear for their deposits and run to their bankвЂ”a self-fulfilling prophesy. вЂў When banks fail, people lose deposits, access to credit, and the economy suffers. вЂў It was determined that in order to avoid this cycle, a вЂњbank for banksвЂќ would be created. Fed would serve as a вЂњlender of last resortвЂќ during times of panic. The FedвЂ™s First Major Test: Banking Panic of 1930 вЂў Several bank failures occur in the Midwest. Soon a вЂњcontagion of fearвЂќ spread throughout the country. In November 256 banks failed, in December 352 more. вЂў On December 11, Bank of the United States failedвЂ” the largest commercial bank to have ever failed at that point in US history. Its significant , but misleading, name in headlines sparked more fear. вЂњThe Great ContractionвЂќ (of the Money Supply) Half of all banks in the US failed between 1929 and 1933. With them went the savingsвЂ”and often livelihoodsвЂ”of their depositors. The Money Supply (currency + deposits) fell by around one-third during this time period. Where was the Fed???? Federal Reserve Failed to Act as a Lender of Last Resort вЂў Most economists, including Ben Bernanke and Milton Friedman, place the lionвЂ™s share of the blame for the Great Depression on the Federal Reserve. вЂў In 2002, Bernanke (then on the Fed Board) apologized on behalf of the Fed: вЂњRegarding the Great Depression, youвЂ™re right. We did it. WeвЂ™re very sorry.вЂќ New Deal Banking Policy вЂў Created the Federal Deposit Insurance Corporation (FDIC) . This cut down significantly on the bank run problem. вЂў Also created the Federal Open Market Committee and gave the Fed broader powers. This is the birth of the Fed as we know it today. These policies halted the bank panic and got the money supply growing again. New Deal General Economic Policies вЂў Economists and Historians are more divided upon whether New Deal economic policies were beneficial or harmful. Certainly work-programs created a large measure of relief for jobless. вЂў My Take: Policies that encouraged cartelization, unionization, and less flexibility of the labor market (high minimum wages) slowed recovery down. Unemployment remained between 14 and 25 percent from 1933 until World War II. The Great Recession, 2007 - 2009 вЂњRoot of the problem is a loss of confidence by investors and the public in the strength of key financial institutions and markets. The crisis will end when comprehensive responses by political and financial leaders restore that trust, bringing investors back into the market and allowing the normal business of extending credit to households and firms to resume.вЂќ вЂ”Ben Bernanke (October 15, 2008) A Bit About Bubbles вЂў Bubble: Price of an asset rises, not because of a fundamental rise in its value, but because people simply expect it will rise. вЂў Greater Fool Theory: IвЂ™ll pay $10,000 for a tulip bulb because IвЂ™ll find someone who will pay $12,000 next week. вЂў Easy Credit: Generally during bubbles assets are purchased on credit. Lenders are willing because they believe the asset will continue to rise in value. Tulip Mania, Holland 1636-37 вЂў Between November and February, tulip вЂњfuturesвЂќ prices rose 8-fold. According to one historian, вЂњthe population, even to its lowest dregs, embarked in the tulip trade.вЂќ People were buying these bulb futures only with the intention of passing along the paper asset for a higher price. вЂў Then in on Feb 4, the bubble burst. By May tulip prices returned to their pre-bubble levels. The economy of the Netherlands was hurt for years. US Housing Bubble and Pop Causes of the Housing Bubble вЂў Low Mortgage Rates: Influx of savings from China, etc. and loose monetary policy in US kept rates low (FedвЂ™s target rate below 2% 2001-2004). вЂў Greater Fool Theory (spurred on by HGTV, TLC) вЂў Lax Lending Standards: Subprime mortgages, adjustable rate mortgages, interest-only mortgages. For example, 80% of all mortgages initiated in San Diego region in 2004 were adjustable-rate, and 47% were interest only. Mortgage Backed Securities (MBS) вЂў Mortgage loans are purchased from banks and assembled into pools which become securities. вЂў Many loans in these were considered вЂњsubprimeвЂќ (higher-risk). Still, MBSвЂ™s were generally viewed as a low-risk, high-reward investment and were purchased by foreigners вЂ¦ and BANKS who held them as assets on balance sheets. вЂў When the bubble popped, these quickly became вЂ¦ Toxic Assets вЂў An asset who value has fallen so significantly that it has no functioning market. вЂў The Housing Crisis morphed into a Financial Crisis since banks held Mortgage Backed Securities and other вЂњtoxic assets.вЂќ вЂў If these assets were priced at these low levels, many banks would be in default (вЂњZombie banksвЂќ). вЂў Banks became afraid to lend to each other for fear of the other bank defaulting before paying back. Effect on Middle America вЂў Stock market fell from 14,280 in October 2007 to 6,440 in March of 2009. Combined with 30% drop in housing prices, this created a huge negative вЂњwealth effectвЂќ on US households. вЂў Perhaps more importantly, access to credit, even for those individuals and firms with good records, became difficult as financial system froze. Government Bailouts вЂў Should the government bail-out banks, homeowners, and others affected by this crisis? Government Bailouts вЂў Should the government bail-out banks, homeowners, and others affected by this crisis? Those who say yes cite вЂњSystemic RiskвЂќ and the notion of вЂњToo Big To Fail.вЂќ Failure of company X will have negative consequences well beyond X. Moral Hazard Problem If people feel they will be bailed out when something bad happens, they will take more risks than are optimal for society. Bailouts: Essentially privatize the gains but socialize the losses of risk-taking. Result will be too much risk-taking in the future because of belief they will be bailed out of bad bets. GovernmentвЂ™s Bailout Response вЂў Bailout Bear Sterns, AIG (who insured MBSs), US Auto Companies, and others. вЂў Allows Lehman Brothers to fail in Sept 2008. вЂў Financial panic ensuesвЂ”reminiscent of the Panic of 1930 after Bank of US fails. Stock market crashes and McCain suspends campaign. вЂў TARP passed in October to вЂњstop bleeding.вЂќ Troubled Asset Relief Program вЂў Allocated $700 billion for Treasury to buy up toxic assets from financial institutions. In effect government buys stakes in private companies. вЂў December 2008, Bush mandates that TARP funds can be used to support any industry government deems needs it to avert system-wide crisis. вЂў February 2009, Government began to regulate pay for executives at firms who took bailout funds. Government also uses its leverage to convince companies like General Motors not to close dealerships that should be closed according to market. Federal ReserveвЂ™s Response вЂў Inject Liquidity into the System. Lower interest rate target to near zero. It also created several new tools allowing it to lend to financial firms. вЂў Restore Confidence. Opened discount window. Expanded FDIC insurance in amount and also provided backing for money market funds. вЂў Global Coordination. Fed consulted with and acted in unison with central banks around the world to stem the crisis. Fiscal Policy Response вЂў Bush Stimulus in 2008вЂ”$138 billion in вЂњtax rebate checksвЂќ to households вЂў Obama Stimulus in 2009вЂ”$787 billion. вЂў $1.4 Trillion deficit in 2009 and projected $1.6 Trillion in 2010. What affect has this stimulus policy had? Economics of Stimulus Economists are somewhat divided: KeynesiansвЂ”believe that government deficit spending can have multiplier effects and can bring an ailing economy back to health. Others claim that government spending вЂњcrowds outвЂќ private sector spending. Deficits, funded by either taxes or borrowing, effectively take resources away from the private sector. Stimulus has little or no economic impact. Problems Looking Forward вЂў Unsustainable deficits and mounting debt. в–« Debt creates a burden on future generations. в–« We must pay interest every year to our creditors on our national debt, harming the current generation as well. в–« What if our creditors view us as a default risk and stop lending to us? (China recently started selling more than buying our debt.) Interest rates would have to rise so that we could attract lenders. This could hurt capital formation here at home. Problems Looking Forward вЂў Inflation в–« While inflation has been tame during the downturn , the Fed has pumped nearly $2 trillion into the system. Historically, such increases in the money supply result in inflation. в–« Fear of inflation hurts the value of the US dollar. You donвЂ™t want to be caught holding something as it loses itвЂ™s valueвЂ”so sell it (buy Euros). в–« Gold has risen significantly in value in the past couple of years reflecting these fearsвЂ”suggesting that they may indeed be real. Problems Looking Forward вЂў Stimulus вЂњExit-StrategyвЂќ в–« If the Fed withdraws liquidity and the government stops running huge deficits, will we return to the вЂњprecipiceвЂќ of the Great Depression from which President Obama claims the stimulus has rescued us? Conclusion: Are comparisons between the Great Recession and the Great Depression valid? Both were largely set off by popping of equity bubbles (stock market and housing). Both morphed into financial crisis in the banking sector. Policy responses were entirely different. Great Depression was a failure of governmentвЂ” specifically Federal Reserve. Government this time around may have overreacted a bit on the side of doing вЂњtoo much.вЂќ But given the history, who can blame them?