“The Great Recession of 2007-2009
and The Great Depression of the
1930s: Similarities, Differences, and
Policy Responses”
Jason E. Taylor
Professor of Economics
Central Michigan University
April 14, 2010: Governmental Affairs Conference
Great Depression versus
Great Recession:
A Question of Magnitude
• Great Depression of the 1930s
▫ Unemployment ranged between 14-25 percent
between 1931 and 1940.
• Great Recession of 2007-2009
▫ Unemployment peaked at 10.2 percent.
Great Depression versus
Great Recession:
A Question of Magnitude
• Real Gross Domestic Product fell by 26.7
percent between 1929 and 1933.
• Real Gross Domestic Product fell by 3.7 percent
between late 2007 and mid-2009.
Great Depression versus
Great Recession:
A Question of Magnitude
• The Overall Price Level fell 24 percent between
1929 and 1933.
• The Overall Price Level rose modestly, around
2.5 percent, between late 2007 and mid 2009.
Great Depression versus
Great Recession:
A Question of Magnitude
• Dow Jones Industrial Average fell from 381.2 in
September 1929 to 41.2 in July 1932—a fall of
over 89 percent.
• Dow fell from 14,164 in October 2007 to 6,543 in
March 2009– a fall of 53.8 percent.
What Caused The Great Depression?
What Caused the Great Depression…
Really Three Separate Questions
• What initiated the downturn?
• What made the downturn so steep
(a “Depression”)?
• What made the downturn so long
(“The Great Depression”)?
Stock Market Crash of 1929
• Unparalleled optimism in the 1920s…
a “New Era” perceived to be upon us.
• A classic stock market “bubble.” (More later.)
In October 1929, the bubble pops.
• Many lose significant portions of their wealth.
Confidence in the “new era” is shattered.
Four Phases of the Great Depression
Phase One: Oct 1929-Oct 1930
• Stock market crash (Oct 29) causes jump in
unemployment rate from around 3 percent to 9
percent in December 29.
• But things settle down and unemployment falls
to 6.1 percent by Oct. 1930.
• Sharp recession, but things are looking up.
Phase Two:
November and December 1930.
• Unemployment jumps from 6.1% in October to
14.4% in December. We have a “Depression” on
our hands.
• Primary Cause: The Banking “Panic of 1930.”
Major banks fail including “The Bank of the
United States,” a private bank in New York with
a very official sounding name.
Phase Three: The Banking Crisis
Continues, 1931-1933
• Unemployment steadily rises from 14 to 25
percent over these two years as banks fail en
masse. By 1933, around HALF of all banks in
the United States had failed.
• The Smoot-Hawley Tariff raised duties on
imports (protectionism). Trade war resulted in
which other countries responded in kind. This
contributed to the world-wide Depression.
Phase Four: Where’s the Recovery?
Putting the “Great” in Depression
• Unemployment fell from its 1933 peak of 25
percent to around 14% in 1937.
• Then unemployment rose back to 20 percent
during the “depression within the Depression” of
1937-38
• World War II. Unemployment finally fall back to
single digits in the 1940s.
A (Very) Brief History of the Fed:
Created in 1913
• Banking Panics: 1873, 1893, 1907. Panics occur
because of “contagion effect.” If people hear of a
failure, they may fear for their deposits and run to
their bank—a self-fulfilling prophesy.
• When banks fail, people lose deposits, access to
credit, and the economy suffers.
• It was determined that in order to avoid this cycle, a
“bank for banks” would be created. Fed would serve
as a “lender of last resort” during times of panic.
The Fed’s First Major Test:
Banking Panic of 1930
• Several bank failures occur in the Midwest. Soon a
“contagion of fear” spread throughout the country.
In November 256 banks failed, in December 352
more.
• On December 11, Bank of the United States failed—
the largest commercial bank to have ever failed at
that point in US history. Its significant , but
misleading, name in headlines sparked more fear.
“The Great Contraction”
(of the Money Supply)
Half of all banks in the US failed between 1929
and 1933. With them went the savings—and
often livelihoods—of their depositors.
The Money Supply (currency + deposits) fell by
around one-third during this time period.
Where was the Fed????
Federal Reserve Failed to Act as a
Lender of Last Resort
• Most economists, including Ben Bernanke and
Milton Friedman, place the lion’s share of the
blame for the Great Depression on the Federal
Reserve.
• In 2002, Bernanke (then on the Fed Board)
apologized on behalf of the Fed:
“Regarding the Great Depression, you’re right.
We did it. We’re very sorry.”
New Deal Banking Policy
• Created the Federal Deposit Insurance
Corporation (FDIC) . This cut down
significantly on the bank run problem.
• Also created the Federal Open Market
Committee and gave the Fed broader powers.
This is the birth of the Fed as we know it today.
These policies halted the bank panic and
got the money supply growing again.
New Deal General Economic Policies
• Economists and Historians are more divided
upon whether New Deal economic policies were
beneficial or harmful. Certainly work-programs
created a large measure of relief for jobless.
• My Take: Policies that encouraged cartelization,
unionization, and less flexibility of the labor
market (high minimum wages) slowed recovery
down. Unemployment remained between 14
and 25 percent from 1933 until World War II.
The Great Recession, 2007 - 2009
“Root of the problem is a loss of confidence by
investors and the public in the strength of key
financial institutions and markets. The crisis
will end when comprehensive responses by
political and financial leaders restore that trust,
bringing investors back into the market and
allowing the normal business of extending credit
to households and firms to resume.”
—Ben Bernanke (October 15, 2008)
A Bit About Bubbles
• Bubble: Price of an asset rises, not because of a
fundamental rise in its value, but because people
simply expect it will rise.
• Greater Fool Theory:
I’ll pay $10,000 for a tulip bulb because I’ll find
someone who will pay $12,000 next week.
• Easy Credit: Generally during bubbles assets are
purchased on credit. Lenders are willing because
they believe the asset will continue to rise in value.
Tulip Mania, Holland 1636-37
• Between November and February, tulip “futures”
prices rose 8-fold. According to one historian,
“the population, even to its lowest dregs,
embarked in the tulip trade.” People were
buying these bulb futures only with the
intention of passing along the paper asset for a
higher price.
• Then in on Feb 4, the bubble burst. By May tulip
prices returned to their pre-bubble levels. The
economy of the Netherlands was hurt for years.
US Housing Bubble and Pop
Causes of the Housing Bubble
• Low Mortgage Rates: Influx of savings from
China, etc. and loose monetary policy in US kept
rates low (Fed’s target rate below 2% 2001-2004).
• Greater Fool Theory (spurred on by HGTV, TLC)
• Lax Lending Standards: Subprime mortgages,
adjustable rate mortgages, interest-only
mortgages. For example, 80% of all mortgages
initiated in San Diego region in 2004 were
adjustable-rate, and 47% were interest only.
Mortgage Backed Securities (MBS)
• Mortgage loans are purchased from banks and
assembled into pools which become securities.
• Many loans in these were considered “subprime”
(higher-risk). Still, MBS’s were generally viewed
as a low-risk, high-reward investment and were
purchased by foreigners … and BANKS who held
them as assets on balance sheets.
• When the bubble popped, these quickly became …
Toxic Assets
• An asset who value has fallen so significantly that it
has no functioning market.
• The Housing Crisis morphed into a
Financial Crisis since banks held Mortgage
Backed Securities and other “toxic assets.”
• If these assets were priced at these low levels, many
banks would be in default (“Zombie banks”).
• Banks became afraid to lend to each other for fear
of the other bank defaulting before paying back.
Effect on Middle America
• Stock market fell from 14,280 in October 2007 to
6,440 in March of 2009. Combined with 30%
drop in housing prices, this created a huge
negative “wealth effect” on US households.
• Perhaps more importantly, access to credit, even
for those individuals and firms with good records,
became difficult as financial system froze.
Government Bailouts
• Should the government bail-out banks,
homeowners, and others affected by this crisis?
Government Bailouts
• Should the government bail-out banks,
homeowners, and others affected by this crisis?
Those who say yes cite “Systemic Risk” and the
notion of “Too Big To Fail.”
Failure of company X will have negative
consequences well beyond X.
Moral Hazard Problem
If people feel they will be bailed out when something
bad happens, they will take more risks than are
optimal for society.
Bailouts: Essentially privatize the gains but
socialize the losses of risk-taking.
Result will be too much risk-taking in the future
because of belief they will be bailed out of bad bets.
Government’s Bailout Response
• Bailout Bear Sterns, AIG (who insured MBSs),
US Auto Companies, and others.
• Allows Lehman Brothers to fail in Sept 2008.
• Financial panic ensues—reminiscent of the Panic
of 1930 after Bank of US fails. Stock market
crashes and McCain suspends campaign.
• TARP passed in October to “stop bleeding.”
Troubled Asset Relief Program
• Allocated $700 billion for Treasury to buy up toxic
assets from financial institutions. In effect government
buys stakes in private companies.
• December 2008, Bush mandates that TARP funds can
be used to support any industry government deems
needs it to avert system-wide crisis.
• February 2009, Government began to regulate pay for
executives at firms who took bailout funds.
Government also uses its leverage to convince
companies like General Motors not to close dealerships
that should be closed according to market.
Federal Reserve’s Response
• Inject Liquidity into the System. Lower interest
rate target to near zero. It also created several
new tools allowing it to lend to financial firms.
• Restore Confidence. Opened discount window.
Expanded FDIC insurance in amount and also
provided backing for money market funds.
• Global Coordination. Fed consulted with and
acted in unison with central banks around the
world to stem the crisis.
Fiscal Policy Response
• Bush Stimulus in 2008—$138 billion in “tax
rebate checks” to households
• Obama Stimulus in 2009—$787 billion.
• $1.4 Trillion deficit in 2009 and projected $1.6
Trillion in 2010.
What affect has this stimulus policy had?
Economics of Stimulus
Economists are somewhat divided:
Keynesians—believe that government deficit
spending can have multiplier effects and can
bring an ailing economy back to health.
Others claim that government spending “crowds
out” private sector spending. Deficits, funded by
either taxes or borrowing, effectively take
resources away from the private sector.
Stimulus has little or no economic impact.
Problems Looking Forward
• Unsustainable deficits and mounting debt.
▫ Debt creates a burden on future generations.
▫ We must pay interest every year to our creditors
on our national debt, harming the current
generation as well.
▫ What if our creditors view us as a default risk and
stop lending to us? (China recently started selling
more than buying our debt.) Interest rates would
have to rise so that we could attract lenders. This
could hurt capital formation here at home.
Problems Looking Forward
• Inflation
▫ While inflation has been tame during the
downturn , the Fed has pumped nearly $2 trillion
into the system. Historically, such increases in the
money supply result in inflation.
▫ Fear of inflation hurts the value of the US dollar.
You don’t want to be caught holding something as
it loses it’s value—so sell it (buy Euros).
▫ Gold has risen significantly in value in the past
couple of years reflecting these fears—suggesting
that they may indeed be real.
Problems Looking Forward
• Stimulus “Exit-Strategy”
▫ If the Fed withdraws liquidity and the government
stops running huge deficits, will we return to the
“precipice” of the Great Depression from which
President Obama claims the stimulus has rescued
us?
Conclusion: Are comparisons between
the Great Recession and the Great
Depression valid?
Both were largely set off by popping of equity
bubbles (stock market and housing). Both
morphed into financial crisis in the banking
sector. Policy responses were entirely different.
Great Depression was a failure of government—
specifically Federal Reserve. Government this
time around may have overreacted a bit on the
side of doing “too much.” But given the history,
who can blame them?