two major economic slumps since World War I

Introduction

Since World War I, the globe has seen two significant economic downturns. The Great Depression was the modern world’s longest financial disaster. It began around October 29th, 1929 and lasted until the commencement of World War II in 1939. (Temin 301). Until the end of 2007, the Great Depression was by far the greatest and longest economic catastrophe in modern history. The subsequent economic crisis equivalent to the Great Depression happened in the late 2000s, specifically between December 2007 and June 2009. (Roberts 1). It would be known colloquially as the Great Recession. The great depression and the great recession were undoubtedly similar in multiple ways. This paper aims at comparing these two great economic crises by highlighting their similarities. This paper answers the question ’How similar were the failures of the financial markets during the great depression and the great recession?’ Some of these similarities are discussed below.

Actions by the Federal Government

The government has a significant role to play in regulating and influencing the financial sector in many ways. Initially, before the great depression, the government believed in a Laissez-faire attitude. Laissez-faire implies the deliberate absence of government regulation. The lack of government involvement within the stock market, while it made decisions outside the stock market which affected the direction which it took, had significant impacts in the great depression. Though the government introduced regulation to guide the stock markets after the great depression, its direct involvement would highly influence the great recession. The discussion below compares the government involvement consequences on the great depression to the great recession.

First of all, the causes of both financial crises were similar.

Though the US federal governments always point fingers to Wall Street each time they are faced with a financial crisis, they(the governments) are to a great extent to blame for instantiating these economic failures. Before the great depression, the Federal Reserve had artificially kept interest rates low. Low interest rates often lead to a boom, since the buyers of property, for instance, are attracted to borrowing, which is offered at affordable terms (Rothbard 12). By 1929, the US government had anticipated this boom. In an attempt to prevent the resulting boom, therefore, the government raised interest rates. The high interest rates meant that investors were not in a position to easily acquire credit which they may have used towards investments. The resulting effect would be a decrease in investment. Furthermore, with increased interest rates, households who had already acquired credit facilities like mortgages experienced a reduction in their wealth and thus could not spend extravagantly on normal consumer products and rather concentrated on paying back the loans as well as accumulating personal savings. The result would be the piling up of produced consumer goods, which would in turn force the companies to lay off workers (in a bid to decrease output) and significantly reduce the wages of those who were lucky enough to retain their jobs. The government action in an attempt to alter the course of the great depression is sometimes viewed by scholars and economists alike as counterproductive. The controversial Smoot-Hawley Tariff, signed into law by President Hoover in 1930, stifled trade between the US and the rest of the industrialised economies. Irwin notes that in the two years following the Smoot-Hawley tariff, US imports fell by over 40% (330).

As regards the great recession, government policy had a huge role to play. The government in the 1990s was pushing for homeownership to a great extent. Financial institutions started marketing Mortgage-Based Securities (MBS) at unprecedented levels, even to people who were not creditworthy. Managers at the Wall Street rode on this wave and, in their greedy pursuit of profit, developed financial products which required very little security backing, or which relied on security which had in itself been acquired in credit terms. The collapse of the housing market in 2007 led to a loss of wealth by most consumers, hence cutting down on spending. This in result led to the collapse of business investment and eventually massive job losses and salary cuts.

Massive Federal Spending

Government intervention was necessary to get the economy out of a looming collapse in each of the financial crises. The government implemented measures to curb a further collapse of the financial system once the economic crunch had started. One of the measures that are available for governments is an increase in federal spending. In fact, this was one of the measures that the government opted for in both economic meltdowns. The discussion on how each government increased its spending in the looming economic crisis follows.

When faced with a looming economic crisis, both governments responsible reacted much in the same way, by increasing government spending. During the great depression, President Hoover put the public spending to a record high. The welfare program and the large scale federal farm program led to budget deficits and a 25% joblessness (Wilson 575). Roosevelt, who took over from Hoover in 1932, further complicated the problem. Roosevelt started the Agricultural Adjustment Program and expanded his predecessor’s Reconstruction Finance Corporation (Skocpol, Theda and Kenneth 255). The Reconstruction Finance Corporation was set up to provide large sums of money as bailouts to collapsing financial institutions and other corporations.

The Obama administration, in dealing with the great recession, reacted in the same way as the Hoover and Roosevelt government during the great depression. President Obama concentrated on a few interest groups during the great recession, implementing stimulus packages that sent federal funds to various states and cities within the entire US country. Additionally, the Obama administration advocated for universal health coverage and cap-and-trade bill, two moves which could only lead to a sharp rise in the federal debt.

Massive Unemployment

The great depression and the great recession were both characterized by massive job losses. By 1933, the unemployment rates in the US had soared to a record 25% (Temin 301). The failure of major financial institutions during the great depression and the loss of confidence in the financial model led to reduced levels of spending, hence the investors and producers reacted by reducing production. The result would be that the reduced output would require fewer workers, hence the massive job losses. Industrial production declined by about 37% during the great depression (Temin 301).

The great recession was also characterized by massive job losses. The unemployment rate in the United States was at 10.1% by October 2009 (Karahan, Fatih and Serena 1). Between the late 20th century and the beginning of the great recession, the US household was spending on a massive scale, leading to a rise in household debt. This is what set the time for the great recession. The increasing buying power of the American fueled the rise in house charges, which in turn generated more home equity, hence more borrowing. Eventually, interest rates rose and refinancing stalled. At this point many homeowners rushed to sell. Home prices started falling and lenders were worried that creditors would default, hence they cut off any further credit. The end result was that over-extended homeowners who could not access credit would default on their mortgages. There was widespread financial panic which eventually led to the near financial collapse. Just like during the great depression, when consumers could no longer access credit, they cut their spending on most products. The producers in turn had to reduce the production of these goods whose demand had plummeted, hence a reduction in output. This in turn meant that fewer employees were needed in these production industries, hence job losses.

Increased Tax Rates

Both the great depression and the great recession were characterized by increased tax rates from the government. During the great depression, households had to keep up with increased rates both on income and excise tax. The highest mark was at 79% in terms of marginal tax. Most Americans, however, lay within the 50% tax rate (Cole, Harold and Lee 159). Entrepreneurship and capital intensive investments were also greatly affected, with the government requiring more than half of any income exceeding a set value. Due to the decreased investment by entrepreneurs, the joblessness problem was further compounded.

Similarly, the Obama administration recommended significant tax hikes, planned for the future. Some of the items that the Obama administration had recommended tax hikes on included liquor, cigarettes, plane tickets, and soft drinks. Furthermore, the many tax breaks that had been enacted under President Bush were discontinued. President Bush had implemented tax cuts on capital gains tax, income tax, and estate tax.

Market Speculation

Stock prices are usually a reflection of the performance of the company. However, stock prices are supposed to fluctuate in an unpredictable manner. This fluctuation prevents the speculation of market prices, which involves the investment in stocks or any other business hoping to gain massively. Investment in real estate, just like in stock, needs to be unpredictable. If, however, it is predictable, the amount of profits that are to be gained from these investments need to be proportional to the investments made.

Market speculation contributed immensely to both economic meltdowns witnessed before the Second World War and in the first decade of the second millennium. Stock speculation led to the collapse of the stock market in 1929. The value of stocks readily increased in the 1920s and sky-rocketed to unrealistic values which did not accurately reflect the health of the companies. The continued increase in the value of stocks created a false indication to investors that the increase would go on infinitely, but the bubble was bound to burst at some point in the future. Within the first quarter of 1929, financial experts had warned about the implications of financial institutions offering too many loans for stock speculation. Stock brokers and financial institutions were buying and selling stock without regard to their actual worth or the health of the companies. Despite some efforts by the Federal Reserve and the American Central Bank to prevent the impending disaster, the bubble eventually burst, marking the start of the great depression.

The market speculation for the home market would lead to a similar near collapse of the economic system nearly a century later. During the great recession, financial institutions were giving loans to high-risk customers without any proper security, or mostly using mortgage-based securities. The low interest rates which were prevailing at that time meant that many people would afford loans. The increased investment in the real estate sector created an impression among the American households that they were getting wealthy and could afford to procure credit based on the already existing homes. The value of property was increasing steadily and for this reason, many Americans kept investing in property, and just like in the great depression, they did not anticipate that this boom was not going to go on infinitely. When interest rates eventually started going up, financial institutions were not willing to finance the American households and there was a rush by homeowners to sell, the prices of homes plummeted, and financial institutions were in a perilous situation, unable to collect the credit from defaulting mortgaged households.

Buying On Margin

Buying on margin involves the purchasing of stocks or homes at only a fraction of the actual value. A couple of years leading to the great depression, investors were able to purchase stock provided they could put up only about 10% of the stock value. Therefore, investors could buy $10 worth of stocks by putting up only $1. If the stocks go up by a mere 10%, therefore, the investors would have doubled their investments. The amount of speculation that followed led to a wild chase for profits, with people investing their life savings into the stock market. All this was owing to the lack of proper stock market regulations, which were set up immediately after the great depression. However, it would be just a matter of time before these regulations would be highly flouted again to result in the great recession.

In the great depression, the same greed for profit and wealth drove millions of Americans to purchase homes that they could not afford, with money they did not have. These purchases were made often without making any down-payment. Often, in fact, these consumers received 100% or more credit to finance their purchase. Therefore, just like in the great depression, most homeowners did not need to have any funds in order to invest. In case that the source of credit was no longer available, as eventually was the case, these real estate investors would be left without any leverage through which they would finance their mortgages. The banks who had offered the risky loans pulled out and also ran the risk of not receiving payments which they had advanced to the homeowners, risking their own existence in the process.

Bank Crisis

Banks rely on the interests they attract from lending out to creditworthy clients for profits. Furthermore, they invest the deposits that they receive from their clients. For this reason, in case a huge sum of bankers decide to withdraw their payments concurrently, the bank will not be in a position to honor these requests. Lending to uncreditworthy clients can also lead to the collapse of a bank, as these clients have a higher probability of defaulting on their loan repayments as opposed to creditworthy clients.

The financial institutions that are at the center stage of controlling credit and the sale of stocks, needless to say, were highly affected by both financial meltdowns. When the stock market crashed on October 29, 1929, depositors panicked and started withdrawing their money at levels never before witnessed. This led to a vicious cycle that further plunged the economy into chaos. As millions of Americans withdrew their monies, banks started collapsing, and as more banks failed, the more withdrawals were made on other banks, leading to their collapse as well. By 1933, more than 11,000 of the 25,000 banks in America had collapsed (Croft Communications, Inc.).

Similarly, in the great recession, banks were failing, but this time it was majorly due to their poor lending practices. Lehman Brothers went bankrupt and tens of other banks were on the brink of doing so, were it not for government intervention. AIG, Merrill Lynch, Fannie Mae, HBOS, Royal Bank of Scotland, Bradford & Bingley, Freddie Mac, Fortis, Alliance & Leicester, and Hypo all were at the precipice, and the government had to inject trillions of dollars to save them from collapsing and dragging the entire modern economic systems with them. These were the big banks that the government considered ’Too big to fall’. The smaller banks had to face the financial meltdown on their own and eventually between January 1, 2005, to December 31, 2013, 492 banks have been reported to have failed (Antoniades 4).

Loss of Consumer Confidence

Consumer confidence refers to the general outlook by the consumer population regarding the economy. It can either be optimistic or pessimistic. An optimistic consumer confidence leads to significant and unrestrained spending by the general population, whereas a pessimistic outlook by the consumers leads to a decline in spending by consumers. The loss of consumer confidence, thus, leads to a negative view of the financial system and hence reduced spending on consumer products by the general population.

The great depression and the great recession are similar in that both of them led to the loss of consumer confidence in the financial system. This was detrimental to the system as it further plunged the economy into disarray. The great depression sent shockwaves across the stock market and in the process millions of investors were wiped out (History.com). What followed was a sharp decline in consumer confidence. Without consumers purchasing the products which were at this point being overproduced, the output of companies had to go down, and as a result, workers were laid off, in turn leading to massive unemployment.

During the great recession, a similar loss of consumer confidence was witnessed. Employment directly supported by American spending dropped by about 3.2 million jobs between 2007 and 2010. In total, the recent economic downturn led to a loss of a total of 8.7 million jobs (United States Department of Labor). The great recession led to a sharp decline in consumer spending, owing to the lack of confidence in the financial system, declining access to credit, and reductions in wealth. Most Americans chose to conduct personal savings as opposed to spending the little money that was accessible to them on consumer products.

Conclusion

The great depression witnessed before the Second World War and the great recession which started in late 2007 up to 2009 had many similarities. This paper aimed at analyzing the similarities between these two financial crises. Some of the similarities that have been discussed include actions by federal governments, massive federal spending, massive unemployment, increased tax rates, market speculation, buying on margin, bank crises, and finally, a decline in consumer confidence. These issues have been discussed in depth and laid side by side between the great depression and the great recession.

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