Lessons from the Great Depression

Anish Shankar Menon

March 28, 2014
Abstract
The Great Depression is one of the greatest failures in the history
of modern capitalism. The impact of it has been such that many
institutions and policies meant to combat it, exists to this day. The
lessons the world learnt(?) from the Depression are relevant to this
day.
This paper tries to briey examine the Great Depression and the
various aspects of it of interets to academics. It then tries to draw
lessons from it, relevant to the nancial crisis of 2008.
1 Introduction
The Great Depression could be categorized as the single greatest economic
event to hit the United States of America (US) in recent history. According
to Temin (1994) the period from the middle of 1929 to the rst few months of
1933 was characterized by an unprecedented downturn in fortunes for millions
of people. The total industrial production fell by 37%, prices went down by
33% and the real Gross National Product (GNP) declined by 30%. As a result
the nominal GNP was down by 50%. Unemployment touched an all time low
of 25% and was so severe that it remained at 15% for most of that decade.
1
In the recent past, the nancial crisis of 2008 has seen a great erosion in
wealth and value across the globe but primarily in the US and other developed
economies. This has immediately resulted in a comparison with the Great
Depression. Though the geo-political landscape in the two epochs is vastly
dierent, similarities in the economic domain resonate through both events.
The aim of this paper is to study the Great Depression and cull lessons
from it to better explain the nancial crisis of 2008. Though the focus is on
the Great Depression, the primary aim is to map similarities between the
two events and to try and explain how (if possible) the crisis could have been
averted and if not, how the eects could have been controlled.
2 The origins
The study of the Great Depression cannot be made in isolation since it is the
consequence of a complex series of socio-economic and geo-political factors.
The Great Depression was arguably the most trying time for America.
In an observation by Chandler (1970), the reduction in employment, real
output and real income did not reect the workers willingness to work, the
capacity of production in the economy or the desires for consumer durables.
It reected instead, the failure of the system to convert the requirements of
the people into a level of spending, money demands for output, prot for
businesses to apply all available labour and existing resources and nally
investment in capital goods and services.
The rst world war (WWI) began in 1914 and lasted till 1918. This was
a period of great instability in the western hemisphere and as a consequence
around the globe. Of all nations, the US was least impacted. According to
Temin (1994), Britain prior to the was was a net exporter of capital. However
2
after the war, it sold debt to the US which became the worlds largest creditor.
The war brought great economic tension in Europe. According to McEl-
vaine (2009) not only did the war reparations add insult to injury, it also
created a dangerous undercurrents of anger in Europe. Not only Britain but
Europe itself became the USs creditors.
After 5 years of the war, the gold standard was re-established. The
exchange rates were still pre-war. Countries favoured deation rather than
devaluation of currency. Temin (1994) notes that during the beginning of
the 1930s, Britain and Germany were facing nancial problems but were ill
equipped to deal with them at a policy level.
The US agriculture was doing extremely well during war times. Temin
(1994) notes that other countries who were not directly involved in the war
were doing well too. After the conict ended, there was a sharp demand
which was earlier primarily fuelled by military requirements. Another point
to note is that, European products also started appearing in the market. This
led to a fall in prices of commodities which together with rising deation
caused farmers to be trapped in debt.
In 1929, industrial production began to decline. The cause of this according
to Temin (1994) was the contractionary monetary policy in 1928 and 1929.
Both the Federal Reserve and the Bank of England tried to protect their
respective currency by choking funds owing to the markets. This caused a
stall in industrial output. Cecchetti (1997) argues that the Federal Reserve
had a role to play in every policy failure in the Depression era. One of the
main criticisms is that it failed to act as the lender of last resort when it was
supposed to.
According to Temin (1994), 4 events led to the Great Depression. These
were the stock market crash of 1929, the Smoot-Hawley tari, the "rst
3
banking crisis" and the worldwide collapse of commodity prices.
2.1 The crash of 1929
According to Galbraith (1977), the US was already facing a crisis by 1929.
The stock market was but the last economic entity hit by the events. He
explains that the economy eects the market and not vice-versa. The main
cause for the crash is attributed to unbridled speculation before the market
entered rapid decline. Some factors among many include fraudulent behaviour
by some powerful players and economic legislation that had a great impact
on the market.
Romer (1988) argues that the Great Crash of 1929 generated a temporary
uncertainty about the future income in the minds of the consumers. This
reduced their purchases of durable and semi-durable goods in 1929 and much
of 1930. This, according to her, establishes a negative historical relationship
between stock market volatility and the manufacture of consumer durables in
the pre-war era.
2.2 The Smoot-Hawley taris"
The Tari Act of 1930, also called the Smoot-Hawley Tari, raised US import
taris on over 20,000 goods. According to Irwin (1996), 2 years after the
Act was promulgated, US imports fell over 40%. He explains using a partial
and general equilibrium analysis that ceteris paribus, the direct reduction of
imports due to the eects of the Act were roughly 4-8% and in combination
with other duties it was 8-10%. The Act has gained notoreity since it was
seen as the beginning of unhealthy protectionism, which lead to worldwide
retaliatory measures and worsened multilateral trade relations.
4
Eichengreen (1986) observes that the Smoot-Hawley Tari helped form a
new coalition of small scale producer and marginal agriculturists, the 2 classes
who were the worst hit by imports and hence the greatest beneciaries of
the Act. He argues that the tari had an asymmetric impact across imports.
The direct eect of the taris would likely have been expansionary. He says
that, if the tari had any signicant macroeconomic impact, then it was likely
through the international monetary system and capital markets.
2.3 The First Banking Crisis(and subsequent events)
According to Friedman and Schwartz (1993), 256 banks with $180 million in
deposits failed in November 1930 followed by 352 banks with over $370 million
in deposits the next month. An interesting anecdote is the failure of the Bank
of United States with over $200 million in deposits which failed on December
11, 1930. Not only was it the largest commercial bank (in terms of deposit
volumes) to fail till then, its name also caused some concern. Though it was
an ordinary bank, people both home and abroad thought, due to its name,
that it was an ocial bank. This caused a greater panic in the economy.
An eect of this crisis was seen in the interest rates. The dierence
between the yields of lower grade corporate bonds and government bonds
began to widen drastically. The corporate bond yields began to rise (hence
bond prices began to fall), while the yield on government bonds began to
fall (consequently their prices began to rise). This was caused due to sale
of lower quality bonds to increase liquidity. The lower bond prices in turn
also caused a substantial dimunition in the asset portfolio values of the banks
thus pushing them towards failure.
The Second Banking Crisis began in March, 1931. In the 6 months from
February to August, 1931, commercial bank deposits fell by $2.7 billion. The
5
epidemic had spread to other nations as well while the economic conditions
further increased the severity of the crisis.
The culmination of the events nally led to the Banking Panic of 1933.
Banks were given loans by the newly established Reconstruction Finance
Corporation (RFC). Banks who were on the list of borrowers from the RFC
were interpreted as "weak". The depositors started making a run at the banks.
There was both domestic drain of deposits as well as foreign withdrawals.
Not only was currency withdrawn, gold was withdrawn too. The problem
aggravated to such an extent that by the midnight of March 6, 1933, President
Roosevelt, closed all banks till March 9th and prohibited gold redemption
and gold shipping temporarily. On the whole the banks suered from an
acute inablity to convert deposits into currency and the government in order
to control the situation made sure that depositors could not withdraw their
deposits at will. Thus the situation together with the other factors worsened
public condence in banks.
According to Calomiris and Mason (2000), in their study Friedman and
Schwartz (1993), document four banking panics. They explain that the
"contagion eect" and liquidity crisis were relatively unimportant factors in
the crisis. In the rst 2 crisis as identied by Friedman and Schwartz (1993),
there is no association with positive unexplained residual risk or liquidity
measures for forecasting banking crisis. The third crisis is ambiguous but
does not demonstrate a wide-spread contagion eect. It is only in the fourth
crisis where unexplained banking failure risk is signicant. On the whole they
argue that fundamental factors are responsible for the crisis.
Richardson and Horn (2008) empirically observe that exposure to foreign
economies did not lead to the crisis in the American banking system. They
argue that it was an intensied regime of inspection, which was a delayed
6
reaction to the failure of the Bank of United States that caused a wave of
banks being liquidated.
Calomiris and Mason (1994) study the June 1932 Chicago Banking Panic.
They divide the Chicago banks into 3 groups: panic failures, failures outside
the panic window and survivors. They nd that the banks that failed during
the panic were similar to the other banks that failed outside the panic window
but dierent from the banks that survived. They note that the characteristics
of failure were reected at least 6 months in advance in factors such as stock
prices, failure probabilities, debt composition and interest rates.
2.4 Collapse of commodity prices
One of the causes of the Great Depression has been attributed to the fall
in commodity prices especially post WWI. The Smoot-Hawley Tari has
been seen as one of the causes of this collapse. According to Hynes et al.
(2009), there was a wartime disintegration of the markets during WWI. The
markets then gradually reinegrated in the 1920s and then disintegrated post
1929. Some of the reasons they give for this disintegration include increased
transaction costs with the collapse of the pre-war gold standard and lack of
free nance for trade. However they argue that the new protectionist policies
adopted by the US and other countries in retaliation is the primary candidate
for the fall in commodity prices.
Cecchetti (1989) nds that the prices were serially correlated. He proposes
that once the deation actually began, it was expected to continue by all. He
concludes that the Depression was expected and this supports the proposition
that monetary contraction was a major cause of the crisis. Romer and Romer
(2013) propose that monetary shocks may in part have depressed spending
and output by raising real interest rates.
7
2.5 The New Deal
The President of the US at that time, Franklin Delano Roosevelt brought
forth a series of domestic measures to improve the economy, colletively called
"The New Deal". As with any crisis time measures, there are many vocal
critics of the program. Though Shlaes (2007) critizes The New Deal for among
other things, prolonging the Depression by suppressing the private sector
which would have aided recovery, she also acknowledges that without it, there
would have been no clarity or sense of direction for the nation to follow.
The Great Depression was not just caused by the aforementioned factors.
These are some of the factors clearly identied by academics as the root
cause of the problem. For example Ohanian (2009) puts the blame squarely
on president Herbert Hoover whose industrial labour program, he argues,
provided protection to industry from labour unions in return for keeping the
nominal wages xed. The wages consequently were higher than competitive
levels and became sticky in the long run.
However the crisis was caused by a multitude of factors working with each
other in a dynamic and complex interplay.
3 Studies on the Great Depression
The Great Depression has been one of the most widely studied economic
phenomenon in the world. It was perhaps the rst complete inter-continental
failure of free market economics. Europe especially Britain was still master of
a signicant part of the world and the US was the new super-power. Russia
was yet to attain the prominence it did after the second world war (WWII).
In the following sections, the paper tries to explore a few aspects of the
Great Depression that have been studied by academics.
8
There are many theories of the origin of the Great Depression. One of
them is the business cycle theory. A detailed study of the business cycle
theory has been made by Haberler (1946), who claims that business cycles
are perpetuated by governments that inject credit into the system at below
market interest rates. This was a view of the Austrian School and went
against the Keynesian school of thought. According to Rothbard (2000),
business uctuations are a common and, in fact, a necessary feature of the
economy. It is only when the business errors cluster, do we nd a depression.
According to him, the boom-bust feature of the economy is a function of
monetary intervention in the market, especially credit policies of banks. He
espouses the "time preference theory of money" and claims that a higher
lending by banks either due to accepting more deposits or by simply printing
money, will increase preference for long term investment (in capital goods).
Once the money percolates through the economy, the consumers will want
more goods that are closer to them. This shift from capital to consumer
goods in a bid to achieve the pre-nancing equilibrium will make investments
ill made and hence to be liquidated thus precipitating the crisis.
Some other causes of the Depression according to Rothbard (2000) could
include overproduction, underconsumption, lack of good investment opportu-
nities, overoptimism and overpessimism. However these causes are not quite
signicant individually but collectively contributed to the crisis.
The banking panic during the Depression has been the focal point of many
studies. Richardson (2006a) examines empirical evidence of banking related
data during the Depression era. In Richardson (2006b), he observes that the
major causes of the panic was illiquidity and insolvency. The initial panics
were further worsened by bank runs. As asset values fell, insolvency became
the major threat.
9
Bank supervision is an important aspect of containing a crisis. Mitchener
(2004) studied banking regulations during the Depression period in the US. He
nds that the states whose laws mandated higher capital adequacy saw fewer
suspensions. However states that prevented branch banking and higher reserve
ratios faced more suspensions. He also found that states that empowered its
regulators to liquidate banks reduced the contagion eect. However states
that oered its regulators a longer term and made it the only enity authorized
to issue bank charters experienced higher bank suspension rates.
Clearing and settlement, a key function of nancial intermediation stopped
functioning properly during the Great Depression. Richardson (2006c) studied
the correspondent clearing systems during the crisis times. According to him
between 1913, when the Federal system was found, to the depression of
the 1930s, 3 cheque-clearing systems functioned in the US. The accounting
conventions did not report the correct reserves available to individuals and the
system as a whole, hence these clearing systems were vulnerable to counter-
party risks. When in November, 1930, 1 of the correspondent system failed,
taking down with it hundreds of institutions and acting as the epicenter of
numerous bank runs, thus adding to the severity of the crisis.
Another interesting feature is that the crises did not aect all countries
uniformly. According to Cassis (2011), there was a major dierence between
the banks in Britain and France on one hand and the US and Germany on the
other. The clearing banks in Britain and the major deposit bank in France,
Crdit Lyonnais did not do badly during the Great Depression.
The gold standard had an important role to play in the Great Depression.
According to Eichengreen (1995), the gold standard was the basic framework
for all international nancial transactions from atleast 25 years prior to WWI.
As noted earlier the arrangement collapsed during the WWI and its successor
10
proved less robust. According to Eichengreen and Temin (1997), the gold
standard was so rmly embedded in the minds of the leaders post WWI that
they could not let it go. In 1931, plagued by banking panics, Austria and
Germany put in controls prohibiting conversion of currency into gold. The
crisis soon aected Britain, France and the US. The US abandoned the gold
standard in 1933 while France did the same in 1936.
The collapse of the gold standard is seen as a cause of the Great Depression.
It is argued that as long as it was in place, the Depression would have been
just another cyclical anomaly that would have turned in due course. However
once the gold standard fell, capital was being pulled to safety which questioned
the liquidity and solvency of many nancial institutions thus bringing about
an economic collapse.
A question that arises is why did countries exit the gold standard. Ac-
cording to Wolf and Yousef (2005), the reasons were primarily economic.
Countries that suered from a higher degree of deation or were in a worse
recession, whose trading partners had abandoned the gold standard and who
suered from a serious external loss of condence were more likely to abandon
the gold standard.
Kindleberger and Aliber (2005) attribute the declines during the Great
Depression to an instable credit system. Funds were channeled to call money
markets from consumption and production during the peak of the stock
market. The crash of the stock market caused the credit system to freeze,
resulting in a huge credit crunch.
Studying the Depression from an international perspective, Irwin (2010)
nds that France contributed more to the global deation of 1929-1933
by raising its gold reserves and eectively keeping it out of circulation.
This created an articial shortage thus putting other countries under severe
11
deationary pressure.
It has been argued that international credit relations in addition to the
abandonment of the gold standard contributed to the crisis. However Richard-
son and Horn (2007) observe that the gold standard was a primary cause.
The US banking system they argue was capable of bearing nancial shocks
caused by the bad debt issues it had with loans lent to Europe. The eects
of the debt are coincidental and not direct.
According to Bemanke and James (1991), the failure of the post WWI gold
standard was that during the prewar standard, Britain was at the absolute
centre of the nancial universe controlling the standard. After the war, Britain
lost its dominant position and America, the new economic superpower was
not experienced to shoulder this responsibility.
In a study McCallum (1989) argues that a rule whereby the monetary
base was set in such a way as to keep the nominal Gross Domestic Product
(GDP) growing at a steady non-inationary rate could have prevented the
crisis.
Bordo and Eichengreen (1998) argue that the Great Depression did not
radically alter the development of the international monetary system, but
rudely interrupted it. According to them, the crisis was pivotal in setting
up of the International Monetary Fund (IMF) and the institutionalization of
monetary policy.
Currency devaluation received a lot of attention in Depression studies.
According to Eichengreen and Sachs (1984), it was either ignored or condemned
for spreading a crisis where one country tries to remedy its economic position
using means that are detrimental to others. They nd that though individual
acts of devaluation were negative, a collective and collaborative eort in
devaluation was not only positive but could have hastened the recovery from
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the crisis.
Corporate governance during the Great Depression is another area of
study. It seems quite logical to see how the Boards functioned in the time of
crisis. Graham et al. (2011), study the board characteristics of rms during
the Great Depression. They found that complex rms which had large boards
beneted from its advice. Simple rms however have a negative relationship
between rm value and board size. Interestingly, they found that simple rms
do not reduce the board size even in the time of crisis and were prone to
using more debt. In a study, Lamoreaux and Rosenthal (2006) observe that
the Great Depression in its aftermath improved the rights of the minority
shareholders through various statutes and precedents. This, they claim, is
one of the reason why corporations increased relative to partnerships.
Tax policies play an important role in an economy. McGrattan (2010)
studies US capital taxation during the Great Depression. She studies the
impact of various taxes using a general equilibrium model and nds that in
totality, taxes did have a major eect on the crisis, predominantly taxes on
dividends.
An important development in banking as a result of the Great Depression
was the seperation of commercial and investment banking businesses. The
Glass-Steagall Act of 1933 prevented commercial banks from undertaking
functions that are typically in the domain of investment banks. However
Kroszner and Rajan (1994) found that not only was there no positive impact
of this change but in some ways the impact was negative. They found that
the securities underwritten by the bank aliates performed better than their
non-aliated counterparts.
Bemanke (1983) studied the credit-related aspects of the nancial sector-
output link. He looks at the problems of both the debtors as well as those of
13
the banking sector. He nds that the crisis of 1930-33 reduces the eciency
of credit allocation. This results in increased costs and lower availability of
credit which exercises downward pressure on aggregate demand.
According to White (1998), deposit insurance has been one of the most
enduring innovations of the Great Depression. According to him, deposit
insurance did not reduce losses from bank failures. However it distributed
the losses among all depositors rather than a few. This meant, though costs
were very high, at an individual level, it was almost nil. This feature made
deposit insurance an innovation that has lasted to this day.
Another lasting impact of the Great Depression was social security. Ac-
cording to Miron and Weil (1998), the social security mechanism has changed
in response to the changing times. The Great Depression has not made a
lasting impact on it. However the old age insurance and old age assistance
that were creatd during those times would not have existed had the crisis not
occurred. According to Baicker et al. (1998), the unemployment insurance
also is an enduring legacy of the Great Depression.
In another study, Rocko (1998) observes that the Federal Government
of the US expanded signicantly during the Great Depression. The imple-
mentation of the New Deal meant that the bureaucracy would needed to
enlarge itself. In a way it also moved away from a capitalist ideology where
the government was thought to have little or no role to play in the economic
aairs of the nation to one where the government was to be an important
agent in admiistering socially relevant programs that coincided with the
economic domain. Similarily the crisis also brought about a clear scal policy
in the US. According to DeLong (1998), prior to WWI, the US did not have a
scal policy as it is known today. The Government borrowed during the time
of war and strove to accumulate surplus during peacetime and reduce the
14
debt. However post the crisis, the government set a scal policy wherein tax
rates and expenditure plans in order to keep the budget in surplus but would
not interfere with the articial stabilizers that the recession had set in motion.
In a study, Wallis and Oates (1998) nd that a "regime shift" occurred during
the crisis and the federal scal share increase by about 9 percentage points.
The crisis brought about a shift in trade policy too. According to Irwin
(1998), the US saw a shift in trade policy from one that was determined by
the Congress and was rigid to a more exible policy where the President was
empowered to reach an agreement on trade and taris on his own accord.
The Great Depression also resulted in the impairment of capital mobility
which was to last over half a century. Obstfeld and Taylor (1998) study the
long term capital ows with the crisis as a backdrop. They observe that
the gold standard was an epitome of free market laissez-faire economics.
However the gold standard crumbled with the crisis. Keynesian economics
then held sway with a larger role for the government in economic aairs. The
government realized that an open market which aims to bring about both
exchange rate stability and domestic employment or growth objectives was
incompatible. If during the prewar era, monetary stability was the focus, post
Depression, growth occupied the place of importance in the national agenda.
Hence the monetary system after the crisis was controlled with capital account
restrictions and pegging of currencies.
The Great Depression also brought in a large scale unionization of Amer-
ican blue collar workers. In a study, Freeman (1998) locked in several leg-
islations that provided the framework to establish labour unions in the US.
Bemanke and Carey (1996) nd that wage stickiness increased in the Depres-
sion period. The nominal wages adjusted at a sluggish pace in comparison
to the falling prices. This stickiness nally led to a fall in output through
15
increased real wages. According to Christiano et al. (2004), the slow pace at
which the economy recovered, could be in part due to the increased market
power of the workers.
According to Libecap (1998), the Great Depression changed agriculture
regulation in the US dramatically. He observes that agriculture, an area where
the lines between public and private are blurred, changed focus from public
distribution i.e., transfers to the public to controlling supplies and purchases
by government which raised prices. The crisis created the regulatory structure
through which these policies were implemented and still continue.
Rajan and Ramcharan (2009) study the relationship between land holdings
and credit availability during the Depression era. They nd that areas with
concentrated land holdings had fewer banks since the landed elite had an
incentive to suppress nance and could also exercise local inuence. These
areas also had fewer banks with higher interest rates and a lower loan to
value ratio. The borrowers in these areas being auent were less riskier than
their counterparts where land concentration was low and there were a higher
number of banks.
Finally, what ended the Great Depression? According to Romer (1991),
the aggregate demand stimulus post the Depression was a primary cause of
ending the crisis. There was a huge inow of gold in the mid and late 1930s.
This resulted in a fall in real interest rates which encouraged investment and
spending in consumer durables which nally pulled up the economy.
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4 The nancial crisis of 2008: Lessons from
the past
4.1 The denition of a nancial crisis
What is a crisis? There are many denitions in the oering. According
to Eichengreen and Portes (1987), a nancial crisis is a disturbance to the
nancial markets characterized with declining asset prices and insolvency
among borrowers and nancial intermediaries which spreads across the syatem
resulting in inecient capital allocation.
Financial crisis is a cyclical event in some sense and will occur at intervals.
For example according to Allen and Gale (2007), the Great Depression was seen
as a merket failure. The government intervened with policy measures. Primary
among these is the control of allocation of funds. This was possible through
various state owned industries and a highly controlled banking sector. However
this disabled the nancial sector from competitively engaging in dynamic
allocation of funds. This caused ineciencies which led to deregulation.
According to Stiglitz (2010), growth during deregulation was fuelled by a
mountain of debt which would fall someday. In the end, the crisis returned.
Financial crises are often long term phenomenon. According to Reinhart
(2012), who studied nancial crises nds 3 discernible characteristics of all
nancial crises. First, there is a deep and prolonged asset market collapse.
Real housing prices declines an average of 35% over 6 years. Second, there is
a signicant fall in output and employment. The unemployment rises over
7% in the down-phase of the cycle and lasts for 4 years. Finally, the value of
government debt explodes.
The nancial crisis of 2008 brings about constant comparison with the
Great Depression. This paper tries to examine some of the reasons as to why
17
the Great Depression is still relevant in the modern day.
4.2 How did it start?
The following section provides a short introduction of the 2008 nancial crisis.
The main sources for this section are 2 reports. One is the Financial Crises
Enquiry Report: Final Report of the National Commission on
the Causes of the Financial and Economic Crisis in the United
States (Angelides et al. (2011)) and the other is the Wall Street and
the Financial Crisis: Anatomy of a Financial Collapse (Levin and
Coburn (2011))
According to Angelides et al. (2011), the ground for the crisis was set much
earlier. There was vulnerability in the commercial paper and repo markets.
The funding through the shadow banking system had grown rapidly. There
was a crisis in the "thrifts" system or what is known as the savings and loan
system. Here came the role of Fannie Mae and Freddie Mac which were the
largest players in the mortgage market. According to Acharya et al. (2011)
they were run like the worlds largest hedge funds. Securitization came up in
a big way. This ushered in an era of "structured products". There was a huge
growth in derivative instruments. Then deregulation came up in a big way
with the repeal of the Glass-Steagall Act. There was the fall of "Long Term
Capital Management" a fund managed by the geniuses of nance. Following
came the dot-com crash. Financial sector compensation had sky rocketed
creating misaligned incentives. The nancial sector was over leveraged.
All this was followed by the sub-prime lending. Aided by the Government,
these institutions began lending to borrowers with dubious credit histories.
The loans were then securitized and bundled into extremely complex products
and sold to investors across the globe. The Credit Rating Agencies (CRAs)
18
whose job it was to ascertain the quality of these products gave misleading
ratings.
The housing bubble was waiting to burst. Yet it was fuelled by populist
politics and an apathetic Federal Reserve. The interest rates on sub-prime
loans reected the risks and hence were extremely protable. The capital
adequacy for sub-prime lenders were grossly inadequate. The market came up
with a new mechanism to "manage" risk, the Credit Default Swaps (CDOs).
Many a time these instruments were cross transacted making the system
extremely vulnerable to a crisis. All this boiled down to funding problems in
2007 where the institutions did not have enough funds to continue operations.
By late 2007 and early 2008, the crisis had set in. Bear Stearns collapsed
and so did Lehman Brothers. The Government intervened. They found some
institutions were "Too Big To Fail" (TBTF). (According to Labonte (2013)
"Too Big To Fail" institutions are those that policymakers believe whose
failure would cause irreparable damage to the overall nancial system due to
their size, interconnectedness or both.) The complex linkages in the system
ensured that the fall of the large organizations sent shock waves coursing
through the nancial nervous system of the globe resulting in a large scale
meltdown.
Levin and Coburn (2011) provide a timeline of the nancial crisis. The
crisis according to the report started in December, 2006 with the bankuptcy
of Ownit Mortgage Solutions. On February 27, 2007, Freddie Mac announces
its decision not to buy the most risky sub-prime mortgages. On March 7,
2007, the Federal Deposit Insurance Corporation (FDIC) announces a "cease
and desist" order against Fremont for unsafe banking. On April 2, 2007, New
Century declares bankruptcy. 2 Bear Stearns sub-prime hegde funds collapse
on June 17, 2007. On July 10 and 12, 2007, CRAs announce mass downgrades
19
of hundreds of Residential Mortgage Backed Securities (RMBS) and CDOs.
This is followed by the bankruptcy of American Home Mortgage on August 6,
2007. On August 17, 2007, the Federal Reserve acknowledges that the market
conditions have worsened and the downside risks have increased signicantly.
On 31st of the same month Ameriquest Mortgage stops operations. On 12th
December, 2007, the Federal Reserve establishes Term Auction Facility to
provide bank funding. In January, 2008 ABX stops issuing new sub-prime
indices. On the 11th of January, 2008, Countrywide announces sale to Bank
of America. On January 30th, Standard & Poor (S&P) downgrades or places
on credit watch over 8,000 RMBS and CDO securities. On March 28, 2008,
Federal Reserve Bank of New York helps help JPMorgan Chase acquire
Bear Stearns by forming Maiden Lane I. On May 29th, the shareholders
of Bear Stearns approves sale. On July 11th, the FDIC seizes the failed
IndyMac Bank. On July 15, 2008, the Securities Exchange Commission (SEC)
prohibits the naked short selling of certain stocks. On September 7th, the
US Government takes over Fannie Mae and Freddie Mac. On the 15th of
the same month, Lehman Brothers declares bankruptcy. On the very same
day Merrill Lynch anounces its sale to the Bank of America. On the next
day i.e., 16th September, 2008, the Federal Reserve oers $85 billion credit
line to AIG. On the same day the Reserve Primary Money Fund Net Asset
Value falls below $1. On the 21st of September, 2008 both Goldman Sachs
and Morgan Stanley convert to bank holding companies. On September 25th,
2008, WaMu fails, is seized by the FDIC and sold to JPMorgan Chase. On
October 3rd, 2008, the Congress and President George W. Bush establish
the Troubled Asset Relief Program (TARP). On the 12th of the same month,
Wachovia is sold to Wells Fargo. On the 28th of October, U.S. uses TARP to
buy $125 billion in preferred stock at nine banks. Finally on November 25th,
20
2008, the Federal Reserve buys the assets of Fannie Mae and Freddie Mac.
The 2008 nancial crisis is considered as the greatest economic catastrophe
to hit the US post the Great Depression. According to Brunnermeier and
Oehmke (2012), post the Great Depression, the banking panics in the US
had become a rare event due to the creation of the Federal Reserve and the
deposit insurance system. Hence the 2008 crisis was one that shook not only
the US but also the world.
According to Reinhart and Rogo (2008), the nancial crisis of 2008 is
not unique. They nd signicant qualititative and quantitative similarities
between the 2008 crisis and 18 other crises after WWII.
There are quite a few lessons learnt from the Depression that can be
applied to the 2008 crisis.
5 The Great Depression and the 2008 nan-
cial crisis: Parallels
A major common factor in both the Depression and the 2008 crisis is the
lack of oversight by regulators. Prior to the Great Depression, the economy
was not quite well regulated. Similarily in the case of the 2008 crisis, many
products were not regulated. According to Kwak and Johnson (2010), the
structured products were largely insulated from regulation. This caused an
unbridled proliferation in these toxic assets.
The TBTF theory is another example of how money pumped in at uncom-
petitive rates can jeopardize the nancial system. According to Kwak and
Johnson (2010), the Government provided capital to banks to improve their
adequacy and get them to invest. However the rates at which these loans were
provided were extremly low and uncompetitive. This is sure to have damaging
21
consequences. This brought in the belief that the government would bail out
large nancial institutions which would create even more incentive incompata-
bility. Schularick and Taylor (2010) study money, credit and macroeconomic
indicators of 14 developed countries for the period 1870-2008. They nd that
credit booms are signicant predictors of nancial crises. Moreover according
to Acharya et al. (2009), the regulators focussed more attention on individual
institutions rather than systemic risk, which was done in both crises.
Rajan (2010), argues that one of the causes of the credit booms was
risisng inequality. The inequality between the rich and the homeless poor
grew so stark that the gvernment intervened by providing home loans at
very cheap interest rates. However Bordo and Meissner (2012) provide an
empirical counter-argument. They argue that credit booms do increase the
probability of nancial crises but they are not caused by rising income of the
top earners in an economy. They do not nd evidence to suggest a nexus
between inequality, credit and crises.
Another important similarity in the 2 crises are the global imbalances.
However Taylor (2012) argues that historically global imbalances have not
been a major factor in a nancial crises. He supports the theory that credit
booms is the most viable predictor of a nancial crisis.
According to Caballero (2010), the global net capital ows had the impact
of stabilizing the US. He attributes the cause of the imbalance to the insatiable
appetite for the countries across the globe for safe assets. Hence these countries
turned to the US in the time of crisis. The US had created an securities
that were safe by securitizing lower quality ones. The crisis started when this
complex structure started to crumble.
According to Priewe (2010), global imbalnces are also caused due to the
use of the US Dollar as the key reserve currency by the global economy
22
which uses it for both national and global purposes. There is a moral hazard
problem when there is inow of capital in the reserve currency countrys
nancial system as it underprices risk.
However Mendoza and Quadrini (2009) argue that more than half of the
net borrowing in the US non-nancial sector since the mid 1980s was nanced
by foreign lending. Moreover, the fall of the housing and mortgage backed
securities markets in the US had its ramications all over the world.
Miron and Rigol (2013), argue that injecting money into the nancial
system by the central banks has costs especially the moral hazard problems.
They note that the Federal Reserve relied on research done on the Great
Depression to justify their nancial support to failing complex institutions.
Carlson et al. (2010), believe that the Federal Reserves intervention halted
the speed of the banking panic by infusing liquidity into the system. However
they empirically observe that bank failures did not have as much of an eect
in perpetuating the Great Depression as earlier believed and that if failures
have a modest cost then such institutions should be allowed to fail.
Almunia et al. (2010) nd 2 interesting parallels between the events. There
was a global decline in manufacturing 12 months following the peak, in 2008,
which was as severe as in the 12 months following the peak in 1929. They
nd that similar to the 1930s, there was a substantial real estate boom with
easy availability of credit and securitization. This in turn caused the nancial
pressure to accumulate. Similar to the Depression era, global excesses were
allowed to accumulate. There was also a sudden shift in market expectation
which resulted in a sharp fall in equity prices. As a consequence there was
widespread uncertainty and dampened spending.
High international capital mobility, according to Reinhart (2012), are
events that have repeatedly intensied nancial crisis. There is a higher
23
chance that there could be a banking panic if there is nancial liberalization
that there is if not. Miscalculated nancial deregulation is also seen as a cause
of the 2008 crisis. According to Grauwe (2008), the ecient market paradigm
made policy makers forget the lessons of the Great Depression and deregulated
banks with acts such as repealing the Glass-Steagall Act. He observes that
bubbles and crashes are an endemic feature in capitalist countries and the
deregulation exposed the banks balance sheets to these vagaries resulting
in a crisis. Cooper (2008) makes a very interesting argument against the
ecient market hypothesis. In simple terms an ecient market is one in
which the asset prices are correct at any given time. However, he argues, it is
very strange that when the asset prices fall, the prices are said to be incorrect
and institutional intervention is deemed necessary. According to Roubini
and Mihm (2011), with the repeal of the Glass-Steagall Act, banks that had
access to both deposit insurance and the Federal Reserve began undertaking
activities akin to gambling. Another impact of the ecient market syndrome
was the decision to leave all economic activities to the market. According
to Rajan and Ramcharan (2009), the Federal Reserve did not intervene in
housing prices since it thought the market can determine equilibrium prices
as well as any central banker.
The impact of real estate prices is important in both the Great Depression
as well as the 2008 nancial crisis. According to White (2009), the real estate
boom in 1920s and bust in 1926 is similar in magnitude to the boom and
bust that was a cause of the 2008 crisis. Both the booms were followed by
securitization, lowering credit standards and weak supervision. However the
earlier crash did not cause a failure of the banking system. The recent crash
had a signicant eect on the banking system due to deposit insurance and
the "TBTF doctrine. According to Shull (2010), the "TBTF" principle was
24
embedded in the system because of career interests of regulators and the belief
that some institutions, beyond systemic risk, are of national importance.
Brocker and Hanes (2013) empirically observe that the ownership and
value of homes fell and foreclosures were higher in cities that experienced the
most construction during the boom of the 1920s. The boom in the mid 1920s
contributed to the Great Depression through the wealth and nancial eects
in falling housing prices. They observe a similarity in this pattern in the
cross-section of metropolitan cities in 2006. According to Shiller (2008), in
the 1920s though there were no institutions to prevent eviction of borrowers
in case of default on their home loans, the eorts made by the leaders to
change the institutional structure helped prevent loss of homes and aided
recovery. He proposes that the policy response in the 2008 nancial crisis
must also be on similar lines.
There are many critics of the Federal Reserves reaction to the crisis.
Hummel (2011) compares the Federal Reserve to Central Planners of the early
communist states. According to him the former Federal Reserve Chairman
Ben Bernankes policies were reminiscent of those of President Herbert Hoover
and would ultimately fail in the long run.
In another study,Mishkin (2009) nds that the monetary policy of the
Federal Reserve has been eective during the 2008 nancial crisis. He says
that a numerical target of ination would help the Federal Reserve tackle
the crisis better. However he notes that the Federal Reserve has pushed the
limits of its power and could risk losing its independence.
According to Eichengreen and Temin (2010), the Gold Standard and the
Euro share many features. They argue that that the Euro is an extreme form
of a xed currency system and like the Gold Standard it is extremely useful
during good times but might worsen rapidly when a crisis ensues.
25
Another area of comparison is corporate performance. Graham et al. (2011)
study the corporate performamnce of rms during the Great Depression. They
nd that rms that have lower bond ratings and higher debt in 1928 are
prone to more frequent nancial distress during the Depression. Firms did
use debt tax shields but this did not contribute signicantly to the cause of
distress. Using the same methodology on a sample during the 2008-09 crisis,
they nd that lower bond ratings and higher debt increased the probability
of distress in this period.
Romer (2009) summarizes some of the similarities between the Great
Depression and the 2008 nancial crisis. First, the impact of a scal expansion
is directly proportional to its scale. Second, monetary expansion is a good
way of ghting a crisis even if interest rates are near zero. Third, stimulus
should be provided for a reasonable amount of time. Fourth, both nancial
and real recovery go hand-in-hand. Finally, be positive, the Depression always
ends.
6 Conclusion
The most intriguing aspect of the nancial crises is that it is never new. It
has always occured before yet we do not remember it. Another factor is
that institutions and policies are rarely dynamic. According to Bordo (2012),
most of the Depression era policies and institutions are now obsolete. For
example many institutions and policies that were introduced to ght the Great
Depression became causes of the nancial crisis of 2008. Unbridled greed is
another factor. This is aided knowingly or unknowingly by the regulators
and the government. Populist politics usually devoid of any economic logic
is followed to gain short term respite thus sacricing a long term cure, akin
26
to treating a dreaded disease with a common painkiller. It would be worth
noting that despite the tremendous amount of literature generated after each
nancial crises, we seem to have learnt almost nothing at all from them.
27
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