Casestudy US Financial Crisis is the Great Depression II in the Making

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Teaching Note ECC0025-1

Structured Assignment ECC0025-2

US Financial Crisis: Is the GreatDepression II in the Making?

Case Study Reference No. ECC0025

This case was written by Akshaya Kumar Jena under the direction of Saradhi Kumar

Gonela, Icfai Business School Case Development Centre. It is intended to be used as the

basis for class discussion rather than to illustrate either effective or ineffective handling of

a management situation. This case was compiled from published sources.

Copyright © 2008, Icfai Business School Case Development Centre

No part of this publication may be copied, reproduced or distributed, stored in a retrieval

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mechanical, photocopying, recording, or otherwise – without the permission of Icfai

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US Financial Crisis: Is the Great Depression II in the Making?

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US Financial Crisis: Is the GreatDepression II in the Making?

“The past is always a rebuke to the present.” 1

– Robert Penn Warren, Pulitzer Prize-winning Author

The US is in the thick of its most threatening financial crisis since the early 1930s, stirring terrible memories ofthose traumatic years. The month of September 2008 has become chock-a-block with a series of convulsing eventsinvolving blue-blooded Wall Street firms. The nationalisation of US’ biggest mortgage lenders Fannie Mae and FreddieMac, the fall of Lehman Brothers, the disappearance of Merrill Lynch into the Bank of America, the $85 billion federalrescue package for the insurance giant American International Group (AIG), the fire sale of Washington Mutual to JPMorgan and of Wachovia to Wells Fargo, the sudden conversion of Goldman Sachs and Morgan Stanley from glamorousinvestment banks into government-regulated commercial banks, and the extraordinary emergency confabulation ofthe current US President with the election year Presidential hopefuls have brought to mind shades of economicbreakdown of the magnitude not witnessed since the Great Depression of the 1930s.

An early feel of this impending financial turmoil was provided 6 months back in March 2008 when Bear Stearnsbuckled, necessitating its takeover by JP Morgan Chase with the help of the Federal Reserve Board. The immediatetrigger was the default on subprime mortgages; although disagreement dwells on the underlying deeper causesand also on the effects of the financial meltdown on the real economy. Some discount the possibility of a recession– let alone a full-blown depression – from the crisis in the credit markets. The basis of their argument is the fact thatnon-financial corporations are not much indebted. Many others including US policymakers, however, fear that theGreat Depression II may well neigh be in the corner, if timely rescue measures are not taken to inject confidenceinto the collapsing credit markets. Depressions or major recessions doubtless spring from cutbacks in productionas the rate of profit declines due to deficient demand, triggered by credit crunch; but the first signs of them are oftenvisible in the form of financial crises as in 1929, 1987 and 1998.

What is Depression?

Depression is broadly perceived to be a prolonged, deep phase of recession, which in turn is defined to be two ormore consecutive quarters of negative growth in GDP, often accompanied with unemployment. Whether a recessionhas reached the stage of depression is a matter of subjectivity. An oft-quoted wry remark captures the point soeffectively:A recession is when your neighbour loses his job, a depression is when you lose yours. Even the conventionaldefinition on recession looks ‘silly’,2 pointed out The Economist. It cited, as an example, that if an economy’s GDPgrows by 2% in one quarter and then declines by 0.5% in each of the next two quarters, the economy is considered tohave fallen into recession; but if its GDP declines by 2% in one quarter, rises by 0.5% in the next, then falls by 2% in thethird, the economy is deemed not to be in recession even though it is obviously weaker compared to the economy inthe first instance. There are at least four key gauges such as aggregate GDP, per capita GDP, unemployment rate and

1 “Is the US going to face a new nightmare?”, http://www.gulfweekly.com/article.asp?Sn=5927&Article=204412 “Redefining Recession”, http://www.economist.com/finance/displayStory.cfm?source=hptextfeature&story_id=12207987, September 11th 2008

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actual GDP relative to potential GDP to judge the severity of the economic downturn and on each criterion the rankingorder of the countries with respect to their economic pain may not be the same (Exhibit I).

Exhibit IFour Gauges for Judging Severity of Economic Slowdown

Source: “Redefining Recession”, http://www.economist.com/finance/displayStory.cfm?source=hptextfeature&story_id=12207987, September 11 th

2008

However, an economic downturn inflicting on the society an unemployment rate of not less than one-quarter ofthe total labour force has generally been acknowledged as a case of depression. Before the Great Depression ofthe 1929 – the benchmark of cataclysmic economic distress, any degree of economic decline was dubbed as adepression. However, to differentiate the likes of the Great Depression from smaller economic declines, the termrecession was brought to usage to refer to the latter. The US economy has fortunately not experienced this newlydefined depression since the one of 1929 that lasted for almost a decade. At the height of the Great Depression in1933, the rate of unemployment reached the traumatic level of 25.2%, which to optimists is a long way off from thecurrent level of 6.1% (Exhibit II).

The alarmists, however, point to the stark proof of the rapidly deteriorating economic situation of the US with theunemployment rate bolting from 6.1% in September 2008 to a 14-year high of 6.5% in October 2008 (Exhibit III). BillGates believes that unemployment rate may exceed 9%. And any substantial swell in unemployment will exacerbateit further in a vicious cycle.

GDP% increase since Q3 2007

GDP per person% increase since Q3 2007

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0.5 - 0 + 0.5 1.0 1.5 1.0 0.8 0.6 0.4 0.2 - 0

Unemployment rate percentage-pointchange since August 2007

GDP relative to potential output %shortfall since Q3 2007

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Exhibit IIGreat Depression of the US: 1929–1940

Source: “Nation’s Unemployment Rate Jumps to a 14-Year High of 6.5 Percent”, http://www.msnbc.msn.com/id/27591780/, November 7 th 2008

Source: Schifferes Steve, “Lessons from the 1929 stock market crash”, http: //news.bbc.co.uk/1/hi/business/7656949.stm

Exhibit IIIBolting Unemployment Rate during September–October 2008

Why Depression Occurs?

In the 1930s, when the axioms of classical economists that ‘supply creates its own demand’ and ‘full employmentis the norm in a non-interfered free market economy’ failed to match with the reality of the extant depression, in cameJ M Keynes to explain why and how recessionary pressures get built up into a capitalist economy. He postulated thata free economy can function normally only if everything produced gets sold. This happens if people spend all theirincome accruals from the production of goods on purchase of those goods or alternatively, if saving leakage fromspending stream is plugged by an equivalent measure of investment injection. If firms cannot sell all their goods

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20086.1%

Seasonally adjusted

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because of an excess of saving over investment, they react by cutting production down and laying workers off. This, inturn, causes further contractions in the market owing to deficient demand, leading eventually to a depression. Thus, anexcess of saving necessitates an offsetting demand. The Keynesian prescription to neutralise excessive saving isgovernment’s intervention in the form of lowering of tax and interest rates to encourage private spending coupled withan up-scaling of its own. Thus, grew the new age economic theory of government intervention with appropriate fiscaltools for the smooth functioning of market forces. Following the current financial crisis in the US, the Keynesian theorywill once again be put to test.

How the US Financial Crisis of 2008 Takes Hold?

The US financial crisis of 2008 has its root in another crisis – the tech bubble of the late 1990’s. When the techbubble bust in 2000 and stock market went into a tailspin, plunging the US into recession the next year, the FederalReserve executed a sharp cut in interest rates to boost the sagging economy. The US has been trying to stave off anincoming pop of a bubble or its painful aftermath by series of drastic cuts in the interest rate, which is at the root of thebubble. This systematic succession of cuts in the cost of credit has led to an extended bubble, the implosion of whichhas got to be more severe. The Fed rate, for example, stood at 6% at the outset of the year 2001, after a successionof 11 cuts, it has come down to a mere 1% in 2003.3 These lower interest rates made mortgages cheaper. Consequently,the demand for homes began to swell, sending prices up. As housing prices kept on rising, the risk on the mortgageswent down on the perception that default on the part of the borrowers leading to foreclosure would not put the lendinginstitutions to any loss in a scenario of ever soaring house prices. Added to it was the development of securitisation ofmortgages, which obviates the need for the banks to hold the loans on their balance sheet, which would have burdenedthem with restricted ability to lend further. At the same time, the banks earn the fees for originating the mortgages.They, therefore, became lax in sticking to procedures pertaining to credit worthiness of borrowers and started givingNo Income, No Job or Assets (NINJA) loans as Asset-Backed Securities were created in huge amounts (Exhibit IV).

Exhibit IVAsset-Backed Securities of US (in $ trillion)

Source: “A Short History of Modern Finance: Link by Link”, http://www.economist.com/displaystory.cfm?story_id=12415730, October 16 th 2008

Securitisation gave rise to Collateralised Debt Obligations (CDOs) and other sophisticated instruments backed bycomputer-aided financial mathematics, which slice the various debts and remix them into different packages of bondsfor resale as per investors’ appetite for risk. When homeowners make their monthly installments, these are passedthrough to ultimate investors as interest payments on their bonds. Investors were happy since CDOs yielded morethan government bonds while at the same time considered as safe as treasury bonds, thanks to the often high ratings

3 “Global Credit Crunch – Towards a Crisis of Globalisation”, http://www.fifthinternational.org/index.php?id=259,1303,0,0,1,0, Autumn 2007

2.5

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*upto end June1995 ’97 ’99 2001 ’03 ’05 ’07 ’08*


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by the rating agencies. This business was supported by the authorities as a means of spreading risk, for they representedclaims on a diversified group of borrowers. Simultaneously, Credit Default Swaps (CDSs) were invented to insure, fora premium, against the risk of default on debt obligations. Thus, potentially high-risk subprime mortgages were insured,turning them into most trusted income generators. The greed of earning a lot in the gamble of betting on default led toexplosive growth of CDS. From 2001 to 2007, the volume of CDS kept on expanding almost doubling each year(Exhibit V). Gramm-Leach-Bliley Financial Services Modernisation Act of 1999, which put aside parts of the Glass-Steagall Act of 1933 that had provided sufficient regulatory firewalls amongst commercial banks, insurance companies,securities firms and investment banks during the era of the Great Depression, has over the years helped in theevolution of these shady financial activities.

Compiled by the author from “A Short History of Modern Finance: Link by Link”, http://www.economist.com/displaystory.cfm?story_id=12415730,October 16 th 2008 and Varchaver Nicholas, “The $55 Trillion Question”, http://money.cnn.com/2008/09/30/magazines/fortune/varchaver_derivatives_short.fortune/

Exhibit VGrowth of Credit Default Swaps (in $ trillion)

This huge CDS market has surpassed even the Gross Domestic Product (GDP) of all the countries of the world puttogether (Exhibit VI). The reason for emergence of such a gigantic CDS market lies in the fact that one need not haveto own a debt to buy a CDS on it. Any person can place a bet on other people’s debt. Therefore, while total corporatedebts are $6.2 trillion, CDS contracts are a massive $54.6 trillion. And these financial derivatives have come to prove–what Warren Buffett famously dubbed them back in 2003 – as ‘financial weapons of mass destruction.’4 Derivatives,though developed to hedge risks on various investments, have themselves turned as the means of investment. Theacceptance of credit derivatives – and more so when they are more complex promising more returns – led to increasingparcelling up of loans in innovative ways and its insurance, reinsurance and sale through a web of transactions. Thisfinancial engineering was both prompted by and justified astronomical salaries for the new age investment bankingprofessionals, who, with their arcane mathematical wizardry, outsmarted the the laidback low-salaried regulators andput the credit system off-guard. Though the CDSs are hailed as wonderful inventions since they increase liquidity by

4 “Buffet Warns on Investment ‘Time Bomb’”, http://news.bbc.co.uk/2/hi/business/2817995.stm, March 4th 2003

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2001 ’02 ’03 ’04 ’05 ’06 ’07 ’08*

*end June

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The credit default swapmarket nearly doubledeach year from 2001through 2007.

Value of CreditDefault SwapsOutstanding

0.92001 2008

Q2

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generating quick and cheap bond portfolios, the scary part is that they are offloaded for realisation during economicdownturn when the default mounts and debt’s value starts melting, leading each other in a self-fulfilling vicious circle.Everyone in the lending chain presumed that the preceding link had checked out on the quality of the loan made,although in reality nobody cared to do. The excessively high leverage in credit market by means of derivatives is at theroot of all bubbles as diagnosed long back by Prof. J.K. Galbraith. For example, the land boom in Florida in the 1920’sleading to the Great Crash of the 1930s was not simply because people actually purchased so much land, but “theybought options to buy the land, and traded those”.5

Exhibit VICDS vs GDP (in $ trillion)

Source: Compiled by the author from Varchaver Nicholas, “The $55 Trillion Question”, http://money.cnn.com/2008/09/30/magazines/fortune/varchaver_derivatives_short.fortune/

In the midst of the US housing bubble, propped up by these exotic debt instruments as well as teaser loans havinginitial low interest rates for a short period with soaring rates later on, the subprime borrowers eventually starteddefaulting on loan repayments. This predicament hastened with successive hikes in the interest rate pursuant to aseries of spikes in the US Fed fund rate which were alleged to be the follow up for the rises in the US Treasury bill rateowing to massive sale of T bills to finance the US’s Iraq war and consequent fall in price of T bills. Since the resumptionof the war, Alan Greenspan, the then Fed Reserve Chairman, raised the US Fed fund rate on 14 occasions and hissuccessor Ben Bernake on 3 occasions, carrying it from 1.25% in 2003 to 5.25% in 2006. 6 The defaults led to moreforeclosures and tighter lending standards. The former presented more houses for auction while the latter shrunk thenumber of buyers. More supply and less demand started depressing home prices. Since the US home loans were non-recourse ones, the borrowers were not personally liable for the loans and had every incentive to default when homeprices nosedived. This pummelled home prices in a downward spiral, leading to the burst of housing bubble in the US.Consequently, the inverse pyramidal debt market that was structured on the base of the housing mortgage crumbled,creating deep turmoil in integrated global financial sector and conjuring up heightened fears over an impendingdepression not only in the US but also in the whole world economy.

5 Mitchell Donald, “Editorial Review: What Actually Happened in 1929?”, http://www.amazon.com/Great-Crash-1929-Kenneth-Galbraith/dp/0395859999, October 24th 20016 Ramachandran G., “Prime Cause of Sub-Prime Crisis”, http://www.thehindubusinessline.com/2008/05/14/stories/2008051450030800.htm, May 14th 2008

54.6 54.3

CreditDefaultSwaps

Outstanding

WorldGDP


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That the decline in home prices would push the economy into depression could be read from Case-Shiller UShouse price index which reveals that house prices were falling on average by 3.2% in 15 out of 20 major cities while ayear back, these prices were rising by 7.5% nationally.7 This is the record year-on-year decline in the 20-year oldhistory of the index. The crisis of confidence has led to crisis in credit. The UBS economists visualise a 1% rise in thecost of capital, with 10% fall in share and house prices, that would push US’ output growth down by 2.6% next year,plunging the economy into recession, which, if persists, will exacerbate into depression.

Would the Present Crisis Slip into Depression II?

In their seminal book A Monetary History of the United States: 1867-1960, Milton Friedman and Anna JacobsonSchwartz probed into the underlying cause of the Great Depression of the 1930s and found it to be the steep creditcrunch due to an epidemic of bank failures. 608 banks failed in the first wave including the Bank of the United States,which accounted for about a third of the total deposits. This resulted in suspension of payments by the banks withcombined deposits of more than $80 million. The crest of the crisis witnessed bust of over 5,000 banks, drop ofindustrial output by 45%, fall of crop prices by more than 50% and loss of livelihood for 15 million people.8 Thus, WallStreet joins to the Main Street through credit highway.

According to Friedman and Schwartz who closely examined the key years of the Great Depression between 1929and 1933, the Great Depression, contrary to popular belief, was not a direct outcome of the stock market crash ofOctober 1929. Nor was the latter a precondition for the former. Rather the burst of the speculative investment bubble,which was blamed for the stock market crash of October 1929, might have itself been triggered by the hike in theFederal Reserve’s lending rate to commercial banks in August 1929. “The true story is that monetary policy triedoverzealously to stop the rise in stock prices” acted mainly in slowing the economy.9

But anti-monetarists argue that the Great Depression was the outcome of a massive shift of income shares fromwages to profits. This shift resulted in huge surplus capital which could not get deployed in productive capacity in view ofless need for it on account of declining consumption. The inevitable end result was flow of funds into speculative channels,especially stock markets. The stock market bubble of the late 1920s eventually burst because euphoria could not besustained for long and panic was the inevitability. The stocks having risen fourfold over the past 10 years, a bubble wasalready in the making. October 1929 saw sharp falls in shares of Wall Street; in 2 days ending on Black Tuesday ofOctober 29th 1929, the Dow Jones industrial average shed 25%. And in July 1932, the record low was reached with theDow Jones knocking off 89% (Exhibit VII). As demand for securities listed on the stock exchange petered out, banksfound themselves clutching at billions of dollars in ‘distressed assets’. Then ensue did the credit freeze of the 1930s.

Exhibit VIIFall of Dow Jones

Source: Schifferes Steve, “Lessons from the 1929 stock market crash”, http: //news.bbc.co.uk/1/hi/business/7656949.stm

7 “Global Credit Crunch – Towards a Crisis of Globalisation”, op.cit.8 Palit Amitendu, “The Great Depression: Then and Now” The Financial Express, October 26th 2008, page 59 “Remarks by Governor Ben S. Bernanke:Asset-Price ‘Bubbles’ and Monetary Policy”, http://www.federalreserve.gov/BoardDocs/Speeches/2002/20021015/default.htm,October 15th 2002

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The Keynesians also argue in a similar vein. They pointed out that consumption tends to be less than outputproduced and the shortfall in demand may not necessarily be taken up in matching amount in the form of privateinvestment expenditure. Therefore, economic instability is a recurring feature in the capitalist, market-driven economyand government intervention in right degree and direction is a desideratum. However, the post-Keynesians like Britisheconomist R.F. Harrod and US economist E.D. Domar, added the rider that the Keynesian solution is a short-term onelooking only at the demand side. For, the investment expenditure, which adds to the demand side in the short run, alsoadds to the supply side through capacity augmentation in the long run. In order to keep the economy stable, the rateof investment expenditure must be so manipulated as to keep on rising in the same ratio as rate of growth of output.A slight deviation off this ‘razor’s edge’ growth rate will throw the economy into instability.10 Economic balance iscompared to ecological balance. Too many tigers kill off the whole lot of deer and the latter’s extinction leads to theultimate starvation and death of the former as well; too many deer, on the other hand, also result in their owndisappearance owing to their overgrazing and collective starvation.

Arguments are also advanced that financial markets, the happenings of which seep into real markets, are inherentlyunstable because of their attempt to do the impossible. While the ultimate lenders or savers want financial assets to beshort, safe and simple, the ultimate borrowers or investors have projects, which are long, risky and complex. Financialinstitutions try to give both sides what they want. In so doing, they have to undergo a tradeoff between efficiency andstability. Therefore, efficient unregulated capitalist institutions add to productivity only at the cost of inherent instability.

But whether a downturn would spin into depression depends on so many factors. As Prof. Charles P. Kindlebergerpoints out getting trapped into the fallacy of compositions may be one cause.11 Overinvestment in railroads businessin the US in 1840–1850 and its subsequent unprofitability is an instance. The railroad investments, which were initiallyvery profitable and attracted so many people to invest in railroads, became very unprofitable because the aggregateeffect was overinvestment. The action of each individual is rational, provided others are not behaving the same way.There is a self-reinforcing mechanism, which allows for irrationality. A person buys an asset because others buy assetsof that sort and by so doing, the person makes their prices rise which validates the wisdom of the people who alreadybought these assets. This, in turn may lead other people to buy and so on. As people overdo it in their irrationalexuberance and some insiders feel that the peak has been reached and quit the market, mania leads to sudden panicat this Minsky moment12 , named after the US economist Hyman Minsky, and the crisis unfolds.

Marxists point out that today’s so-called financial crisis is merely a symptom of depression and the underlyingcause is, in fact, capitalism itself, for it entwines destructive conflict into its production and distribution of goods andservices. Capitalism has over the years promoted a general increase in the share of output going to capital as opposedto labour, known in Marx’s phraseology as the increase in the rate of exploitation (Exhibit VIII).

Exhibit VIIIWage Share of National Income (%)

Source: Harman Chris, “From the Credit Crunch to the Spectre of Global Crisis”, http://www.isj.org.uk/index.php4?id=421, March 31st 2008

10 “The Harrod-Domar Growth Model”, http://www.sjsu.edu/faculty/watkins/growthmodels.htm11 “A Review of ‘Manias, Panics and Crashes: A History of Financial Crises’”, http://www.geocities.com/hmelberg/papers/981006.htm12 Cassidy John, “The Minsky Moment”, http://www.newyorker.com/talk/comment/2008/02/04/080204taco_talk_cassidy, February 4th 2008

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The lowly stagnant or declining share of the wages of workers in the total income accrued in the production processis insufficient to enable them to purchase the growing output of their labour. Employers, unable to vend all that theyproduce, start to lay off their own employees, which would only aggravate the problem further. On the other hand, bubblescrop up because profits do not find any avenues of productivity to get deployed and therefore gush, through the financialsystem into higher risk and reward laden speculative ventures one after another. The results are periodic booms waitingto be burst. It happened with the stock exchange and property booms of the late 1980s, the dotcom boom of the late1990s. And it is happening with the subprime mortgage boom of 2002–2007. The bubbles inevitably burst becauseslowing pace of growth in the real economy reduces the value of the assets upon which the fictitious capitals – the claimson future wealth in the form of financial instruments and their complex derivatives – rest. Empirical data also provideveracity to the above logic how skewed income distribution causes the bubble. The Great Depression of the early 1930sand the dotcom bubble of the late 1990s were, for instance, the years of more skewed income distribution (Exhibit IX).

Exhibit IXSkewed Income Distribution and the Bubble

Source: “Does Income Concentration Cause Bubbles?”, http://economistsview.typepad.com/economistsview/2008/10/does-wealth-con.html,October 10th 2008

Although Marx and Keynes, quintessentially, hit at the same button pertaining to the cause of the downturn in theeconomy, the former acted as the grave digger of capitalism while the latter was the saviour of it. One wanted thehopeless terminal patient to die; the other prescribed periodic doses of medicine with the faith that it would rejuvenatethe patient.

Some believe that one cannot predict whether depression would pan out, although one may explain how or why ithas happened. A particular action may have different effects and it is then not possible to figure out the effect inadvance. A rise in interest rate, for instance, may either attract funds or repel them, depending upon the expectationsthat a rise in interest rates generates. Rising interest rate may be anticipated to head for a decline as the next step. Or,it may be expected to continue the trend of rising even further. Only after the event, one can know which effect hascome out stronger.

However, the steep decline in the US house prices and the indices of the US banks and agencies (Exhibit X) havestarted to create business pessimism and panic that spook some into believing that the Depression II is round thecorner. Relative to the S&P composite index, banks have lost almost half of their market value within a year. Historyattests to the fact that a banking crisis invariably leads to an economic slump, the scale of which depends on the sizeof the banking crisis. And the year 2008 has witnessed the biggest systemic financial crunch up since the 1930s.

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The broadest barometer of economic health, the GDP, which clocked 2.8% growth for the US in the second quarterended June 2008, has shrunk to 0.3% in the third quarter of July–September.13 This reverse swing of the US economyunderlines the enormity of the impact of the 2008 financial crisis of the US. Claims for joblessness by 400,000 personsare reckoned to be the state of a struggling economy. Current claims for joblessness by 479,000 persons14 for theweek ending October buttresses the belief of many that a full-blown recession is a certainty and a Depression II is aprobability.

But many economic experts are confident that a much better understanding of macroeconomics down the yearssince the Great Depression, coupled with the provision of social safety nets, will stave off any reemergence of adepression. The government and the Federal Reserve are on the job of recovering the banking system so that thelatter can do its job of transferring the funds of the savers to business firms that provide employment and income andkeep the wheels of the economy moving. US Fed Chairman Ben Bernake (Bernake) has learnt from Milton Friedmanand Anna Schwartz’s magnum opus A Monetary History of the United States the importance of providing the economya stable monetary background, lack of which had led to the Great Depression. Referring to the Great Depression,Bernake acknowledged to the duo at the end of his speech, “You’re right, we did it. We’re very sorry. But thanks to you,we won’t do it again.”15 If the current effort by the government at buying up mortgage-backed securities fails to boostasset prices and investment profits to create the ambience of confidence in banks and business firms, the governmentcan forestall bank failures by sufficient recapitalisation by way of investing public money in them.

Sceptics however counter that making available credit facilities does not mean the same thing as making use ofthese, if deteriorating economic scenario shattering business confidence forbids it. Even if monetarists’ diagnosis ofthe underlying cause of the economic depression is supposed to be correct, the prescription of reversing the cause isnot right. A horse can, for instance, be stopped from drinking by pulling it off from water; but no amount of effort inpushing it towards water will make it drink if it is not thirsty. Credit line is just like a string that one cannot push on, asevident in the ‘Lost Decade of Japan’ during 1990s. Even though interest rates were practically non-existent in Japan,domestic demand failed to pick up, forcing Japan to wallow in low or negative growth.

Exhibit XSteep Decline in the US House Prices and Bank Indices

Source: Wolf Martin, “A Year of Living Dangerously”, http://www.ft.com/cms/s/0/2cc4291c-52a2-11dd-9ba7-000077b07658,dwp_uuid=d355f29c-d238-11db-a7c0-000b5df10621.html

13 Lewis Jon, “Consumer Spending Plunges”, http://wsbradio.com/localnews/local/2008/10/, October 30th 200814 Ibid.15 “Remarks by Governor Ben S. Bernanke on Milton Friedman’s Ninetieth Birthday” http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021108/default.htm, November

8th, 2002

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Nominal Real RealNominal

US House Prices

S&P/Case-Shiller 10-city composite

Index Annual % change

1988 ’90 ’95 2000 ’05 ’08

Commercial banks

Investment banks

Fannie Mae

Freddie Mac

US Banks and AgenciesIndices and share prices relative to S&P 500

1998 2000 ’02 ’04 ’06 ’08


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Optimists believe that even if all the above-stated plans fail to fructify, the ultimate Keynesian strategy of massivegovernmental expenditure on infrastructural building programmes is there to be adopted as a last resort to keep thespectre of depression away. Nobel Laureate economist, Joseph E.Stiglitz is hopeful that a Depression II is unlikelythanks to the new ‘instruments’ that can be deployed to fight off the occurrence of a depression.

Critics argue that though a lot of safeguards have been built into the system that were not existent earlier in the1930s, none of these, however, can deal with CDS and other complex derivatives which have blown up the subprimemuddle into the present state of crisis in confidence and financial turmoil. The high-earning innovating wizards at WallStreet have always proved too smart for their low-paid laidback regulators. Moreover, more regulation may not immunisethe economy against future crises, as experienced by more rule-bound economies like Japan and South Korea inrecent years. What is really required is not more regulation but better regulation. Moreover, as the followers of Austrianeconomist Ludwig von Mises assert contrary to mainstream Keynesian postulate, what the economy needs during thedownturn is not more spending on consumption but more saving, so as to agree with the excessive investments of thepreceding boom. More and more spending to avoid the burst of bubble is simply postponing the day for a biggerburst.While more saving is frowned upon by the Keynesians since this virtue of economising at individual or micro levelresults in vice at aggregate or macro level, Misesians see no such dichotomy since saving ultimately sustains investment.According to the Misesians, the Keynesian approach is akin to continuous doping of a race horse with increasingdoses of steroid. Once the doses drop off, the race horse turns into the ordinary or even worse.

Liberals put up the brave front that capitalism corrects itself in due course and there is no need to be panicking.The auto corrections in the form of minor crises are indicative of the fact that major crises are going to be averted. Thedownswing is an unpleasant yet necessary process by which the free market discards the errors of the boom to avertthe horror of a hard landing. The Great Depression of the 1930s was rather the offshoot of a ‘perfect storm’ of destructivepolicies carried out almost at the same time. The record hike in tax in response to huge decline in tax proceeds causedby the prevailing economic slowdown, the increase in tariffs by protectionist Smoot-Hawley Tariff Act that resulted inretaliation leading to the reduction of demand for the US exports, the enactment of wage and price controls under theNational Recovery Administration that prevented market adjustments were some of the prime instances of thesepolicies, the consequences of which went opposite to what was intended. Moreover, after a crisis, appropriate lessonsare learnt and exactly the same mistakes are hardly repeated. For example, the lack of transparency in CDS transactionshas actually led to the plan for instituting clearing houses for CDS. The Great Depression of the 1930s is unlikely toreplicate itself in the current financial crisis of 2008, given the fact that present mortgages delinquencies of reallyserious nature as percentage of loans stand at a little over 4% (Exhibit XI) while the figure in the 1930s was 40%.

Source: “America’s Bail-Out Plan: The Doctors’ Bill”, http://www.economist.com/opinion/displaystory.cfm?story_id=12305746, September 25 th

2008

Exhibit XIMortgages Delinquencies (in %)

All Loans

90+days Delinquent

1980 ’85 ’90 ’95 2000 ’05 ’08

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Besides, as argued by noted economic historian of Carnegie Mellon University’s Tepper School of Business, theGreat Depression had ‘waves of bank failures’ while the current financial crisis involves only ‘a few failures’16 . Then in1933, above 4000 banks failed; now as of mid-November 2008 merely19 banks have met the same fate. Then thedownslide lasted for a grueling 43 months; the present downslide of 2008 is believed to be over by the next year, as asurvey of economists’ opinion by the Philadelphia Federal Reserve Bank reveals.17 More over, the US economy is agigantic economy with great ‘ability to reinvent itself’. Therefore, it will come out fast ‘in routine fashion’ from what isactually a localised problem – the US housing crisis covering mainly six communities such as Southern California,Southern Nevada, Arizona, Southern Florida, Cleveland and Detroit. The slowdown in housing construction will definitelyresult in a modest economic downturn but not at all a Great Depression.18 Added to all these are the benefit of hindsightand experience of shock-absorbing economic policies. Prof Krugman, however, points to the urgency of the analogybetween the Great Depression of the 1930s and the US financial crisis of 2008 in respect to the collapse of themonetary policy. The Fed is getting as impotent now as it was then on account of “its inability to cut rates any more,because they’re essentially zero” (Exhibit XII).

Exhibit XIIInterest Rate of 3-Month Treasury Bill of US Federal Reserve System

Source: Krugman Paul, “Depression Analogies”, http://krugman.blogs.nytimes.com/2008/11/22/depression-analogies/, November 22nd 2008

Given the fact that about 90% of the world trade moves by sea, the Baltic Dry Freight Index that measures theshipping cost of dry bulk commodities is viewed by some as a proxy for general economic health and reflection of thedirection towards which the economy is heading. The drop in this index by a massive 80% in the year 2008 as ofSeptember (Exhibit XIII) is a strong indicator of an unfolding recession with the depth to be turned into a depression.The index has, indeed, tumbled below the levels logged in 2004.

16 Norton Rob, “The Thought Leader Interview: Allan Meltzer”, Strategy + Business, Issue 53, Winter 2008, pages 1–917 Gross Daniel, “Don’t Get Depressed, It’s Not 1929”, http://www.slate.com/id/2205186/?from=rss, November 22nd 200818 “The Thought Leader Interview: Allan Meltzer”, op.cit.

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1925 1940 1955 1970 1985 2000 2015

Shaded areas indicate US recessions as determined by the NBER.

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Even though both of the recessions arrow-marked (Exhibit XIV) were preceded by declines in the Baltic Dry FreightIndex, every decline in shipping rates is not a sign of approaching recession, not to speak of the spooky depression.

Exhibit XIIIY/Y Change in Baltic Dry Freight Index (2004–2008)

Source: Shedlock Mike, “Baltic Dry Shipping Collapse Sign of Consumer Recession”, http://www.marketoracle.co.uk/Article6813.html, October 15th 2008

Exhibit XIVY/Y Change in Baltic Dry Freight Index (1985–2007)

Source: “Baltic Dry Freight Index Indicates Recession Unlikely”, http://seekingalpha.com/article/31164-baltic-dry-freight-index-indicates-recession-unlikely, March 30th 2008

2004 May Sept. 2005 May Sept. 2006 May Sept. 2007 May Sept. 2008 May

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Some argue that the beginning of the 2008 recession should be dated to the first quarter of 2008 though officialaffirmation puts the US growth at a positive territory of 0.6%. They reason that the final sale of products of the economyis the true measure of the economic growth. The increase of inventory of unsold goods of 0.8% ought to be excludedinstead of being added since firms have to expunge that additional unintended inventory by means of cutback inproduction and employment. Effectively, the first quarter growth is a negative 0.2%.19

A glimpse at the quarterly analysis of the US GDP with its component breakdown for the second and the thirdquarter of 2008 (Exhibit XV) gives an idea of a depression lurking in the corner.

Exhibit XVQuarterly Analysis of the US GDP

Source: “GDP: Negative 0.3%”, http://bigpicture.typepad.com/comments/economy/index.html, October 30th 2008

Auto sales, which have large linkage effects – both forward and backward – in terms of job creation, have alsogone for a skid into the negative territory in September 2008 compared to September 2007 (Exhibit XVI).

However, the National Bureau of Economic Research (NBER) Business Cycle Dating Committee is yet to declarethe state of recession for the US economy because it has to consider net adverse impact of five indicators such aseconomic output, wholesale and retail sales, industrial production, personal income and jobs (Exhibit XVII) instead ofthe straight mechanical definition of recession. The intensities of recessions are usually compared on the basis itsthree Ds, namely Duration (No. of months), Depth (in terms of % change in real GDP & unemployment rate, maximum)and Diffusion (% of industries with declining employment, maximum)20

19 Roubini Nouriel, “Q1 GDP: Aggregate Demand (Final Sales) in Negative Growth Territory”, http://www.rgemonitor.com/roubini-monitor/252541/q1_gdp_aggregate_demand_final_sales_in_negative_growth_territory, April 30th 2008

20 Moore Geoffrey H., “Recessions”, http://www.econlib.org/library/Enc1/Recessions.html

Personal Consumption Expenditures Gross Private Domestic Investment

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Exhibit XVIPercentage Change in Auto Sales; September 2007–September 2008

Source: “Auto Sales Tank”, http://bigpicture.typepad.com/comments/economy/index.html, October 1st 2008

Exhibit XVIIFive Indicators to Examine the State of Recession

*Less transfers or income for which no servicesare performed such as net insurance paymentsand government social payments.

Notes: Series adjusted for inflation are in chaineddollars; sales, income and GDP data areseasonally adjusted.

Source: Reddy Sudeep, “Economists Weigh Possibility of a Recession Amid Economic Growth”, http://online.wsj.com/article/SB121720283536488455.html, July 28th 2008

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Industrial Production

Index of output in factories,utilities, mines

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Critics, however, say that NBER’s non-declaration of the state of recession does not matter much since it takes atleast two quarters to know of its existence. What actually does matter is the perception whether one is in recession atpresent or not. And the perception points to the making of another Great Depression.

History has a mystic capacity of repeating itself. The Great Depression of the 1930s and the present financialconvulsion have tell-tale common signs between them. Then it was easy money policy following the First World War,which led to over borrowing and high-risk speculation and asset-price bubbles. Now it is also easy money policyfollowing 9/11, which has led to sordid subprime saga, huge credit derivatives and house price bubbles. Then it wasNew York Bank; now it is Lehman Brothers, Merrill Lynch and Washington Mutual. Then it was an election year withFranklin D. Roosevelt, a Democrat, taking over from a Republican; now it is an election year with Barack Obama, aDemocratic nominee and clear frontrunner (eventually, the November 4th 2008 election has favoured him as thePresident-elect).

But to break the linearity, as an upside, while there was a policy vacuum of 5 months between the election of a newPresident and his taking of office in 1933 that worsened the US banking crisis, the current Bush administration’sgigantic bail out plan under Troubled Assets Relief Programme (TARP) to the tune of $700 billion is a quick one,endorsed as it is promptly by both the presidential candidates despite some misgivings. Then ill-conceived protectionistmeasures of the US exacerbated the crisis; now in this globalised era all the countries hang together too tightly to allowany non-cooperation to bring them the collective doom of depression. Then the US spending, particularly militaryspending was much smaller than what it is today and this sets up the bottom below which the US economy will notslump. As a downside, while there was a trade off between unemployment and inflation then, as exemplified by thePhilips Curve, now there is the likelihood of the both keeping company in the form of double whammy stagflation. Thenthe modes of information mining and transmitting were not as rapid and varied as it is now to scare people out withhyperbolic headlines.

However, the moot question remains: Whether the policy framework will accentuate or alleviate the present USfinancial crisis of 2008: or, whether policy activism serves any purpose at all. And there hangs on the torrid story ofDepression II to be or not to be.

Casestudy US Financial Crisis is the Great Depression II in the Making

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