The Great Depression Essay Example for Free

The non bad(p) embossment EssayA large amount of literature including look and text books, exist on the subject of the Great Depression. It is considered by many economists as the worst scotch crisis in American History. Statistics suggest that from the stage business cycle pennant in 1929 to the trough in 1933, the rattling Gross Domestic Product (gross domestic product) contract by 39%. From 1929 to 1933, the un employment graze ruddiness from 3. 2% to 25% any may who had jobs were only able to work part-time. By 1933, 50% of American buzzwords had fai unused-emitting diode. From 1929 to 1933, the consumer wrong mightiness (CPI) fell by -25%. The Dow Jones industrial average fell -89. 2% mingled with september 1929 and March 1933. give nonice enthronization was negative from 1931 to 1935 and the thriftiness experienced a sharp decay in sum of money real(a) income, then there were huge defaults and avowruptcies by business and households (Bernanke. S, 2 004, White, 2009). But what caused the great opinion? Or rather, wherefore did the recession of 1929 turn into a depression? Calomiris (1983) remarks there is still very little consensus amongst economist on this question.Before Maynard Keynes (1936) General Theory of Employment, Interest and Money, economist relied on the Classical approach both to like and explain the Great Depression. However, the classical speculation could not explain a lot of the data at the time for instance, it could not explain the protracted unemployment (Keynes, 1936). This signified the need for a clean supposition of macroeconomics. much(prenominal)(pre token(a)) a theory was provided by Keynes. The essence of Keynes theory is contained in the simple conflate demand model.Keynes identify the cave in of the product in the 1920s as part of the enigma. In his opinion, the collapse of growth led to a reduction in investment opportunities and a mintward shift in investment demand. The uncommon l evels of unemployment could similarly be explained by the collapse of aggregate spending. Keynes along with Irvin Fischer (1933) likewise identified the financial markets as heavy sources and propagators of economic decline during the Great Depression (Calomoris, 1983).However, the exact nature of this connection is still a hot topic of debate, and this is where much of the literature on the great depression can be found. gibe to Keynes theory of aggregate demand, monetary policy had no causal role in the Great Depression (Mishkin, 2007). Mishkin (2007 p 588) argues that this assumption was based on 3 pieces of secern. He states that during the Great Depression come to place on U. S treasury securities were extremely natural depression (Be diminished 1%).To the early Keynesians, the small-scale nominal invade regularise meant that the monetary policy was easy involutionary (Hamilton, 1987). The second assumption was underpinned by the lack of empirical secern on the co-movement between nominal affair rates and investments spending. While the third assumption was based on the fact that surveys by macroeconomists carried on businessmen indicated that their decision to invest was not influenced by market interest rates (Mishkin, 2007).In 1963, Friedman and Schwartz published the Monetary History of the United States in which they outlined a theory implicating notes total as the major cause of the Great Depression. In their opinion, what transformed the recession of 1929 into a depression were the imprudent policies by the supplyeral Reserve, which led to the tune market crash and to the waves of edgeing failures which skipd the money multiplier and the money sprout (Bernanke, 1983a Friedman and Swartz, 1963).The figure 1 below shows the close correlation between GDP and the money stock. Friedman and Swartz countered the Keynesians argument that interest rates on U. S. treasury securities and high grade corporate bonds were low was counter ed by the observation that interest rates on lower grade bonds rose radically during the peak of contraction (between 1930-1933) this indicated that monetary policy was tight (Mishkin, 2007).The second reason why the Keynesian assumptions were regarded as conduct on the question of the tightness of the monetary policy during the depression was that in a period of deflation the important interest-rate transmission mechanism is through the real interest rate and not the nominal interest rate, because low nominal interest rates do not necessarily mean that cost of acquire is low and that monetary policy is easy since public expectation of a reduction in price levels can amplify real interest rates (Hiuzinga, 1986 Summers, 1984).A good example of how the real-nominal interest rate relationship affected the U. S. economy during the Great Depression was seen in the housing sector. Wheelock reports that even though the nominal value of mortgage dept peaked in 1930, deflation caused a rise in the real value of bully mortgage dept up to 1832. Thus the outstanding mortgage dept burden increase sharply during the contraction level of the depression (Wheelock, 2008). Re hunt clubers also criticized the use of Structural Model evidence by Keynesians.Mishkin (2007) argues that the quality of this type of evidence is dictated by the goodness of the model used. Friedman and Swartz narrative on the Great depression was that the original detonate of the Great Depression was the, 1928, Federal Reserve attempt to contain inflated share prices at hem in Street which they attributed to speculative activity. To accomplish this, they raised the policy interest rate. This depressed interest-sensitive spending in areas such as construction and Motor industry.This in turn induced a drop in employment and investments, which led to reduced hiring of workers by companies. The tightening of the monetary policy through the recession which begun in exalted 1929 precipitated the Oc tober 1929, stock market crash (Hamilton, 1987, Bernanke, 2002b). The stock market crash eroded the nations amass savings, leading to a reduction in aggregate demand. From 1930, the contracting economy triggered successive waves of widespread banking panics (Calomiris etal, 2003 Hamilton, 1987 Chandler, 1970). posit failures and hoarding of cash increased both the currency deposit ratio and the reserve deposit so a decline in money stock this added to the deflationary pressures (Bernanke, 2007b White, 1984). They asserted that failure by the Fed to check the decline in money stock with open market operations and loans to banks through cut windows added further pressure to the economy (Friedman, 1963). According to them, the 1937 -1938 recession was triggered by the Feds attempt to belt along lending by doubling of the required reserve ratio, this had the opposite magnetic core.Mishkin (2007) writes that the importance of this theory to some economists is that it capable a whole new connection between the financial sector and the macroeconomy. An otherwise important division was that it suggested new research agenda Calomiris (1993) summarized them thus 1) Can the reduction in money stocks from 1930 to 1933 explain the bank failures or did they energize a separate origin? 2) Was the demand for money stable given the low nominal short term interests rates in the 1930s or was there a runniness hollow 3) Could nominal price and wage rigidity offer an adequate explanation for the persistent stagnation during the 1930s?4) Were policy failures by the Fed actions acts of omission or commission or did they represent the operation of the old classical theories to new circumstances? 5) Were open market operations by the Fed, unaccompanied by reforms in the monetary and bank regulations, sufficient in reversing the 1930-1933 stagnation? Following the publication of the Monetary History, economist tensioned both on confirming Friedman and Swartz asserti ons or in researching the implications of their findings. For two decades, the focalisation was mainly on the first three questions.Unfortunately, economists restricted there inquiries within the framework of the sticky-price, IS-LM paradigm. This approach severely peculiar(a) the search for alternative transmission mechanisms between financial markets and the macroeconomy (Bernanke, 1983). Support for the Monetarist theory has come from formal statistical ladders which examined the correlations between money and aggregate spending (Mishkin, 2007) a number of researchers found that there was no liquidity trap during the 30s therefore, money supply shocks could fox had an important effect on aggregate output signal (Meltzer, 1963 Temin, 1989).Field argued that the pre-depression stock market boom increased money demand and that this was not offset by corresponding increase in money supply. This resulted in increases in the interest rates and in deflation (Field, 1984). Evidence corroborating Friedman-Swartz illiquidity hypothesis as the trigger of the bank failures came from data on bank suspensions aggregated at national or regional level, this data show a correlation between bank failures and turning points in indices of industrial production, the money supply, the money multiplier, interest rate, and deflation rate (Friedman, 1963 Wicker, 1980).According to White (1984, p 138), the first bank failures in the 1930 were not unique rather, it was a continuation of the banking failures of the 1920s. Recently studies by Calomiris and Joseph (2003) take away revealed a strong correlations between the characteristics of banks, the economic environment in which they operated and their chances of survival. The thesis that banks failures were not panic induced, but were a continuation of the bank failures of the 1920s, which were conjugate to bank overbuilding suggested a lesser role of bank failures as a transmission mechanism.Other critics advocated extra ex ogenous expenditure shocks to explain the cause of the depression noting that the real money stock had not contracted during the early stages of the depression (Temin,1976 Bernanke,1983 ). At the selfsame(prenominal) time, some scholars argued that the reduction in money stocks during the initial stages of the depression was not large enough to trigger the depression (Meltzer, 2003) In short, economists realized that money shocks alone could not have transformed the recession into a depression.Thus, additional link were needed between the financial markets and the macroeconomy. Bernanke captured it this fashion in his 1983 research paper One task is that there is no theory of monetary effect per se on the real economy that can explain protracted non neutrality. Another is that the reduction of money supply in the period seems quantitatively insufficient to explain the subsequent fall in output (Bernanke, 1983, p257) The new paradigm shift came with the application of theoretical models of consultation allocation under asymmetric knowledge in delicate markets to the Great Depression.Mishkin was the first to apply this model in his study of the impact of changes in household balance sheet and consumer spending during the Great Depression (Mishkin, 1978). He argued that in the 1930s, the depressive effect of aggregate wealth reduction on consumption was compounded by the dept deflation which in turn reduced aggregate consumption demand. Using empirical evidence, Bernanke research suggests that the efficiency of reference point allocation was reduced under imperfect market conditions of the 1930s and that aggregate demand was reduced by the resulting higher cost and reduced accessibility of credit (Bernanke, 1983).This process, in his opinion, can account for he protracted length of the great depression. Taken together, this new paradigm was not a rejection of Friedman and Swartz thesis, it merely showed that the monetary shock and other events in the ear ly manikin of the Depression prolonged the Depression through there effect on the institutional structure of the credit markets and the balance sheet of borrowers (White, 1984 Romer,1989).In short, macroeconomists have concluded that the tendency of banks to respond to deposit outflows and increased peril of loan defaults by freezing credit can aggravate recessions, magnifying declines in investment, production and asset prices (Calomiris, 2008) The focus on deflation and financial collapse throughout the initiation also suggested ways through which the depression was channeled to other countries.Currently, economists agree that the gold standard contend an important role in transmitting the economic decline in America to the rest of the world (Campa, 1990 Bernanke, 2002b) under the gold standard trade imbalances gave rise to outside(a) gold flows. In his analysis of international transmission of the American Depression, Kindleberger reasoned that that the stock market collapse and deflationary shocks triggered a liquidity squeeze, a reduction in bank lending and the international financial collapse of the 1930s i. e.the lack of access to credit forced less-developed countries to use up their gold and unlike exchange reserves this forced them to sell old quantities of primary products at reduced prices (Kindleberger, 1973). He also noted that the depression was more protracted in countries which stuck to the gold standard The countries that abandoned gold prosecute independent monetary policy and were able to rebound faster. International studies correlating adherence to the gold standard, deflation and continued economic decline have confirmed this argument (Bernanke and James, 1991 Eichengreen, 1992).Economists also call back that the enactment of The Smoot-Hawley Tariff which was supposed to nurture American Farmers triggered a counterproductive wave of protectionist measures roughly the world, which worsened the depression (Draghi, 2009 Hamilton , 1987, Meltzer, 1963) Although most of these debates occurred after the Great Depression, scholars now agree that both inept monetary and monetary policies transformed a normal business cycle into a depression. Since monetary contraction was part of the problem during the Depression.Currency devaluation and monetary expansions had to play a leading role in the recovery process. A number of commentators have shown that the American money supply increased by 42% between 1933 and 1937 and worldwide monetary expansion led to a heavy of interest rates and easy access to credit (Mishkin, 1991). Economists argue that since fiscal expansion can reduce expectation of deflation, they can reduce the cost of borrowing (Romer, 2009). Keynes theory that government spending, tax cuts, and monetary expansion are essential in countering recession can also be justified in light of historical evidence.Economists reason that the massive government spending, such as the New deal program specifically Work Progress Administration (WPA) and Agricultural Adjustment Administration (AAA) reignited the economy (Calomiris and Mason 2003, Romer 1989, Temin 1989). In fact, the cosmopolitan consensus among scholars is that the economy American economy began to recover with a new monetary expansion and spending in preparation for war (White, 2009b). Concerning Banking sector reform, the view on the Bank Holiday is that it was a dramatic and rough-and-ready remedy.The other reforms have also drawn support from Great Depression scholars (Blinder, 2008 Gapper, 2007 White, 2009b). These reforms saw the creation of a number of regulations and institutions, Banking Act of 1933 (commonly known as Glass Steagall Act) the act prohibited commercial banks from underwriting of dealing in corporate securities. Insurance of bank deposits by FDIC was designed to prevent depression type bank runs. south regulated investment and Federal Home Loan Bank (FHLB) guaranteed Residential mortgage loans.Colle ctively, scholars now believe that these regulations insulated Americas banking arrangement from the booms and busts of the financial markets (Russell, 2008). Bernanke (1983 p2) argues that only with the rehabilitation of the financial system in 1933-35 did the economy begin its slow emergence from the Great Depression. The 2007 Economic recession The economic literature on the genuine recession is still limited, however adequate amount of literature exist on the impact of the down turn on the U.S. economy. The Economic Report of the President Jan, 2009 gives a comprehensive coverage of how the recession started where it started and what is to be done. A large amount of literature can also be found on the causes of the crisis. among others. In terms of impact, the reports from the Bureau of Economic Analysis (BEA) indicates that from Dec 2007 to May 2009, America has had 57 bank failures the unemployment rate has increased to 8. 9% the economy has declined by 3.3% from the secon d quarter 2008 first quarter of 2009 from Sept 2008 to may 2009, the federal government has increased the money stock by 125% and over the same period the biggest fall in the Dow Jones industrial stands at -53. 8%. The outlook is equally dire most analysts have predicted a recession that may last up to two years (Roubini, 2009) Moodys Investors Services (MIS), while further job losses are also expected have predicted increased foreclosures, while further job losses are also expected. But the impact has not been limited to America.The International Monetary Funds (IMF) World Economic Outlook published in Jan 2009 painted a bleak picture of the world economy in general They predict that the real global growth will be close to zero in the same report, growth in advanced world economies was projected at -2%. In his report, presented to the V Symposium on International Trade (Feb 20, 2009) Cline reported that the economic crisis in America has triggered a highly synchronized global rec ession, which has seen a contraction in all economies (see the interpret below showing global growth over 3 decades (Cline, 2009).Figure, 3 Showing the Synchronization of ball-shaped Recession Taken together, commentators are unanimous that, in term of severity, this recession is still mild opposite number The Great Depression. Shiller (2009) writes that a lot of the upheavals in the economy have not been seen since the Great Depression. He cites the stock market volatility, the bank failures, the housing bust, the breakdown in intermediation, and the near zero interest rate.Besides the statistical comparisons, the ongoing debate and research effort is focused on how the how the crisis started. The proximate consensus is that the mortgage security plump for housing boom in America it to blame and that the origination and distributions of this paper assets is at the heart of the problem (Markus 2008 Grotty, 2009 Bernanke, 2009 Gapper, 2009) at the same time, researchers maintain that the crisis in the banking sector, was not independent, but resulted from distortions and incentives created by past policy actions.Blundell-Wignall, etal (2009), in there paper presented at a Reserve bank of Australia conference, averred that the current financial crisis is caused by global macro policies affecting liquidity and by very poor regulatory frame work. More specifically, economists choose that any theory of causality, must, among other things, explain how the housing boom started, describe the factors behind the explosion of the residential mortgage backed securities (RMBS), how the banking crisis was triggered and the policy distortions that made it possible (Tett, 2007 Rajan 2009 Grotty, 2009).The findings of a number of researchers who have studied the causes of the current financial crisis in America conclude that the policy distortions started with gradual undermining of the Glass Steagall Act, from the 1980s and the rise of the neo-classical theory of free markets (which advocates markets deregulation) Shiller (2005, p 43) argues that business cycles in the financial markets would not have been a major problem had banks been kept off the asset markets.The same argument is advanced by Summers (2008) who asserts that the deregulations in the banking sector undetermined the banks to the bubbles and bursts of asset markets. Wray (2009) traces the poor regulatory framework in the U. S to the New Financial Architecture (NFA) which he claims is represented by a globally networked system of giant bank conglomerates and shadow banking system of investment bank, hedge funds and bank created special investment vehicles (SIV).In short, most scholars agree that the Riegle-Neal interstate banking and leg efficiency Act of 1994 and the repeal of Glass Steagall Act in 1999 through the Gramm-Leach-Bliley Financial Act played a crucial role in laying the foundation which led to this crisis (Mishkin, 2009, p 268 Grotty, 2009). Atkinson, Wigall, and Le e (2009) have also concluded that the Basel II accord on international bank regulation also clear an arbitrage opportunity for banks which led to the acceleration of off-balance-sheet activities.In the same paper, they claim that SEC 2004 decision to will investment banks to manage there own risk was a major policy blunder. Soros puts it this way. Since 1980, regulations have been more and more relaxed until they have practically disappeared. authorities could no longer calculate their risks and started relying on the risk management methods of the banks themselves (Soros 2008) At the same time, scholars have concluded that the other root cause of the problem is traceable to the easy availability of credit. Diamond, etal (2009, p 615) argue that the policies affecting liquidity availed a lot of funds to the banks.The 1% federal interest rate, the % interest rate in Japan, the fixed exchange rate in china and large reserves of sovereign wealth funds are listed in his paper as sou rces of cheap credit which fuel the economic boom in America led to an inflation of prices around the world. The claims that interest rates were low are supported by statistics which indicates that real short term interest rates were negative from mid(prenominal) 2001 to mid 2005, given the modest values of inflation (Yellen, 2008) The low interest rates, in turn, ignited a housing boom.Fig, 3 shows the Case-Shiller house index from 2000-2008. According to Grauwe (2009), the doubling of US house prices from 2000-2006 was not underpinned by real changes in the U. S economy. In the same survey, he reports that between July 2006 and July 2007 the value of Dow Jones and the SP 500 rose by 30% while GDP increased only by 5%. Taken together, researchers have concluded that the collapse of the real estate market in 2006 was the origin of the crisis. The rising foreclosures turned the credit boom into a bust.however, economist have at the same time stated that the severity of the housing ma rket bust has been compound by the weakness inherent in the financial system (Calomiris, 2008 Rajan 2009 Bookstabber, 2007) namely use of bank deposits for speculative activities- this operation was made possible though special investment vehicles (SIV) sometimes called shadow banking new financial innovations derivative products like Credit Defaults Swaps (CDS) and Collateral Dept Obligations (CDO) they have been described as complex and overly opaque failure of rating agencies to properly calculate the risks embedded in this performer and failures by regulators and supervisors.Some have added that the formulas used to compute the level of risk in this instrument was impugnable and that the development of riskier higher order CDOs tended to magnify the systemic risk (Volcker, 2008 Veneroso, 2007 Soros, 2007 Rajan 2009 b). Sorros (2008) argues that the new types of mortgage-backed securities central to the boom were too complex and opaque to be priced correctly. Grotty (2009 p 40 ) also argues that these instruments encouraged fraud since most investors did not even know what they were buying. That when the risk inherent in these products became apparent in 2007, investors pulled back from structured products in general, banks had to re-absorb the losses incurred by their off balance entities SIV, straining there balance sheets in the process.Moral game problems and adverse selection worsened with time lending to a credit freeze which led to a slow down in economic activities around the world (Mishkin, 2007, Folkman etal, 2007 Dornbusch etal, 2000) Concerning solutions, most policy makers agree that to reverse the recession, there is need for closely coordinated intervention at global level and that efforts must focus simultaneously on fiscal, monetary and financial stability policies. The underlying assumption is that restoring confidence in the prospects for employment and income and returning to balanced growth are the only way out of the recession (Dra ghi, 2009). Strong expansionary fiscal policies, with measures to support demand and safeguard banking and financial system have been instituted throughout the western world.The $ 800 billion horse stimulus plans in America has been seen as bold policy initiative, although many economist are upset about its repercussion on the national dept. The proponents of this plan see it as the best way to either create jobs or prevent job losses (Romer, 2009). At the same time, most central banks around the world have speedyly lowered there interest rates. Draghi (2009) argues that in the initial stages of a crisis, rapid disinflation should not be allowed to turn into a deflation. To keep the banks afloat, central banks have injected large quantities of money into the system in some instances, they have bought corporate dept to keep financial institution afloat.Russell (2009) notes that reactivating financial intermediation is also essential since capital requirements cannot be satisfied by the state alone. To achieve this goal, economists agree on three basics steps. The need to guarantee liabilities to stop bank runs taking the banks through a stress test to identify the banks with solvency problems and ring-fencing the problematic securities or transferring them to separate entities such as bad banks followed by recapitalization (Wheelock, 2009 White, 2009, Draghi, 2009) are possible ways of unfreezing bank lending. At the same time, economists agree that a solution to the housing crisis is necessary.Lastly economists have pointed out that there is a need to reform securitization, credit rating agencies, poor risk framework and underwriting standards, as well as corporate governance lapses (Krugnall etal, 2008). Some economist has also concluded that massive failure in corporate governance in some companies reflects poor incentive structures for decision, thus bank reforms should be extended to corporate remuneration practices (White, 2009 Blinder, 2008, Crotty, 2 009) Reference Bekaert, G, Harvey, C. R. , 2005, Market Integration and Contagion, Journal of Business, Vol. 78, (No. 1), pp. 3996. Bernanke, B. S. , 1983. Nonmonetary personal effects of the financial crisis in the propagation of the great depression.American Economic Review 73, 257276. Bernanke, Ben (2002). 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