Comparing and Contrasting Economic Conditions of the
Great Depression of 1929-1939 and Great Recession of 2007-2009 December 6, 2015
The Great Depression of 1929-1939 and the Great Recession of 2007-2009 in the United States are analyzed to identify similarities and differences of these historic economic shocks and the events surrounding them. Both were part of downturns in business cycles that exhibited unusual and stubborn resistance to the upturns that followed. It is apparent that market forces, government actions, and unique circumstances were factors in these dilemmas. Economic models and analysis techniques have evolved over the years to provide improved insight that will be helpful to avoid comparable economic catastrophes in the future. Success will be determined by the ability of the government and Federal Reserve Bank, as appropriate, to maintain necessary separation of commercial and investment banking, balance free market principles while mitigating for negative externalities, and use economic models to judiciously monitor and forecast market conditions to set monetary and fiscal policy.
A number of factors appeared to contribute to the Great Depression. Friedman and Schwartz provide evidence that tight monetary policy causing large declines in the money supply played a major role, with the Federal Reserve raising interest rates in 1928. Later, the Federal Reserve raised interest rates to stop devaluation of the dollar and losses of gold reserves due to speculators. This fueled banking panics and failures as depositors feared losses of uninsured savings. Thus, the high interest rates during much of the 1930’s appeared to inhibit recovery. Gross Domestic Product (GDP) declined more that 35 percent in 4 years and by 1939 it was still 27 percent below the 1929 level. Unemployment skyrocketed from about 3 percent in 1929 to 25 percent in 1933 as more than 12 million people lost their jobs and 85,000 businesses shut down. More than one-half of all owner occupied urban home mortgages were delinquent by 1933. The aforementioned Federal Reserve policy was questionable as the economy was only just coming out of a recession in the late 1920’s, commodity prices were dropping dramatically, and there was next to no inflation. As a consequence, real output started declining in August 1929 prior to the sharp drop of stock prices in October 1929, otherwise known as the Great Crash, and accelerated through 1930 due to continuing market volatility. Stock market conditions caused consumers to curtail spending on durable goods as they tried to decipher the state of the economy, which led to lower aggregate income. Other Great Depression causal factors were the destruction of wealth due to the declining stock prices, and the high amount of liabilities held by consumers from the boom period of the late 1920’s. Another contributing element was an aggregate supply collapse that prevailed from 1931 to 1933.
During the period of the Great Recession in 2007-2009, unemployment in the U.S. increased from about 4 percent to 10 percent while long-term unemployment went from under 1 percent to more than 4 percent. GDP contracted by about 5 percent while consumer expenditures declined about 8 percent. Labor force participation rate dropped about 1.5 percent. Bank failures were 0.6 percent compared to 50 percent in the Great Depression while changes in prices during the two periods were +0.5 percent compared to -25 percent. There were a number of factors leading to the sharp decline in economic activity during the Great Recession. U.S. financial markets were destabilized by extensive malfunctions in oversight due to deregulation in recent decades. Major financial institutions exhibited failures in prudent corporate governance and risk management practices. The financial system exhibited excessive levels of borrowing and high-risk investments lacking in transparency. The Treasury Department, Federal Reserve Board, and other agencies did not properly scrutinize the financial system and were ill-prepared to respond appropriately. The financial markets experienced a systematic breakdown in accountability and moral principles. Mortgage-lending standards plummeted and a risky mortgage securitization pipeline was created that set the stage for systematic failure. Over-the-counter derivatives, no longer regulated after the year 2000, were a significant contributing factor. Credit rating agencies failed to properly analyze mortgage-related securities. A financial bubble was created as the economy was functioning above its sustainable level of output and consumers were given a false sense of well-being.
Romer reviewed 1920’s and 1930’s business reports from 5 representative firms. Following the Great Crash, four of these publications noted great uncertainty that was unprecedented in their earlier predictions during the 1920’s, particularly the recessions of 1920-1921 and 1923-1924. Some of the forecasters became positive in 1930 while one remained pessimistic. Indications are that the purpose of these forecasts was at least in part to point out the bright side of invents and minimize the downside. However, these publications documented consumer uncertainty and the prospect that the downturn and diminished household spending could continue for an extended period if volatility remained in the stock market.
In recent years, the Wall Street Journal has reported monthly surveys of up to 60 business economists’ predictions in the areas of GDP, unemployment levels, rates of interest and inflation, housing prices, etc. Analysis of the forecasts by both these economists and the Federal Reserve found there was recognition of a slowdown and that a recession could occur in the late 2000’s. However, the Great Recession, its severity, and reductions in GDP were not predicted at least until the quick decline of the economy was evident and the failure of Lehman Brothers in the third quarter of 2008. A key reason was that real-time information was not representative of economic conditions. Generally, economists also failed to discern between downturns involving banking and financial crises as opposed to traditional recessions. Additionally, analogies of past downturns, particularly the dot-com collapse in 2001 and the 1987 stock market crash, did not lead to severe recessions.
Labor Union Reactions
The Great Depression led to heightened demands by workers for stronger unions and the population became more sympathetic as faith in free markets waned. This helped to influence changes in labor law as evidenced by the amount of such legislation that occurred as part of the New Deal during the 1930’s. A primary macroeconomic objective of New Deal legislation was to redistribute economic resources by creating sufficient union bargaining power. Consequently, there was a rapid increase in the proportion of the work force in unions from about 10 percent in the early 1930’s, to 28 percent by the end of that decade and 35 percent by the end of World War II. Private sector and overall union membership then began a slow decline to about 14 percent by 2000 while public sector unions expanded. At least part of the reason for this later downward trend appears linked to the strong post-war economy and the increased public belief that it was due more to Keynesian expansionary policies than unions. Labor laws began to reflect the declining support for unions as conservative pro-business attitudes prevailed. In the 1980’s to the present, rapid globalization and international trade has given businesses more alternatives to circumvent unions and lower costs by moving outside the country to use foreign workers.
There are differing views regarding the impact of unions on recovery from economic shocks. The conventional interpretation of the law of supply and demand is that government intervention during both economic shocks exacerbated the problem and inhibited recovery by artificially increasing wages through various work programs, union proliferation, monetary expansion, and entitlements. Conversely, in the 1920’s New Era wage theory came about with four distinct components purportedly necessary for a sound economy. The first is the concept of a living wage in which the price of a good or service should cover all production expenditures, including fixed labor costs necessary to support a minimal level of worker subsistence. Second, the productive efficiency wage posits that higher pay likely will be more profitable due to improved employee morale/loyalty and less turnover, which in turn stimulates innovation. The third is the mass consumption wage concept which holds that higher income goes hand-in-hand with increased consumption and spending which shifts both supply and demand curves to the right. Finally, in depressions, market-induced wage cuts must be stopped as they lead to destructive competition or a downward spiral in wages and prices, i.e. a race to the bottom.
The hoarding of labor and capital from 1929-1933 had a strong impact on total factor productivity (TFP), a measure for how efficiently and intensely inputs are used in production. In turn, consumption and investment were depressed as a result of high interest rates. Procyclical productivity explains about 5 percent of the 18 percent decline in aggregate productivity during the Great Depression. This includes changes in capital utilization, increasing returns, labor hoarding, and shifts in production to low-productivity sectors from high-productivity sectors. During the Great Depression, the motor vehicle industry was in the midst of improving mass production technology. Those firms that had not progressed substantially in implementing this model were at a competitive disadvantage and tended to fail while low average cost companies survived. Generally, the remaining companies, both large and small, retained about one-half their number of employees at the trough than they did at the peak. Low marginal cost firms obtained larger market shares amongst the survivors. Between 1929 and 1933, the auto industry experienced closing of one-half the plants and more than one-half of the companies. This accounted for almost one-third of the decline in overall industry workers. The eventual upturn in the auto industry was marked by company expansions as opposed to new replacement firms.
Surprisingly, real wages in the industries studied increased from 1929-1937 despite high unemployment rates. This is difficult to explain when the demand for labor was likely very low. A Keynesian explanation is that the “stickiness” of nominal wages and rapid deflation together caused increases in real wages. This forced companies up their labor demand curves thereby increasing unemployment. A more reasonable or supplemental explanation is that the number of hours worked by each employee varied, i.e. the “intensive margin.” This is because firms were required to maintain a relatively intact skeletal workforce for staggered or spread-work schedules resulting in work of only a few days per week. Employees would reach a point where they would leave a company for another firm if they could not receive minimal subsistence. Firms were then forced to increase real wages for remaining workers, as in the iron and steel industry, to remain in business.
During the Great Recession, employment dropped significantly in all sectors except extraction industries, with job losses in manufacturing and construction together accounting for about 40 percent of the decline. Nevertheless, there was not any single sector that was largely responsible for the downturn. Consistent with other research, one study found that sectoral changes or job restructuring accounted for 34 to 96 percent of the 4.1 state median unemployment rate increase from 2009-2011 but much smaller levels afterwards. Labor force reductions continued after the Great Recession from 66 percent at the beginning to 63 percent by 2014 and have not recovered due to both structural and cyclical factors. Causes of the former consist of baby boomer retirements/aging of the population, and less men and youth in the labor force. Also included are lack of pertinent education and job skills, as some choose to forgo retraining and employment in new fields, due to job polarization. This is a long-term trend, particularly in areas with greater losses in middle-class blue collar employment shares, that is exacerbated during extended recessions. The unemployment rate and labor force participation rate gaps both contribute equally to reduced employment/population ratios. Another factor in unemployment was the reduced availability of credit which tended to drive those firms out of business that were highly dependent upon financing. This impacted up to 8 percent of the total change in unemployment.
Monetary and Fiscal Policies
Fiscal policy was not expansionary and had little impact on recovery from the Great Depression prior to 1942 as tax revenues increased and relatively small deficits were maintained despite up to four-fold increases in federal spending. On the other hand, the rapid growth in money supply for a period after 1933 appears to have been a major factor in aiding recovery. This was facilitated by political occurrences in Europe prior to World War II along with Roosevelt Administration policy (via the U.S. Treasury and not the Federal Reserve Bank) causing a large inflow of gold to the U.S. This was effectively an aggregate-demand stimulus which resulted in lower real interest rates and increased investment spending. Supporting evidence consists of a noticeable rebound in consumer expenditures on durables in 1933-1934 and services in 1935. The U.S. economy returned to trend level prior to World War II.
Fiscal policy in the form of deficit spending was much more profound in response to the Great Recession, almost twice that of the Great Depression as a percentage of GDP. The Economic Stimulus Act of 2008 provided temporary relief for individuals and businesses in the form of tax rebates and incentives worth about $152 billion. The Emergency Economic Stabilization Act of 2008 authorized the U.S. Treasury to use about $700 billion for loans to companies in financial peril and the purchase of distressed assets, particularly mortgage-backed holdings. The American Recovery and Reinvestment Act (ARRA)(2009) increased funding to localities for Medicaid, education, transportation projects, and other investment. It also temporarily reduced tax rates on individuals and businesses, extended unemployment benefits and expanded food assistance reimbursement. Cost of ARRA in terms of the net estimated increase in the federal deficit is about $787.2 billion for the period 2009-2019.
The value and beneficial impacts of these policies since the recession have been hotly debated in the following years due to slow recovery, stubborn unemployment and large rising federal debt levels. A number of states have proposed and/or passed legislation that weakens wage and labor standards in efforts to address public sector fiscal challenges. These efforts include: limitations on unemployment benefits; less restrictive child labor provisions; restrictions on minimum wages; and elimination of collective bargaining rights for public employees. Perhaps due in part to this backlash, state government employment declined 2.2 percent from 2009-2011.
Wen and Wu compare and analyze responses to the Great Recession in China with the U.S. and other Western nations. When China went through economic reform, they transitioned from central planning to a market economy but created a dual-track system of state-owned enterprises (SOE) and private-owned enterprises (POE). The purpose was to prevent a large increase in unemployment during reform and to protect against failure due to the uncertainty of success. The SOE sector comprises about 20 percent of total industrial development. In 2009, Chinese SOEs reacted to collapse of the export market impacting all countries by substantially expanding credit borrowing and fixed investments to stimulate aggregate demand. GDP growth and renewal of private investments came about quickly after these actions. In the U.S., the proportion of stimulus funding used for government purchases was very small. This was due primarily to state and local governments that, despite receiving stimulus funds, often focused on reducing borrowing and increasing transfer payments. Therefore, U.S. fiscal policy in response to the Great Recession may have been far too small and did not achieve the desired impact compared to the SOE’s actions in China. Further, the U.S. relied too heavily on monetary policy such as lowered interest rates and increasing the supply of currency. Banks reacted by increasing excess reserves at a disproportionate rate compared to loans. After the Great Recession, both China and the U.S. were able to re-establish their long-run growth rates but only China retained its long-run output level.
In response to the Great Recession, the central bank instituted quantitative easing programs, consisting of large-scale purchases of mortgage-backed securities and long-term treasury bonds from banks to expand liquidity and reduce long-term interest rates. This increased the value of the Federal Reserve’s asset holdings from less than $1 trillion to more than $4 trillion in 2015, and the amount of commercial bank reserves, encouraging them to make loans and buy assets which raises stock prices, lowers interest rates, and spurs investment. Banks have allowed reserve balances to increase substantially due to quantitative easing but the program has had the desired effect on increasing asset prices and countering deflation to some extent. The Federal Reserve also introduced qualitative (credit) easing to reduce the amount of high-risk assets held by financial companies and change the quality/mix of assets purchased by the central bank. This included Federal Reserve purchases of mortgage-backed securities from financial institutions which served to hold up their prices, increase the monetary base, and direct credit into markets by circumventing banks. Another unconventional monetary policy used by the Federal Reserve was a precommitment policy of pledging to continue the Fed funds rate near zero for an extended period. This expansionary policy served to keep the short-term rate down to minimize investment losses from those holding low-interest bonds.
The moral hazard problem is a dilemma created when individuals are not required to account for or bear the brunt of the harmful effects of their decisions. Commercial banks and investment firms may take riskier actions in business dealings than they otherwise would, knowing that the Federal Deposit Insurance Corporation (FDIC) or the Federal Reserve Bank will cover any losses. Moral hazard was also a concern for both economic shocks in terms of the principal-agent problem in executive pay. The common perception is that these events were largely due to irresponsible corporate and investment banking behavior and speculation driven by greed. Executives during both eras often held incentive-laden and performance-driven contracts that encourage such practices as they did not include consequences to those individuals when decisions are not in the best interests of shareholders. Legislation enacted in response was symbolic as the appearance is given that the problem will be alleviated in the future. Yet, enforceable barriers were not imposed to stop the practice due to lack of political will.
The cushioning effect provided by the FDIC and Federal Reserve may serve to promote the very behavior these institutions were created to avoid, particularly after a precedent is set. The central bank’s traditional role during a crisis has been to decline intervention and stand by while allowing markets to self-correct. This approach has been reevaluated in recent years as the interconnectedness of financial entities has become more apparent in the globalizing markets. Some firms become “too big to fail” in certain situations that could have major impacts in disrupting the overall economy. Thus the Federal Reserve has the overall critical responsibility of maximizing macro moral hazard to ensure the flow of capital and consumption continues while unemployment and recession severity is minimized. When economic disruptions occur, the central bank’s approach is to minimize micro moral hazard or the level of aid given to a particular company or trade pursuant to its established goals. These actions must be consistent with the Federal Reserve’s most critical mandates: maximum employment; sustainable economic growth; and stability of prices, banking and financial systems.
During an intervention, as with the onset of the Great Recession, the Federal Reserve first takes a stern approach which includes facilitating the methodical dismantling of the distressed entity. Alternatively, the central bank may provide a loan at a high interest rate with sufficient collateral which allows the firm to recover. In this vein, a two-year $85 billion line of credit was given to AIG, at a punitive interest rate and secured by warrants, allowing the Federal Reserve to purchase most stock in the company if there is a default. Second, “constructive ambiguity” is often used by the central bank to keep most information about the companies and any intercession indistinct or confidential. Third, the Federal Reserve only aids firms when absolutely necessary and may choose instead to transition investment banks to holding companies as they did with Goldman Sachs and Morgan Stanley. Alternatively, firms such as Merrill Lynch, Washington Mutual and Wachovia were purchased by private-sector firms. J.P. Morgan was given a $29 billion loan to purchase the assets of Bear-Stearns via a newly created limited liability company.
Glass-Steagall Act and Dodd-Frank Act
Commercial banks manage financial deposits and provide loans for businesses and individuals. Brokers or investment banks are generally involved in facilitating transactions of bonds, stocks and other investments. Prior to 1933, there was not much difference between bankers and brokers. In the early 1930’s, Congress found evidence of fraud and conflicts of interest in the securities activities of some banks. The Glass-Steagall Act of 1933 served to prohibit the mixing of commercial banking and brokering to reduce risks for the former. Specifically, the legislation prevents securities institutions from accepting deposits; bans banks from underwriting or dealing in securities; and forbids affiliations between banks and the organizations involved in those activities. The Glass-Steagall Act also established the FDIC to protect the commercial banks and depositors in case of failure. The Glass-Steagall Act was based significantly on John Maynard Keynes’ General Theory which disputed the classic economic standard that markets would return to full employment equilibrium in the long-run without government involvement. For the most part, financial markets were stable while the Glass-Steagall Act was in effect. The Gramm-Leach-Bliley Act of 1999 repealed portions of Glass-Steagall to once again allow affiliations between commercial banks and investment firms, seemingly to increase profits.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was passed in response to the Great Recession. There are two primary objectives of the legislation: 1) reduce the risk of modern-day finance, particularly the shadow banking framework, i.e. financial intermediaries that operate similarly to banks but do not access central bank liquidity or public sector guarantees of credit; and 2) restrict the harm from failures of large financial institutions. The Dodd-Frank Act addressed the same problem of investment banks having access to commercial bank deposits. However, unlike Glass-Steagall, Dodd-Frank does not re-separate commercial and investment banking. Glass-Steagall was very precise in specifying the law while Dodd-Frank set the stage for massive rulemaking by agencies focused on reporting requirements and reactionary provisions.
Prior to the Great Depression, the dominant macroeconomic philosophy was that of Classical economists, based largely on the writings of David Ricardo, who posited that fluctuations in business cycles were normal. Potential output and full employment would prevail without assistance in the long-run by focusing on the supply curve and reducing obstacles to production. The Keynesian viewpoint took hold beginning in the 1930’s, based on the thinking of John Maynard Keynes, which professed that economic downturns could last for extended periods with devastating impacts on society. Keynesian’s promote short-run government intervention policies focusing on the demand curve.
Large reductions in wealth and consumption occurred due to loss of confidence from the 1929 Great Crash and governments at all levels raising taxes significantly, all of which shifted the aggregate demand (AD) curve to the left. Reductions of 20 percent in nominal wages served to shift the macroeconomic short-run aggregate supply (SAS) curve to the right which might have increased production and lowered prices (Figure One). However, this was offset by the Smoot-Hawley Tariff Act of 1930 which raised tariffs, resulting in international retaliation and reduced demand for U.S. exports.
Additionally, the money supply fell more than 30 percent due to the numerous bank failures.
Further, the sharp reduction in demand was overwhelming and shifted the AD curve to the left which lowered output and pushed prices down even further. New Deal employment programs served to stabilize wages but also resulted in a barrier to recovery in terms of short-run aggregate supply expansion. There was no expansionary fiscal policy to address aggregate demand as increased taxes more or less offset increases in government spending. Monetary policy was generally not expansionary due to increased interest rates during a portion of the period and reductions in the money supply via the central bank. Consequently, the Great Depression lasted much longer than the typical recession. Figures 2 and 3 depict respective Keynesian and Classical policy results that may have moved equilibrium closer to potential output under alternative government actions. As mentioned earlier, expansion of the money supply via the U.S. Treasury was a major factor in resolving the Great Depression. The effect was solidified further due to massive government spending with the onset of World War II.
Comparatively, the Great Recession was caused due in part to prior government policies that unsustainably propped up aggregate demand and reduced unemployment. When the bubble burst, the AD curve shifted to the left, unemployment rose, and output fell significantly below its potential. The expansionary monetary and fiscal policies that followed shifted the AD curve partially back to the right but employment and output remained below pre-recession levels (Figure 4). The stimulus was expected to create fast-paced temporary growth to put the economy back on its previous 3 percent growth trend. This did not occur. More expansionary tools might have moved the economy closer to equilibrium. However, there appears to also be a long-run barrier in recent decades that is inhibiting potential output due to globalization, high exchange rates and the trade deficit that are all causing structural stagnation. The structural stagnation hypothesis holds that the configuration of the U.S. economy has not evolved with international markets. Recovery has taken increasingly longer from the last three recessions indicating that supply-side changes are necessary. If the hypothesis is true, demand-side government policies have been excessive since the late 1990’s. Without a positive supply shock, slower long-term growth trends below 3 percent and higher unemployment of 6-7 percent are likely for the long-term. The trade deficit exists because the domestic economy’s long-run equilibrium price level is above the world supply curve and the exchange rate has not adjusted to balance trade movement (Figure 5). As a result, the U.S. consumes excessive quantities of imported (and domestic) goods but has difficulty exporting products. Domestic producers have not reduced wages and costs sufficiently to be competitive with foreign companies, which will in turn lower aggregate demand. Thus the U.S. suffers from import-led stagnation. Expansionary policies encouraged workers to forgo retraining in globally competitive employment and take available non-tradable jobs in education, health care, government, and retail. 
The Great Depression of 1929-1939 and the Great Recession of 2007-2009 in the United States both occurred and were followed by slow recovery periods due to much of the citizenry living beyond its means, uninhibited commercial and investment banking practices, and the failure of appropriate Federal Reserve monetary policy in forecasting and manipulating business cycles. In both instances banking, businesses and the population at large exhibited a herding mentality through increasingly risky purchases and sales of assets on credit. It is unclear that the Dodd-Frank Act will prevent these practices in the future, and provide the necessary barrier that the Glass-Steagall Act imposed, by segregating bankers and brokers to maintain stability in financial markets. Such legislation is critical in eliminating the necessity for the Federal Reserve to impose contractionary policies to reduce dangerous speculative uses of credit which can be counterproductive to reaching potential output at equilibrium of the AS/AD curves. The Federal Reserve must continue its practice of minimizing moral hazard concerns by only assisting financial institutions directly when there is a significant threat to the overall economy. The government must discontinue its moral hazard practice of expansionary monetary policy that encourages risky consumer behavior such as the purchase of overpriced homes on credit.
Expansionary monetary and fiscal policies each had roles in mitigating declining output during both economic shocks. As a result, GDP eventually returned to trend levels after the Great Depression. However, in response to the Great Recession, these policies have not brought the economy back to its previous growth trend, likely due to structural stagnation from globalization. Future changes in interest rates should be made with this in mind. Policies must be chosen to facilitate a downward shift in the SAS curve to realize potential output. Such strategies include: ensuring that the workforce is retrained to compete in the tradable global economy; incentives for improving production technology; reductions in transfer payments for unemployment support (in part to address moral hazards); and lower overall wages with reasonable subsistence levels. In turn, these actions will help to shift the world supply curve up via increased exports, lower exchange rates, and foreign wage growth.
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