Academic journal article The European Journal of Comparative Economics

The Great Depression and the Great Recession: A Comparative Analysis of Their Analogies

Academic journal article The European Journal of Comparative Economics

The Great Depression and the Great Recession: A Comparative Analysis of Their Analogies

Article excerpt

1. Introduction

Until recently the conventional opinion was that major disruptions in financial markets characterized by sharp declines in assets and firm failures would always exist but that financial crises of the type experienced during the Great Depression were a thing of the past for advanced countries such as the United States or the countries of the European Union. The 2007-9 crisis proved them wrong.

Analogous circumstances triggered similar crisis dynamics. The periods from 1921 to 1929 and 2001 through 2007 both experienced fairly rapid growth without major contractions, which led to a climate of confidence, highly decisive for the outbreak of the crisis. These periods were characterized by the following aspects, in the order of importance for the outbreak of the crisis: (1) developments in finance that modified the role of commercial banks; (2) an increase in liquidity at the global level that did not lead to inflation but caused risk premiums to decrease; (3) a banking sector that became concentrated in number and size of banks; and (4) a strong belief in the capacity of central banks to promote economic stability and to prevent financial crises in the long run.

These two financial crises started with severe defaults on mortgages that led to significant loan losses on bank balance sheets. Both crises erupted in periods of high uncertainty after the failure of a major American financial institution: the Bank of the United States in 1930 and Lehman Brothers in 2008--and both failures could have been avoided. While the failure was believed to have domestic consequences at the time, the decision to let them go bankrupt was a mostly decisive cause for the dramatic outbreak of the international crises.

Both crises consolidated the powers of young central banks, at the time of the Great Depression it was the young Federal Reserve System and of the subprime crisis, it was the recently founded European Central Bank.

The Banking Acts of 1933 (Glass--Steagall) and 1935 created the Federal Deposit Insurance Corporation (FDIC), separated commercial banking from the securities industry, prohibited interest on checkable deposits, restricting such deposits to commercial banks, and placed interest-rate ceilings on other deposits. The fact that less than a decade after the demise of the Glass--Steagall Act, a similar crisis appeared, and that in March to September 2008, all five of the largest, free-standing investment banks ceased to exist in their old form hint to the fact that the Great Depression and the Great Recession may have similar causes. Understanding these causes will help in rebuilding a regulatory framework that is capable of preventing such occurrences in the future.

2. Close similarities of the periods 1921-1929 and 2001-2007

2.1 Rapid growth without contractions

The absence of a severe depression over almost a decade could have caused apprehension (1), but instead it had the opposite effect: the longer a significant depression was avoided, the greater confidence in the future became.

In the United States, the declines of 1920-21 and 2000-2001 were followed by economic expansions. From 1921 to 1929, two recessions occurred: one from May 1923 to July 1924, and the other from October 1926 to November 1927. These recessions slowed steady growth but they were so mild and brief that most people at the time did not realize a recession had occurred.

The steady economic growth from 2001 to spring 2007 can only be explained by the continuous expansion of credit. In 2001, the Federal Reserve implemented an expansive policy to support the depressed economic climate and productivity, and get companies that had borrowed a lot during the stock market boom of the 1990s out of debt. But the bankruptcies that occurred in 2002 because of bad corporate governance--the most famous being that of Enron in December 2001--forced the Federal Reserve to continue its expansive policy in order to prevent deflation. …

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