The great depression and the great recession: a comparative analysis of their analogies.

• Author: Peicuti, Cristina
• Position: Report

1. Introduction

   Until recently the conventional opinion was that major disruptions in financial markets characterized by sharp declines in assets and firm failures would always exist but that financial crises of the type experienced during the Great Depression were a thing of the past for advanced countries such as the United States or the countries of the European Union. The 2007-9 crisis proved them wrong.

   Analogous circumstances triggered similar crisis dynamics. The periods from 1921 to 1929 and 2001 through 2007 both experienced fairly rapid growth without major contractions, which led to a climate of confidence, highly decisive for the outbreak of the crisis. These periods were characterized by the following aspects, in the order of importance for the outbreak of the crisis: (1) developments in finance that modified the role of commercial banks; (2) an increase in liquidity at the global level that did not lead to inflation but caused risk premiums to decrease; (3) a banking sector that became concentrated in number and size of banks; and (4) a strong belief in the capacity of central banks to promote economic stability and to prevent financial crises in the long run.

   These two financial crises started with severe defaults on mortgages that led to significant loan losses on bank balance sheets. Both crises erupted in periods of high uncertainty after the failure of a major American financial institution: the Bank of the United States in 1930 and Lehman Brothers in 2008--and both failures could have been avoided. While the failure was believed to have domestic consequences at the time, the decision to let them go bankrupt was a mostly decisive cause for the dramatic outbreak of the international crises.

   Both crises consolidated the powers of young central banks, at the time of the Great Depression it was the young Federal Reserve System and of the subprime crisis, it was the recently founded European Central Bank.

   The Banking Acts of 1933 (Glass--Steagall) and 1935 created the Federal Deposit Insurance Corporation (FDIC), separated commercial banking from the securities industry, prohibited interest on checkable deposits, restricting such deposits to commercial banks, and placed interest-rate ceilings on other deposits. The fact that less than a decade after the demise of the Glass--Steagall Act, a similar crisis appeared, and that in March to September 2008, all five of the largest, free-standing investment banks ceased to exist in their old form hint to the fact that the Great Depression and the Great Recession may have similar causes. Understanding these causes will help in rebuilding a regulatory framework that is capable of preventing such occurrences in the future.

2. Close similarities of the periods 1921-1929 and 2001-2007

   2.1 Rapid growth without contractions

   The absence of a severe depression over almost a decade could have caused apprehension (1), but instead it had the opposite effect: the longer a significant depression was avoided, the greater confidence in the future became.

   In the United States, the declines of 1920-21 and 2000-2001 were followed by economic expansions. From 1921 to 1929, two recessions occurred: one from May 1923 to July 1924, and the other from October 1926 to November 1927. These recessions slowed steady growth but they were so mild and brief that most people at the time did not realize a recession had occurred.

   The steady economic growth from 2001 to spring 2007 can only be explained by the continuous expansion of credit. In 2001, the Federal Reserve implemented an expansive policy to support the depressed economic climate and productivity, and get companies that had borrowed a lot during the stock market boom of the 1990s out of debt. But the bankruptcies that occurred in 2002 because of bad corporate governance--the most famous being that of Enron in December 2001--forced the Federal Reserve to continue its expansive policy in order to prevent deflation. Beginning in 2003, economic growth was strongly sustained by household consumption triggered by low long-term interest rates. The transfer of corporate debt to household debt sustained American growth.

   2.2 Increase in global liquidity

   From July 1921 to the cyclical peak in August 1929 the stock of money in the United States rose at a rate of 4.6 percent per year, that is, by 45 percent for the whole period. Of this rise, the increase in the public's deposit--currency ratio accounted for 54 percent, in the banks' deposit--reserve ratio--15 percent, and in the stock of high-powered money--27 percent. Beginning in 1929, money stock declined very slightly as a result of the restrictive monetary measures taken by the Federal Reserve System in response to the stock market boom. (2)

   If we take into consideration the ratio between the stock of money and the gross domestic product for the six main monetary zones (the United States, the eurozone, Japan, China, the United Kingdom, and Canada), we can see that it goes from 18 percent during 1980-2000 to more than 26 percent in 2002, and to almost 30 percent in 2006-7. (3) This rise in liquidity can be explained by external causes such as a very rapid increase in the exchange reserves of the emerging countries (particularly, of China) and of the countries exporting raw materials. The rise in reserves is the result of significant commercial trade surpluses as well as the high savings rate of these countries that had high growth rates for several years. The expansion of credit--caused by the fall in interest rates, the development of financial innovations, and the search for economic growth--is the major internal cause of this rise in global liquidity. The increase in liquidity did not lead to inflation in either period.

   2.3 Lack of inflation

   In spite of the widespread belief that inflation was very high before 1929 in the United States, the 1920s were not an inflationary decade. By 1923, wholesale prices had recovered only a sixth of their 1921 decline. From 1923 to 1929, they fell an average of 1 percent per year. Prices remained low during the cyclical expansion beginning in 1927. The stock market grew at a fairly steady rate until early 1928. Afterward it declined very slightly until 1929 as a result of the restrictive monetary measures taken by the Federal Reserve System. (4)

   In the 2000s, the increase in liquidity on a global scale was caused by the rapid growth of exchange reserves of central banks in emerging countries and in countries exporting raw materials (an external factor), as well as credit expansion (an internal factor). Generally speaking, an increase in liquidity leads to inflation on prices for goods and services, but the databases of the International Monetary Fund from 1996 to 2006 show the opposite: (5) in spite of an increase in liquidity, inflation continued to decline worldwide from 12 percent to less than 4 percent.

   Kenneth Rogoff explains the generalized decrease in inflation as a result of pressure caused by decreased prices for manufactured goods from emerging countries (in spite of pressure caused by these same countries on prices of raw materials). (6) The excess productivity capacities of emerging countries, which have low wage costs, continued to influence prices and contributed to noninflationist economic growth. And the significant rise in prices for oil, metals, and food products as a result of the demand of emerging countries was not strong enough to reverse the tendency. Inflation and its volatility went down.

   The expansion of credit is normally limited by a rise in inflation that has the consequence of tightening monetary policy and interest rates. The fact that inflation went down led to a substantial development of credit in the 2000s.

   2.4 Falling risk premiums

   Risk premiums fell during the 1920s in the United States. As Ilse Mintz explains, (7) basic yields on 30-year bonds, which can be regarded as representative for the high-grade domestic bond market, declined from 4.50 percent to 4.05 percent between 1925 and 1928. In other words, the "scarcity of quality loans" meant that the investor had to accept a 10 percent decline in nominal yield. In 1925 the average risk premium for issues of foreign bonds, 30 percent of which subsequently proved to be of bad quality, was 2.18 percent. In 1928 a crop of foreign bonds, 65 percent of which were failures, could be sold to yield no more than a 2.00 percent risk premium. Thus investors accepted an (8) percent reduction in risk premium for a much riskier investment at the very time they accepted only a 10 percent reduction in yields on high-grade investments of stable quality. This caused the prices of risky foreign bonds to rise relatively more than prices of high-grade domestic bonds.

   Mintz emphasizes that high-grade foreign loans might have been expanded if American investors had accepted a more drastic cut in their yields. The public's demand for high-yield bonds excluded borrowers who offered lower yields. To a certain extent the lower-grade bonds drove the high-grade bonds from the market. But this was not the only reason why low-grade bonds attracted investors. Investors bought low-grade bonds because they were not aware of the risks they were taking. And this underappreciation of risk was not the result of the influence of a few fraudulent investment bankers. It was rooted in the optimistic economic climate of the twenties. During the entire decade, there were no defaults on foreign government bonds. Bad risks accumulated but did not become apparent. The confidence of bankers and investors grew as time passed and no losses were incurred.

   This confidence was strengthened by the considerable profit made by investors over a long period. Moreover, these profits furnished funds for more investments of the same kind. Even those who were aware of the cyclicity of the economic activity were reassured by the mild contractions of the twenties, which passed without inflicting losses on...