Why the Recession of 2008 is More Like the Great Recession Than the Great Depression.
Posted: December 3rd, 2008 | Author: Joe | Filed under: Economy | Tags: Bank Failures, Depression, Economy, Investments, protectionism, Recession, Stock Market, Stock Market Crash, Tariffs | 13 Comments »
Unemployment during the Great Depression went over 25%
To understand why the economic recession of 2008-2009 is more like a Great Recession than the Great Depression, it is best to look at the Great Depression and compare and contrast with current conditions.
While there is no single, agreed upon cause for the Great Depression, there are a number of events that are generally held to be responsible.
Causes of the Great Depression.
The Great D is largely seen to be the result of 5 general events, a perfect storm, if you will:
1. Stock Market Crash of 1929.
During the 1920′s, many investors and businesses became over leveraged, and took on too much debt. Investors could buy stock on margin (i.e. on loan) from banks that were willing to lend $9 for every $1 in assets. Times were good, but just like the .COM bubble in 2000, and the housing bubble of 2006, the bubble burst. Investors panicked, and rightfully so since they now owed 90% more than they started with. In a mad dash to raise capital to pay off the loans, investors began to sell and sell big, causing the DJIA to lose 89% of its value within 3 years.
2. Bank Failures.
Many people believe that the stock market collapse caused the great depression, but it only set the stage. After the mad dash to liquidate stocks to raise capital, investors (and eventually non-investors) started taking money out of the banks. The result was disastrous. More than 9,000 banks failed over the next decade. People who kept their money in those banks lost everything. The surviving banks stopped lending money, in fear that they too would become overextended and fail. This credit crisis led to a collapse of the economy as people lost their savings and businesses lost access to capital for expansion.
3. Very Bad Recession.
The eventual result of the stock market crash followed by the bank failures meant that discretionary spending came to a stand-still because discretionary income evaporated. People, businesses and banks were too fearful of spending money on non-essentials which led companies to cut production and downsize, eventually resulted in unemployment over 25%.
4. The Smoot – Hawley Tariff act of 1930.
Government intervened in an attempt to protect American companies, and passed the Smoot – Hawley Tariff act which applied steep taxes to imports. The result was a stifling of trade between America and other countries and retaliatory tariffs on American goods, further crippling economic growth.
5. The Dust Bowl.
Drought Conditions may not have caused the Great Depression, but it made a bad situation significantly worse. Drought and dust storms crippled the agriculture business and bankrupted farmers. It also increased food prices and poverty rates.
How is the current recession different from the great depression?
There are clearly many similarities to the recession and credit crisis of 2008-2009 and the Great Depression, but there are many differences as well.
1. Stock Market Crash of 2008.
As I write this, the DJIA has been down to a low of about 45% from it’s previous 2007 high of just over 14,000. This is not the same as the 89% loss of the Great Depression. It’s possible it will go lower, but there are other factors that differ. One reform that took place in the ’30s was in relation to margin trading. Today, investors can only borrow 50% of their asset value for margin trading, and not 90%. It’s also important to note that even in the 1929 crash, the stock market did not fail. In fact, prudent and disciplined investors who stayed in the market with dividend paying stocks had lost less than 5% by the end of the decade.
2. Bank Failures.
There have only been 19 bank failures in 2008. In the first 10 months of 1930 there were 744 bank failures. Another reform brought about by the 1930′s bank failures was the creation of the FDIC ( Federal Deposit Insurance Corporation). When the banks had a run in deposits in the early 1930′s, there was no deposit insurance and there was no requirement that a bank keep a percentage of reserves for just such a run. Now, a bank that offers FDIC insurance must keep a percentage of assets available, with the FDIC kicking in the rest required to return the insured limit (usually $250,000) should a run occur.
3. Very Bad Recession.
Well, this one is going to happen. The only question is how much are consumers going to reduce spending, and for how long? Also, how restrictive are lenders going to be with credit? So far, most “experts” predict that it will be at least as bad as the early 90′s, maybe 80′s.
4. The Smoot – Hawley Tariff act of 1930.
One of the lessons learned from the Great Depression was that economic protectionism backfires, while free trade brings about prosperity and helps alleviate recessionary factors. The global economy is much more integrated than it was in the 1930′s, and as long as governments don’t favor protectionist policies that cripple free trade, we should avoid this factor of the perfect storm.
5. The Dust Bowl.
The dust bowl is thought to have been brought about by unstable oceanic temperatures. but was most likely accelerated by poor soil conservation practices of the time as well. It’s unlikely that a dust bowl would happen again at the precise time the country experiences the worst economic crisis in a century, but that’s not to say that some other natural disaster couldn’t hit.
Further lessons from the Great Depression.
Along with protectionists tariffs, the government at the time had one other misguided policy: restricting the money supply. It was thought at the time that the government should be fiscally responsible, tighten spending, raise interest rates and this would provide stability and eventually borrowing would be restored to healthy levels. It has since been shown that this is precisely the wrong thing to do in a contracting economy. Doing so leads to deflation, which is much worse than inflation.
This is why Paulson and Bernanke have been pumping as much money as they can into the system – to avoid an all out deflationary depression. Incidentally, it’s also why raising taxes in a recession is bad, and running a deficit is good. Counterintuitive, but governments are not like citizens and have a much longer life span in which to pay back they debt than you or I.
If the experts are to be believed, it seems likely that the economy will head into either a severe, but relatively short lived recession, or a long, but relatively shallow recession but not a full blown depression. It also seems likely that it will be one of the worst recessions since the Great Depression. Call it, the Great Recession of 2008-09.
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