Lessons from the Great Depression

Anish Shankar Menon

March 28, 2014

AbstractThe 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 briefly 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 financial 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 first 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 financial 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

different, 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 financial 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 effects 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 reflect the workers’ willingness to work, the

capacity of production in the economy or the desires for consumer durables.

It reflected instead, the failure of the system to convert the requirements of

the people into a level of spending, money demands for output, profit for

businesses to apply all available labour and existing resources and finally

investment in capital goods and services.

The first 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

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after the war, it sold debt to the US which became the world’s 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 US’s creditors.

After 5 years of the war, the gold standard was re-established. The

exchange rates were still pre-war. Countries favoured deflation rather than

devaluation of currency. Temin (1994) notes that during the beginning of

the 1930s, Britain and Germany were facing financial 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 conflict 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 deflation

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 flowing 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 tariff, the "first

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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 effects 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 tariffs"

The Tariff Act of 1930, also called the Smoot-Hawley Tariff, raised US import

tariffs 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 effects 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.

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Eichengreen (1986) observes that the Smoot-Hawley Tariff 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 beneficiaries of

the Act. He argues that the tariff had an asymmetric impact across imports.

The direct effect of the tariffs would likely have been expansionary. He says

that, if the tariff had any significant 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, it’s name also caused some concern. Though it was

an ordinary bank, people both home and abroad thought, due to it’s name,

that it was an official bank. This caused a greater panic in the economy.

An effect of this crisis was seen in the interest rates. The difference

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

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epidemic had spread to other nations as well while the economic conditions

further increased the severity of the crisis.

The culmination of the events finally 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 suffered 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 confidence in banks.

According to Calomiris and Mason (2000), in their study Friedman and

Schwartz (1993), document four banking panics. They explain that the

"contagion effect" and liquidity crisis were relatively unimportant factors in

the crisis. In the first 2 crisis as identified 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 effect. It is only in the fourth

crisis where unexplained banking failure risk is significant. 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 intensified regime of inspection, which was a delayed

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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 find that the banks that failed during

the panic were similar to the other banks that failed outside the panic window

but different from the banks that survived. They note that the characteristics

of failure were reflected 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 Tariff 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 finance 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) finds that the prices were serially correlated. He proposes

that once the deflation 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.

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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 identified 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 fixed. 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 first complete inter-continental

failure of free market economics. Europe especially Britain was still master of

a significant 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.

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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 fluctuations are a common and, in fact, a necessary feature of the

economy. It is only when the business errors cluster, do we find 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-financing 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

significant 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.

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Bank supervision is an important aspect of containing a crisis. Mitchener

(2004) studied banking regulations during the Depression period in the US. He

finds 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 it’s

regulators to liquidate banks reduced the contagion effect. However states

that offered it’s 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 financial 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 affect all countries

uniformly. According to Cassis (2011), there was a major difference 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,

Crédit 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 financial transactions from atleast 25 years prior to WWI.

As noted earlier the arrangement collapsed during the WWI and it’s successor

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proved less robust. According to Eichengreen and Temin (1997), the gold

standard was so firmly 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 affected 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 financial 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 suffered from a higher degree of deflation or were in a worse

recession, whose trading partners had abandoned the gold standard and who

suffered from a serious external loss of confidence 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)

finds that France contributed more to the global deflation of 1929-1933

by raising it’s gold reserves and effectively keeping it out of circulation.

This created an artificial shortage thus putting other countries under severe

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deflationary 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 financial shocks

caused by the bad debt issues it had with loans lent to Europe. The effects

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 financial universe controlling the standard. After the war, Britain

lost it’s 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-inflationary 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 it’s economic position

using means that are detrimental to others. They find that though individual

acts of devaluation were negative, a collective and collaborative effort 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 firms during

the Great Depression. They found that complex firms which had large boards

benefited from it’s advice. Simple firms however have a negative relationship

between firm value and board size. Interestingly, they found that simple firms

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 it’s 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 finds that in

totality, taxes did have a major effect 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 affiliates performed better than their

non-affiliated counterparts.

Bemanke (1983) studied the credit-related aspects of the financial sector-

output link. He looks at the problems of both the debtors as well as those of

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the banking sector. He finds that the crisis of 1930-33 reduces the efficiency

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, Rockoff (1998) observes that the Federal Government

of the US expanded significantly 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

affairs 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 fiscal policy

in the US. According to DeLong (1998), prior to WWI, the US did not have a

fiscal policy as it is known today. The Government borrowed during the time

of war and strove to accumulate surplus during peacetime and reduce the

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debt. However post the crisis, the government set a fiscal policy wherein tax

rates and expenditure plans in order to keep the budget in surplus but would

not interfere with the artificial stabilizers that the recession had set in motion.

In a study, Wallis and Oates (1998) find that a "regime shift" occurred during

the crisis and the federal fiscal 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 flexible policy where the President was

empowered to reach an agreement on trade and tariffs 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 flows 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 affairs. 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) find 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 finally led to a fall in output through

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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 find that areas with

concentrated land holdings had fewer banks since the landed elite had an

incentive to suppress finance and could also exercise local influence. These

areas also had fewer banks with higher interest rates and a lower loan to

value ratio. The borrowers in these areas being affluent 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 inflow 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 finally pulled up the economy.

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4 The financial crisis of 2008: Lessons from

the past

4.1 The definition of a financial crisis

What is a crisis? There are many definitions in the offering. According

to Eichengreen and Portes (1987), a financial crisis is a disturbance to the

financial markets characterized with declining asset prices and insolvency

among borrowers and financial intermediaries which spreads across the syatem

resulting in inefficient 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 financial sector from competitively engaging in dynamic

allocation of funds. This caused inefficiencies 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 financial crises finds 3 discernible characteristics of all

financial 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 significant 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 financial 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 financial 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 world’s 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 finance. Following

came the dot-com crash. Financial sector compensation had sky rocketed

creating misaligned incentives. The financial 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)

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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 reflected the risks and hence were extremely profitable. 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 financial 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 financial nervous system of the globe resulting in a large scale

meltdown.

Levin and Coburn (2011) provide a timeline of the financial 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

it’s 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

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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 significantly.

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 it’s sale to the Bank of America. On the next

day i.e., 16th September, 2008, the Federal Reserve offers $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 financial 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 Rogoff (2008), the financial crisis of 2008 is

not unique. They find significant 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 finan-

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 financial 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 financial 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 find that

credit booms are significant predictors of financial 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 financial crises but they are not caused by rising income of the

top earners in an economy. They do not find 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 financial crises. He supports the theory that credit

booms is the most viable predictor of a financial crisis.

According to Caballero (2010), the global net capital flows 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 inflow of capital in the reserve currency country’s

financial system as it underprices risk.

However Mendoza and Quadrini (2009) argue that more than half of the

net borrowing in the US non-financial sector since the mid 1980s was financed

by foreign lending. Moreover, the fall of the housing and mortgage backed

securities markets in the US had it’s ramifications all over the world.

Miron and Rigol (2013), argue that injecting money into the financial

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 financial support to failing complex institutions.

Carlson et al. (2010), believe that the Federal Reserve’s 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 effect

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) find 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

find that similar to the 1930s, there was a substantial real estate boom with

easy availability of credit and securitization. This in turn caused the financial

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 intensified financial crisis. There is a higher

23

chance that there could be a banking panic if there is financial liberalization

that there is if not. Miscalculated financial deregulation is also seen as a cause

of the 2008 crisis. According to Grauwe (2008), the efficient 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

efficient market hypothesis. In simple terms an efficient 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 efficient 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 financial 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 significant effect 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 financial effects

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 efforts 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 financial crisis

must also be on similar lines.

There are many critics of the Federal Reserve’s 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 Bernanke’s policies were reminiscent of those of President Herbert Hoover

and would ultimately fail in the long run.

In another study,Mishkin (2009) finds that the monetary policy of the

Federal Reserve has been effective during the 2008 financial crisis. He says

that a numerical target of inflation would help the Federal Reserve tackle

the crisis better. However he notes that the Federal Reserve has pushed the

limits of it’s power and could risk losing it’s 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 fixed 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 firms during the Great Depression. They

find that firms that have lower bond ratings and higher debt in 1928 are

prone to more frequent financial distress during the Depression. Firm’s did

use debt tax shields but this did not contribute significantly to the cause of

distress. Using the same methodology on a sample during the 2008-09 crisis,

they find 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 financial crisis. First, the impact of a fiscal expansion

is directly proportional to it’s scale. Second, monetary expansion is a good

way of fighting a crisis even if interest rates are near zero. Third, stimulus

should be provided for a reasonable amount of time. Fourth, both financial

and real recovery go hand-in-hand. Finally, be positive, the Depression always

ends.

6 Conclusion

The most intriguing aspect of the financial 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 fight the Great

Depression became causes of the financial 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 sacrificing 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

financial crises, we seem to have learnt almost nothing at all from them.

27

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