Critically compare the cause and macroeconomic policy responses to the 1930s Great Depression and the current

global recession.

Econ 1103 International Macroeconomics Vincent Williams-Savery ID No. 000661906 November 29th 2011 Submitted to Dr Tesfa Mehari

Vincent Williams-Savery ID No. 000661906

Introduction

This essay will discuss the causes of both the Great Depression of 1929 1939, and the current global recession, which has been referred to as the Great Recession 2007 - 2009. It will also evaluate the macroeconomic policy responses to each event, identify similarities, and critique their effectiveness. During periods of economic decline, monetary authorities often utilize policy instruments such the interest rate, bank reserve requirements, money supply and the exchange rate. The Federal Reserve employed a combination of these instruments to combat each financial crisis. There is great debate on the topic of the cause of the Great Depression while the cause of the most recent recessionary period is agreed by without dispute. The Great Depression and the Great Recession were major occurrences in the history of the world economy. However it must be acknowledged that the Great Depression was much more severe than the most recent crisis. It spanned a longer period of time, national output decreased by a more significant amount, price decreases were more intense, and unemployment was greater. In addition, many of the social helping programmes that are available today were not in existence in the 1930s. Thus, the overall effect of the Great Depression on the United States was unlike any other economic period. It is generally agreed that it was the worst economic disaster of the 20th century. The Great Depression was longer in duration and more severe in terms of economic indicators beginning in 1929 and finally ending in 1939. The most recent global recession began in 2007 and arguably ended in 2009. There is indeed, much debate over whether the current economy has completely exited the downturn or whether there will be a double-dip, as the economies of most of the western world are still lagging.

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The Great Depression (1929-1939) and the Great Recession (2007 2009) Although not unanimously considered as the start of the Great Depression, it is generally agreed that stock market bubble and then crash in 1929 played a significant role in the Great Depression. Many peoples entire savings were erased when the market collapsed. This caused questioning of the strength of the economy. With the questioning came uncertainty. Uncertainty about the economy, resulted in a reduction in spending by the population. The uncertainty also translated into loss of confidence in the economy. The loss of confidence caused people to speculate about the security of their funds in banks. This caused a banking panic as massive of people poured into banks to withdraw their money. Unprepared for such mass withdrawals, many banks were forced to collapse. Thus began a cycle of more bank run ons and closures as hysteria spread. In addition to those individuals that had lost everything when the stock market collapsed, others had now lost life savings as banks were forced to close. As a precautionary measure, banks reduced the amount of funds available for lending for investment. The combination of reduced investment funds and reduced spending hit businesses hard. Sales were down resulting in losses for business. The consequence of business losses was unemployment for many, and reduced wages for those fortunate enough to remain employed. With no or reduced sources of income, many were forced to default on mortgage and loan payments, further testing the stability of the banks. Prices fell as business faced challenges gaining sales, and output declined. The state of the economy comprised reduced spending, low consumer confidence, extreme job losses, widespread defaults on mortgages and loans, deflation, and falling output. The combination of these events translated into real output (GDP) falling by 29% from 1929 to 1933. Unemployment increased to 25% of labor force, while some 7,000 plus banks failed. Consumer prices fell 25% and wholesale prices fell 32%.

Banks were now holding large quantities of excess reserves. Federal Reserve doubled reserve requirements in 1936 and 1937. However, banks, weary of the past bank run ons instead chose to keep reserves above what was required. This further reduced funds available for money creation.. According to Friedman and Schwartz, this action greatly decreased the money supply
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because banks wanted to hold excess reserves. As a result, they decreased lending so that reserves were still higher than the new required levels. Interest rates rose and lending plummeted. As a result, GDP rose by only 5% in 1938 and unemployment rose again reaching 19% in 1938. This added another 2 years to the Depression, but policymakers soon reversed course and a strong recovery resumed.

Policy decisions before the Great Depression may have also contributed to its occurrence. During the roaring twenties the fed kept interest rate low, which instigated the rapid expansion that preceded the collapse. Leading economist, such as Milton Friedman have indeed suggested that the Fed's mismanagement of the economic situation greatly contributed to the Great Depression, (investopedia). The first action of the Federal Reserve was a response to the stock market boom of 1928-29 in an attempt to slow the speculative effects of the market boom. The Fed raised interest rates which ultimately caused spending by businesses and households to slow dramatically. This added to the drop in industrial production and output. Banks, already experiencing liquidity problems, also suffered as a result of this move by the Fed.

Another policy which perpetuated the situation of the Great Depression was the protectionist policy The Smoot-Hawley Tariff, imposed in 1930. This policy, intending to assist the country, ultimately had the reverse effect. It caused the prices of imported goods to increase in an attempt to assist local merchants. However, the result was that other countries, concerned that their firms were having difficulty selling their goods in the United States, retaliated by imposing tariffs on the importation of US goods. This made it more difficult for U.S. firms to sell their goods abroad

Initially, the Fed largely ignored the banking panics and failures of 1930-33 and did little to arrest large declines in the price level and output. The election of Franklin D. Roosevelt (FDR) brought New Deal policies including ones aimed at resolving the banking crisis. FDR correctly recognized that it was critical that he restore public confidence in the economy and the banking system. The Fed eventually provided support the banking system however it was a policy of discriminatory banking relief, only allowing banks with sufficient collateral or those banks that
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were members of the Federal Reserve System to be eligible for emergency funds. The effect was that all banks that were in dire need of cash, were left with nowhere to turn and ultimately failed in large numbers. According to Wheelock, The Fed was considerably less responsive to the financial crises of 1929-33 than it was to the most recent. It neither lent significantly to distressed banks nor increased the monetary base sufficiently to arrest declines in the money stock and price level (Wheelock, 2010, p 91)

Under FDR, the Fed also began by removing the dollar from the gold standard. This had the effect of devaluing the U.S. dollar relative to other currencies. This encouraged exports and stimulated demand for domestic products relative to foreign ones. When the dollar went back on the gold standard at the new higher price, gold flowed into the US from abroad as investors sought the safety of US assets. Economist Arthur Bloomfield correctly recognized that "the devaluation of the dollar was . . . the direct cause of much of the heavy net gold imports in February-March, 1934"(Bloomfield, Capital Imports, p. 142). H e then argued that "probably the most important single cause of the massive movement of funds to the United States in 1934-39 as a whole was the rapid deterioration in the international political situation. The growing threat of a European war created fears of seizure or destruction of wealth by the enemy, imposition of exchange restrictions, oppressive war taxation. . . . Huge volumes of funds were consequently transferred in panic to the United States from Western European countries likely to be involved in such a conflict." (Bloomfield, Capital Imports, pp.24-25).

Under Franklin D. Roosevelt (FDR) and his New Deal policies, there was support offered to the businesses and people of the US. Initiatives under FDRs New Deal - set lofty goals to maintain public works, obtain full employment, and improve wages through price, wage, and even production controls. The New Deal followed Keynesian economics in that it was based on the ideal that government projects can stimulate the economy. Recovery involved rapid money supply growth, the end of banking panic, gold inflows, rising price level, and increased spending. The effect of the devalued dollar was an increase in the money supply. According to Romer, The very rapid growth of the money supply beginning in 1933 appears to have lowered real interest rates and stimulated investment spending. The money supply grew rapidly in the midVincent Williams-Savery ID No. 000661906 5

and late 1930s because of a huge unsterilized gold inflow to the United States (Romer 1992, p 781) Under FDR and his New Deal policies, there was support offered to the banks, the businesses and people of the US. Initiatives under FDRs New Deal set lofty goals to maintain public works, obtain full employment, and improve wages through price, wage, and even production controls. The New Deal followed Keynesian economics in that it was based on the ideal that government projects can stimulate the economy.

While the most recent financial crisis is centered in the whole subprime mortgage lending arena and has come about through the collapse of house prices and so many mortgage securities not paying their contracted amounts.A big decline in house and a large increase in mortgage foreclosure rates, distress in the housing market was largely caused by the housing market itselfthe boom and the bust, which has been centered on the subprime market. Origin of the Great Depression began with the downturn in U.S. residential real estate markets. Beginning in early 2007, a growing number of banks and hedge funds reported substantial losses on subprime mortgages and mortgage-backed securities.

The fed was criticized for its response to the Great Depression. However, it learned from that experience and its response has been different to the most recent crisis. During the Great Depression, it was seen that the Fed let the banking system collapse, allowed prices to fall drastically and the money supply to collapse. In contrast, when faced with the most recent crisis, the Fed acted quickly. The key difference between the most recent response and the 1930sthe 30s is the numerous actions taken by the Fed to try to keep markets liquid and to keep the banking system from collapsing in order to keep the whole financial system from collapsing. The Fed acted decisively to stave off the collapse of the financial sector. In addition, unlike during the Great Depression, the Fed did not limit the available bailout funds to specific banks. It recognized the importance of saving the banking system to maintain confidence in the economy. In addition, this time around, the Fed used innovative methods of stimulation the economy. The Fed did utilize new New Deal versions of stimulus packages, however, it also utilized
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quantitative easing by large-scale purchases of Treasury bonds. This injected money into the money supply and was to reduce the risk of the deflation that devastated the economy during the Depression.

The more recent experience saw the Fed respond quickly and in a stronger manner. Wheelock agrees that the Federal Reserves response to the financial crisis and recession of 2007-09 was markedly more aggressive than the Feds anemic response to the Great Depression (Wheelock 2010, p97). The Great Recession in the United States gave way to recovery as quickly as it did largely because of the unprecedented responses by monetary and fiscal policymakers (Zandi and Blinder 2010, p14). Also, the experiences of the Great Depression meant that with the As said laissez-faire was not an option (Zandi and Blinder 2010, p17)

Another parallel is the worldwide nature of the decline. During the great depression, virtually every industrial nation experienced a severe contraction in production and a terrible rise in unemployment. Now, the downturn is not just faced by US either. Europe especially, is facing large declines as well. Another similarity is the US President Obama began his presidency under similar challenges as President Roosevelt faced in 1933.

Conclusion

As the economy operates in cycles, intervals of economic boom are eventually followed by recessionary periods. The key determinant to the magnitude and length of such recessionary periods is the national response. The Federal Reserves response to the Great Depression has proven to be a great tool for approaching subsequent economic turmoil. It is clear that the Fed did not repeat many mistakes of the Great Depression during the most recent recession.

Vincent Williams-Savery ID No. 000661906

The Depression demonstrated how the collapse of a banking system and severe deflation can wreck an economy. The lessons are that central banks must respond to financial crises that threaten the macro economy, and that price stability should be the paramount objective for monetary policy because of the harm that deflation and inflation can do to the real economy

Vincent Williams-Savery ID No. 000661906

Reference list

Ahamed, L. (2010), Lords of Finance: 1929, The Great Depression, And The Bankers Who Broke the World, Windmill Books Bloomfield, A.I. (1950,) Capital Imports and the American Balance of Payments, 1934-1939, University of Chicago Press Chapman, T. L., Monetary Failures of the Great Depression, The Park Place Economist, Vol. III Friedman, M., and Schwartz A. J. (1963), A Monetary History of the United States, 1867 1960, Princeton University Press Galbraith, J. K. (1954), The Great Crash 1929, Penguin Press Romer, C. D. (1992) What Ended the Great Depression?, The Journal of Economic History, Vol. 52 No. 4, pp757-784 Wheelock, D. C., (1998), Monetary Policy in the Great Depression and Beyond: Source of the Feds Inflation Bias, published in The Economics of the Great Depression, ed. Mark Wheeler, Kalamazoo, Michigan: W.E. Upjohn Institute for Employment Research Wheelock, D. C., (2010) Comparing the Federal Reserves Responses to the Crises of 19291933 and 2007-2009, Federal Reserve Bank of St. Louis Review, March/April 2010, pp 89-107 Zandi, M. and Blinder, S., (2010) Stimulus Worked, Journal of Finance & Development, December 2010, pp 14-17 http://www.pbs.org/wgbh/americanexperience/features/timeline/rails-timeline/ November 19th 2011

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http://www.investopedia.com/articles/economics/08/cause-of-great-depression.asp#axzz1 fDXDqHtM , November 19th 2011

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