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Assignment

Course code: ECON 403

Course title: Monetary Theory and Policy

Lecturer: Asst. Prof. Dr. Hasan Gungor

Student: Murad Alakbarov

Student number: 065028

Task for Assignment II:

Compare and contrast 1929 – 39 Great Depression and current global economic crisis with respect to causes and responses and actions of monetary authorities to this crisis.

Introduction

“…In the old days, we used to suffer nearly periodic economic crises, the sudden onset of which was called a "panic", and the lingering trough period after the panic was called "depression". The most famous depression in modern times, of course, was the one that began in a typical financial panic in 1929 and lasted until the advent of World War II. After the disaster of 1929, economists and politicians resolved that this must never happen again. The easiest way of succeeding at this resolve was, simply to define "depressions" out of existence. From that point on, America was to suffer no further depressions. For when the next sharp depression came along, in 1937-38, the economists simply refused to use the dread name, and came up with a new, much softer-sounding word: "recession". From that point on, we have been through quite a few recessions, but not a single depression. But pretty soon the word "recession" also became too harsh for the delicate sensibilities of the American public. It now seems that we had our last recession in 1957-58. For since then, we have only had "downturns", or, even better, "slowdowns", or "sidewise movements". So be of good cheer; from now on, depressions and even recessions have been outlawed by the semantic fiat of economists; from now on, the worst that can possibly happen to us are "slowdowns".” [1] Dr. Murray N. Rothbard wrote about this terminological evolution in American economy in 1969 sure at that time he cannot have any idea about new term, which will be in use approximately 40 years after publishing of this article, for defining economical misbalance. This term is “financial crisis”. Here in this little study I will try to draw parallel between causes and responses to the “depression” in 1929-39 and today’s “crunch”. * The abbreviation GD indicates the events and facts which belong to the Great Depression and FC correspondingly indicate present Financial Crisis (don’t confuse with FC Barcelona Hocam( ).

History and Causes of Great Depression and Global Financial Crisis

How it starts?

(GD) The fundamental reason of Great Depression in USA was decline in aggregate demand which led to a decline in production as manufacturers and merchandisers noticed an unintended rise in inventories. But all this start as it always happens in American economy from the financial sector. Stock prices had risen more than fourfold from the low in 1921 to the peak reached in 1929. In 1928 and 1929, the Federal Reserve had raised interest rates in hopes of slowing the rapid rise in stock prices. These higher interest rates depressed interest-sensitive spending in areas such as construction and automobile purchases, which in turn reduced production. By the fall of 1929, U.S. stock prices had reached levels that could not be justified by reasonable anticipations of future earnings. As a result, when a variety of minor events led to gradual price declines in October 1929, investors lost confidence and the stock market bubble burst….. (FC) In 2008, the United States fell into recession following a rapid decline in housing prices and a consequent rapid contraction in credit. Government policies and competitive pressures for several years prior to the crisis encouraged higher risk lending practices. Further, an increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. This encouraged speculators to enter into the housing market and as a result it drove up housing demand and continued to propel the upsurge in housing prices. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and adjustable rate mortgages interest rates reset higher. Banks and credits crunch

(GD) The stock market crash reduced American aggregate demand significantly. Financial instability generated considerable uncertainty about future income, which in turn led consumers and firms to put off purchases of durable goods. A banking panic arises when many depositors lose confidence about future expectations and simultaneously demand their deposits be paid to them in cash. Banks, which typically hold only a portion of deposits as cash reserves, must liquidate loans in order to raise the required cash. This process of rapid liquidation can cause even a previously solvent bank to fail. From fall of 1930 till the winter of 1933 American economy experienced 5 widespread banking panics and finally in the march of 1933 president Roosevelt declare “bank holiday”. The bank holiday closed all banks, permitting them to reopen only after being deemed solvent by government inspectors. (FC) The credit crisis is a direct outgrowth of the fall in housing prices that began in 2006. Every bank or other financial entity in the United States is required to have capital assets backing its loans. Major Banks and financial institutions had borrowed and invested heavily in mortgage-backed securities, so when housing prices decline, the value of mortgage-backed securities decline as well. Because banks’ capital assets are declining in value, they must issue fewer loans. It start unwrap the spiral. Tighter credit narrows the market for housing. The fall in demand pushing housing prices further down what again create defaults and foreclosure activities and it reduces the value of mortgage-backed financial derivatives and they decline, credit conditions further tighten… this vicious circle continue until the capital assets are fully re-priced but Americans still didn’t reach this point what they reach that in 17 July 2008 banks reported losses of approximately 435 billion dollars (according to the Congressional Budget Office it reaches 1.2 trillion[2]) . Furthermore as credit conditions tighten, consumer loans, loans for business operating expenses, and loans for corporate expansion become increasingly difficult to obtain. This drives down the sales of many items and forces many otherwise well-functioning firms into failure, consequently it brings to the higher unemployment so if USA let this spiral to be expand freely situation will not get fixed by itself it just will be more deplorable. Responses and actions of monetary authorities

(GD) The Federal Reserve did little to try to stop the banking panics. As it has been shown above bank panics caused a dramatic rise in the amount of currency people wished to hold relative to their bank deposits. This rise in the currency-to-deposit ratio was a key reason why the money supply in the United States declined 31 percent between 1929 and 1933. In addition to allowing the panics to reduce the U.S. money supply, the Federal Reserve also deliberately contracted the money supply and raised interest rates in September 1931. According to the monetarists Milton Friedman, Anna Schwartz and current chairman of Federal Reserve System Ben Bernanke at the time of Great Depression American central bank’s policy making was really poor and it unwind loop of the crisis even more dramatically. Friedman claimed that, if the Fed had provided emergency lending to these key banks, or simply bought government securities on the open market to provide liquidity and increase the quantity of money after the key banks fell, all the rest of the banks would not have fallen after the large ones did, and the money supply would not have fallen as far and as fast as it did. But there was the reason why the Federal Reserve did not act to limit the decline of the money supply, the reason was a gold standard thereby all the credits which are issued by the Fed have to be gold backed and at that period Fed had almost hit the limit of allowable credit that could be backed by the gold. (FC) Since August of 2007 when crisis became apparent financial structures and institutions took several actions regarding to it. For sure the most concerned and agitated about it is the Federal Reserve System and “Broadly, the Federal Reserve’s response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy”.[3] So what they made about it? First of all via open market purchase Fed decrease interest rate from 5.25 to 2 and later on to 1 percent also they reduce discount rate from 5.75 to 2.25 and later on to 1.25 percent. After that Fed increased the monthly amount of short-term loans to the banks in the period of crisis, from 20 billion to the 300 billion, via Term Auction Facility. Moreover Fed expanded the collateral it will lend against to include commercial paper, $271 billion in corporate debt purchased so far by the Fed since Commercial Paper Funding Facility opened, Fed allocated $1.4 trillion for the program. Finally Fed provide a lot of financial support for bailing out companies like Fannie Mae, Freddie Mac, AIG, City Group, GM, Ford, Chrysler etc. Conclusion

If we make comparison in history of American economy the credit condition was never this much poor like they poor today except the period of Great Depression. Actually a lot of articles are arguing that today crisis almost similar to the crisis which took place in 1929-39 and sometimes even we can face with publications which are stating that Credit “Crunch” worse than the Great Depression. But I prefer opinion of the publications which state that it is little bit early to compare this two negative issues in American economy because the economy is a science which actually crated for providing benefits to the society and satisfy the needs of the people, so from the social perspectives the condition of peoples in America still didn’t fall to the level as it fell in the period of the Great Depression. Also compared with great depression today Fed and government really concerned and involved to the “crisis fixing program”, and they are running completely reverse policy correspondingly to the policy which Fed conduct in the period of the Great Depression. This is like a competition between neoclassical and monetarist doctrine as we know fixing of troubles via classical way took ten years from 1929 till 1939 because they assume that monetary policy don’t influence explicitly to the aggregate output, so let’s see how long it will take to fix today’s crisis for monetarists like Ben Bernanke, which implement wide monetary activities for avoiding of harmful effect of financial crisis to the global economy.

References

1. Clair R. T., Tucker P. (2004). Six Causes of the Credit Crunch

2. Jickling M. (2008). Averting Financial Crisis. CRS Report For Congress

3. Krugman P. (2007). Who Was Milton Friedman? The New York Review of Books

4. Terwilliger G. J. (2008). The Financial Crisis. The National Law Journal.

5. Romer C. D. (2003). Great Depression. Encyclopedia Britannica.

6. Siklos P. L. (2008). The Fed’s reaction to the stock market during the great depression: Fact or artifact? Department of Economics, Wilfrid Laurier University, Waterloo, Canada

7. (2008) Understanding the Financial Crisis: Origin and Impact. Junior Achievement

8. Weiss M.A., Jackson J. K., Dolven B, Morrison W. M., Cooper W. H., Hornbeck J.F., Martin M. F. (2008). The U.S. Financial Crisis: The Global Dimension with Implications for U.S. Policy. CRS Report For Congress

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[1] Full citation from “Economic Depressions: Their Cause and Cure” Murray N. Rothbard
[2] Jeanne Sahadi, CNNMoney, January 7, 2009.
[3] Citation from the speech of the Fed’s chairman Ben S. Bernanke “At the Women in Housing and Finance and Exchequer Club Joint Luncheon, Washington, D.C.” January 10, 2008