Causes of the Great Depression and 2008 Financial Crisis

In October 2008, President Obama said that the United States is suffering the worst financial crisis since the Great Depression. As this crisis continues to develop, it has led to a global economic recession. At the beginning of the 2008 financial crisis, many people wondered: Will the current financial crisis be another Great Depression? Both the Great Depression of the 1930s and the current recession are world-wide, and governments have intervened by creating new regulations and policies regarding business and financial practices, etc. However, there still are differences between these two events, especially the causes of these two financial crises. In this paper, the Great Recession and the Great Depression will be compared though expounding the different causes related to historical background, economic nature and monetary policy.

Historical background
After WWI, the American economy developed fast and people were optimistic to that development, but unbalanced economic structure appeared gradually. Killian (2010) pointed out that America experienced an industrialization movement and there became a market economy with more competition in the early twentieth century. (p. 3) The economy and productivity increased quickly, but the citizen’s real wages did not have a big change. According to Killian (2010), people had to rely on the market economy instead of enjoying it, and a lack of employment and job opportunities made many people’s lives more difficult, especially in urban areas. (p. 3-4) Due to the increasing imbalance between economy and personal wages, the economic collapse led to a widespread depression. “Increased prosperity led to an increase in consumer spending which encouraged production. Advertising and the use of the installment plan to purchase big-ticket items spurred this increased consumption” (Killian, 2010, p. 4). People used an installment plan to purchase products and paid off their debt with almost all of their incomes.

“While any significant increase in bank failures indicates banking instability, the bank failures of the 1920s suggest that other factors played a large role” (Killian, 2010, p. 6). In this historical background field, the lagged citizen’s wages and a series of bank failures led to this world-wide depression. Different to the causes of the Great Depression, today’s recession initially caused from the housing market. Killian (2010) presented, “Prosperity in the late 1990s, although not as substantial as that of the prosperity of the 1920s, led to increased consumer confidence and business investment… a housing market showing signs of weakness, the economy was headed for another recession” (p. 23). Housing prices rose continually until 2007, but the housing market turned to be slowed since 2006. However, the other industries related to real estate met same challenge as same as the declining of housing market. The saving rate was enhanced by the Federal Reserve for many times. “An increased savings rate, however, implies a decreased consumption rate” (Killian, 2010, p. 6). People spent less money to consume which led to a powerless economy. Therefore, the recession of the housing market and improper fiscal policies mainly caused the current financial crisis.

Economic nature
The Great Depression was banking crisis and liquidity crisis; the current financial crisis firstly is liquidity crisis, then credit crisis, presented Zhang (2009). A serious banking crisis happened during the early years of the Great Depression, which influenced by the FED’s improper policies and the real economy problems. Zheng (2009) stated that the collapse of the commercial banks played a decisive role on economic and financial systems during the Great Depression. In October 1930, the independent small and medium-sized banks began collapsed in a wide range with the volatility of commodity prices. Zheng (2009) thought that this round of crises was not the most destructive, however, the Fed’s biggest policy failure directly led to the second round of the banking crisis from March 1931 to June.

As Zheng (2009) reported, in early 1931, there was no timely and appropriate expansion policy from the Federal Reserve System, and the vicious cycle of continuing deflation forced asset prices to decline. A new round of bank failures occurred. Zheng (2009) stated that the increase of interest rates and the outflow of gold brought more bank failures and the greater decline of economic activities. The continuous development of deflation turned into a Great Depression in the fall of 1931. Zheng (2009) said that Federal Reserve Bank was powerless in resolving the banking crisis, making the banking system suffered a new round of failure in the fourth season of 1931, and finally resulted into the 1933’s “bank holiday”. Zheng (2009) concluded that the important causes of the Great Depression were the real economy crisis, the decline in total demand and the overproduction in 1920s. All of these reasons influenced banking system mutually which led to the comprehensive economic depression.

In recent decades, people overly relied on virtual economy, and easily lose confidence when serious financial problems happened. Zheng (2009) thought that the current financial crisis is a liquidity crisis firstly. First, the behavior of financial institutions has changed the people’s motivation of holding currency, because of changes in the structure of the demand for money. Second, the determinants of the demand for money have become more complex and uncertain, which has reduced the stability of money demand. Third, the money supply subjects to the domination of internal factors of the economic system more than controlling by the central bank, which severely weakened the central bank’s control of money supply capacity and degree of control. After the liquidity crisis, the market began a serious lending and credit crunch. The collapse of large financial institutions, especially Fannie Mae and Freddie Mac which were stealthily guaranteed by government, made people worried about credit-based system as well as the country’s credit.

Based on the above analysis, the difference can be simply clarified: The Great Depression originally caused in real economy field and then financial field; today’s crisis can be seen as a credit crisis because of the people’s excessively dependence on virtual economy.

Monetary policies
The international gold standard monetary system played a key role in the Great Depression, said Hang (2011). In 1929, the United States was trying to cool the overheated economy by tightening monetary policy, and France just completed a period of inflation and restored the gold standard. The two countries experienced massive capital inflows, the resulting international payments surplus made the two countries absorb gold from the world at an alarming rate. In 1932, the two countries held more than 70% of the world’s gold. The other countries which used the gold standard could only sell domestic assets to save the declining gold reserves. Hang (2011) thought that this formed global monetary tightening, and made the world economy into the Great Depression with the impact of Wall Street stock market crash. “During the Great Depression, monetary policy needed to be strong, decisive and extreme; instead, it was weak, fearful and passive” (Killian, 2010). Hang (2011) stated that many countries attempted to protect their gold reserves to ensure the country’s gold standard, which made them reluctant to provide liquidity to banks for continued operation.

Hang (2011) concluded that the gold standard international monetary system was the main factor for spreading economic collapse, because it prevented governments to adopt an independent monetary policy, particularly the expansionary policy. The establishment of only central position of U.S. dollar in international currency system caused problems combined with the previous fiscal policies and national policies. IMF passed the Jamaica Agreement in 1976, announced the non-monetarilization of gold, and began floating exchange rate regime. According to Hang (2011), although the dollar no longer bear the obligations of exchanging gold, the central position of the U.S. dollar in the international monetary system has not changed. Hang (2011) mentioned, as reserve currency, the U.S. dollar could be issued without any restrictions, and the United States dumped the U.S. dollar to the world, but the repayment could not be guaranteed because of the floating exchange rate. After the Internet bubble burst in 2001, the U.S. government took the policies of the “twin deficits” and issued a large number of currency to promote economic growth.

After “9•11”, the United States continually increased fiscal spending for military expansion, causing a sharp rise of the budget deficit. According to Hang (2011), on the one hand, the U.S. government outputted large-scale U.S. dollars to the world through paying the trade deficit; on the other hand, the government steadily inputted dollars to the domestic through fiscal deficits. Hang (2011) thought that the large-scale return of the U.S. dollar pushed up asset prices further and promoted the excessive consumption of United States nationals. It is clear to see that both economic depressions were related to monetary policies closely. However, they were caused by different policies in different monetary policy environment. In the Great Depression, all the countries were prefer to adopt golden standard as monetary policy basement, but when the financial crisis happened, golden standard had already been canceled.

As mentioned above, the Great Depression and today’s financial crisis experienced different historical background, had different economic nature, and were influenced by different monetary policies. It is revealed that the following could be considered: Strengthening financial supervision to prevent speculation activities, balancing the development of different economic structures to steadily develop the economy, and enhancing international cooperation to reduce risk, to prevent a next economic crisis.

References

Hang, P. (2011, August 08). Similar crises: Two depressions with same causes. Retrieved from http://article.m4.cn/history/1119965.shtml Killian T. N. (2010). Teaching points in comparing the Great Depression to the 2008-2009 recession in the United States. Retrieved July 29, 2012, from http://digital.library.unt.edu/ark:/67531/metadc28442/m2/1/high_res_d/thesis.pdf Zheng, L. (2009). Historical comparison between new financial crisis and the great depression in United States. International economic review, 1st of 2009(ISSN1007-0974). Retrieved from http://www.doc88.com/p-7178391 7105.html