Analyzing the Causes of Great Depression And

Analyzing the Causes of Great Depression and

Comparing it to a More Recent Economic Crisis, the Financial Crisis of 2007-08

Directions: Read the handout and answer the following questions on a piece of notebook paper.

(1)What are the causes of the Great Depression of 1929 to 1939 in the United States mentioned throughout this handout?

(2)How did the Federal Reserve Banking System encourage stock speculation in the 1920’s?

(3)How did the Stock Market Crash of 1929 lead to more bank failures, and what caused the stock market crash?

(4)What did the Federal Reserve Banking System do in 1929 to make economic problems worse?

(5)How did the decrease in consumer spending and investment after the Stock Market Crash of 1929 affect the economy?

(6)How did bank runs affect the nation’s overall economy?

(7)What are some economic statistics of the Great Depression relating to the nation’s economy?

(8)What is Keynesian economic theory?

(9)How did the Hawley–Smoot Tariff Act of 1930 further slow down the economy?

(10)What effect did New Deal policies have upon the U.S. economy?

(11)What did the United States government do in 2008 that it did not do in 1929?

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THE collapse of Lehman Brothers, a sprawling global bank, in September 2008 almost brought down the world’s financial system. It took huge taxpayer-financed bail-outs to shore up the industry. Even so, the ensuing credit crunch turned what was already a nasty downturn into the worst recession in 80 years, since THE GREAT DEPRESSION.

“Bank Failures – During 1920’s”

On average, more than 600 banks failed each year between 1921 and 1929. The failed banks were primarily small, rural banks, and people in metropolitan areas were generally unconcerned. Investors and other businessmen thought that the failing institutions were weak and badly managed and that those failures served to strengthen the banking system. A major wave of bank failures during the last few months of 1930 triggered widespread attempts to convert deposits to cash, leading to many “bank runs.” Confidence in the banking system began to erode, and bank runs became more common. In all, 1,350 banks suspended operations during 1930. Some simply closed their doors due to financial difficulties.

“What Caused The Great Depression?”

Economists may dream of a perfect market where no bubbles, crashes, or recessions occur,but these phenomena are inevitable when the players are human. The Great Depression,one of the worst blows to the world economy, serves as a prime example of how vulnerable markets can be.
The stock market crash of 1929, usually cited as the beginning of the Great Depression, was preceded by the Roaring '20s, a period when the American public discovered the stock market and dove in head first. The crash wiped out many people's investments and the public was understandably shaken. When bank failures erased the savings of those who weren't even invested in the stock market, people were shattered. Although the market crash was unavoidable, the bank failures could have been prevented with better regulation. One major cause was the poor response of the Federal Reserve Banking System in 1929, leading to less market liquidity.

The Fickle Fed
Twenty-two years earlier, the panic of 1907 offered a similar scenario, as panic sellingsent theNew York Stock Exchange (NYSE) spiraling downward (loosing profits and financial value) and led to a bank run to boot. With no Federal Reserveto inject cash into the market, it fell upon investment banker J.P. Morgan to organize Wall Street. Morgan rallied people who had cash to spare and moved that capital to banks lacking funds. The panic led the government to create the Federal Reserve Banking System in 1913, in part to cut its reliance on financial figures like Morgan in the future.

In the crash of 1929, however, the Federal Reserve Banking System took the opposite course by cutting the money supply by nearly a third and raising interest rates, thus choking off hopes of a recovery. Consequently, many banks suffering liquidityproblems simply went under. (When an economy has sufficient market liquidity this means financial assets can be bought or sold without affecting the assets’ value, and there is the presence of a lot of cash which offers flexibility and allows for healthy borrowing and trading.)The Fed's harsh reaction, while difficult to understand, may have occurred because it wished to give Wall Street some tough love by refusing to bail out careless banks, a response that it felt would only encourage more fiscal irresponsibility in the future.

Ironically, by increasing the money supplyand keeping interest rates low during the roaring twenties, the Fed instigated the rapid expansionthat preceded the financial collapse. In some ways, it set up the market bubble leading to the crash and then kicked the economy when it was down.

“Bank Runs”

The stock market crash of October 1929 left the American public very nervous and extremely susceptible to rumors of impending financial disaster. Consumer spending and investment began to decrease, which would in turn lead to a decline in production of goods and more unemployment. Another phenomenon that compounded the nation’s economic woes during the Great Depression was a wave of banking panics or “bank runs,” during which large numbers of anxious people withdrew their deposits in cash.

The Great Depressionin the United States began as an ordinary recession in the summer of 1929, but became increasingly worse over the latter part of that year. At its lowest point, industrial production in the United States had declined 47 percent, real gross domestic product (GDP) had fallen 30 percent, and total unemployment reached as high as 25 percent.

THE FIRST BANK RUNS

The first of four separate banking panics began in the fall of 1930, when a bank run in Nashville,Tennessee, kicked off a wave of similar incidents throughout the Southeast. During a bank run, a large number of depositors lost confidence in the security of their bank, leading them all to withdraw their funds at once. Banks typically hold only a fraction of deposits in cash at any one time, and lend out the rest to borrowers. During a bank run, a bank must quickly liquidate loans and sell its assets (often at rock-bottom prices) to come up with the necessary cash to give to depositors wanting their money back. This can cause banks to fail.

The bank runs of 1930 were followed by similar banking panics in the spring and fall of 1931 and the fall of 1932. In some instances, bank runs were started simply by rumors of a bank’s inability or unwillingness to pay out funds.

FROM PANIC TO RECOVERY

The last wave of bank runs continued through the winter of 1932 and into 1933. By that time, DemocratFranklin D. Roosevelthad won a landslide victory in the presidential election over the Republican incumbent,Herbert Hoover. Almost immediately after taking office in early March, Roosevelt declared a national “bank holiday,” during which all banks would be closed until they were determined through federal inspection to be healthy enough to stay open.

On March 12, 1933, Roosevelt gave the first of what would become known as the “fireside chats,” or speeches broadcast over the radio in which he addressed the American people directly. In that first fireside chat, Roosevelt spoke of the bank crisis, explaining the logic behind his closing of all banks and stating, “Your government does not intend that the history of the past few years shall be repeated. We do not want and will not have another epidemic of bank failures.” He reassured the nation that banks would be secure when they reopened, and that people could trust that they could use their money as they saw fit at any time. “I can assure you, my friends,” Roosevelt intoned, “that it is safer to keep your money in a reopened bank than it is to keep it under the mattress.”

Roosevelt’s words and actions helped to begin the process of restoring public confidence, and when the banks reopened many depositors showed up ready to deposit their currency or gold, signaling the end of the nation’s banking crisis.

“The Great Depression and Keynesian Economics”

It is hard to imagine that anyone who lived during the Great Depression was not profoundly affected by it. From the beginning of the Depression in 1929 to the time the economy hit bottom in 1933, real GDP plunged nearly 30%. Real per capita disposable income sank nearly 40%. More than 12 million people were thrown out of work. The unemployment rate soared from 3% in 1929 to 25% in 1933. Some 85,000 businesses failed. Hundreds of thousands of families lost their homes. By 1933, about half of all mortgages on all urban, owner-occupied houses were delinquent.

The economic recession of 1929 was not, of course, the first time the economy had slumped. But never had the U.S. economy fallen so far and for so long a period. Economic historians estimate that in the 75 years before the Depression there had been 19 recessions (economic downturns for at minimum more than one half of a year in length). But those contractions had lasted an average of less than two years. The Great Depression lasted for more than a decade. The severity and duration of the Great Depression distinguishes it from other contractions. It is for that reason that we give it a much stronger name than “recession.”

Keynes versus the Classical Economic Tradition

In a nutshell, John Maynard Keynes, a British economist,supported the ideas that (1) governments should spend money heavily in recessions and depressions, even if it required deficit spending (spending more money than the taxes dollars the government collects); (2) recessions or economic downturns are a problem of “demand,” meaning people are not buying goods, businesses are not investing or hiring people, and there is not simply enough money flowing through the economy; and (3) the prices of goods remain “sticky” during a depression or recession, that is, they do not fall fast enough, meaning the economy cannot reach full employment of all its workers fast enough. In response to classical economists who insisted on “laissez faire” economics that the government should do nothing, as they argued, “In the long-run the economy will reach full employment,” Keynes famously said, “In the long run,” he wrote, “we will all be dead.”

Keynesian Economics and the Great Depression

The experience of the Great Depression certainly seemed consistent with Keynes’s argument. A reduction in aggregate demand (consumers not buying and businesses not hiring) reduced the economy’s potential output.

The stock market crash reduced the wealth of a small fraction of the population (just 5% of Americans owned stock at that time), but it certainly reduced the consumption of the general population. The stock market crash also reduced consumer confidence throughout the economy. The reduction in wealth and the reduction in confidence reduced consumption spending.

Other countries were suffering declining incomes as well. Their demand for U.S. goods and services fell, reducing the real level of exports by 46% between 1929 and 1933. The Smoot–Hawley Tariff Act of 1930 dramatically raised tariffs on products imported into the United States and led to other countries passing tariffs on U.S. goods, bringing world trade to a halt. This act, which more than 1,000 economists opposed in a formal petition, contributed to the collapse of world trade and to the world-wide depression.

Keynes argued that “expansionary fiscal policy”(meaning an increase in government spending and cutting taxes or both) represented the surest tool for bringing the economy back to full employment. New Deal policies increased government spending, stimulated employment through a variety of federal programs, andencouraged economic growth. Ultimately, the United States did not carry out full “expansionary fiscal policy”until another world war prompted increased federal spending for defense. Because during the Great Depression state and local governments continued to cut purchases and raise taxes, leading to the net effect of government at all levels of the economy not increasing aggregate demand and employment enough. The U.S. entry into World War II after Japan’s attack on American forces in Pearl Harbor in December of 1941 led to much sharper increases in government purchases and helped the economy ultimately recover.

“Liquidity And Toxicity: Will TARP Fix The Financial System?”

The credit crisis affecting the world’s economy that began in the spring of 2007 can be characterized by the following two issues: (1) market liquidity and (2) toxic financial assets. Money needs to move through the economic system in order for the economy to prosper: people have to buy the goods businesses produce so people stay hired; big financial purchases require the existence of banks; businesses needs loans from banks to exist; and the whole economic system needs investors.

If banks won't extend credit to individuals or businesses, then liquidity problems exist. This might occur when banks anticipate an economic recession (or down-turn)or if they are distrustful of the creditworthiness of borrowers or other banks. Both of these conditions existed in the fall of 2008. Banks and other corporations were anticipating a recession. Meanwhile, interbank lending froze up as banks became suspicious of the investments they had all made in toxic, mortgage-related debt. (Toxic, of course, means bad, as many people had overinvested in homes leading to home foreclosures, which crippled the banks that had invested in the housing market.) These financial assets, which were held by many Wall Street firms, went down in value right along with the value of the real estate market. A financial bailout by the government was needed.

Making History
The events of September 2008 were of historical significance. The U.S. Treasury Department took over control of government-sponsored financial entities Fannie Mae and Freddie Mac on September 7, 2008. This should have been a positive thing for the economy, but the investors who had stock in these firmswere shocked that their investments turned out to be worthless.

Also, on September 14, 2008, the financial world was troubled by Lehman Brothers, a financial services firm, also an investment bank, declaring bankruptcy. Lehman Brothers needed financial capital to stay in business and no other lender was willing to buy out Lehman Brothers to take-on the financial risk. All of this pressure forced the last two remaining Wall Street investment banks, Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE: MS), to become bank holding companies on September 21, 2008. Going forward, these were to be regulated by the Federal Reserve Banking System.
As if September wasn't dramatic enough, the month ended with the nation’s largest savings and loan, Washington Mutual, eventually failing and being placed into receivershipby the Federal Deposit Insurance Corporation (FDIC) and then sold to JPMorgan (NYSE: JPM). All of these events had the already jittery markets positively frantic. Investors didn't feel they could safely invest in the financial markets and feared their cash could be at risk if their bank failed.

TARP to the Rescue
The sum total of the events of September 2008 brought the market to its knees and pushed the government to explore a bailout forWall Street. It had to be flexible, it had to get to the heart of the issue, and it needed to be passed quickly. The initial proposal for theTroubled Asset Relief Program(TARP) was to allow banks,brokers,and insurance companies to sell residential and commercialmortgage-backed assetsto the government, establishing a floor for distressed asset prices. The government wanted to get the toxic assets off the balance sheets of banks, allowing them to be more confident in the financial marketopening up credit markets and restoringmarket liquidity.

Emergency Economic Stabilization Act of 2008
On October 3, 2008, President George W. Bush signed the $700 billion, Emergency Economic Stabilization Act of 2008 (EESA). Sometimes referred to as the "TARP Act," it included several provisions. One of those provisions gave the U.S. Treasury Department broad authority to purchase, manage, modify, sell, and insure mortgage-related assets as well as any other financial instruments deemed necessary to stabilize financial markets, including equity markets. These provisions of EESA were aimed at bolstering the economy and restoring confidence in the banking system.

Capital Purchase Program
With the Capital Purchase Program (CPP)the Treasury Department purchased equityin banks as a way to inject capital into the banking system. The first $250 billion of the $700 billion approved by Congress was used to make direct cash investments in regional and super-regional banks. The U.S. government's direct investment in banks was a historically unprecedented move,especially since it is a capitalistcountry. This emphasizes how urgent the situation had become.The banks that received the capital injections were "strongly encouraged" not to hoard the cash, but to use it to make loans (to get money moving), thus encouraging market liquidity.