Why the recession did not turn into a depression.

Hi. Since i was doing this for the past seven days of my life (and more), I wanna share this with you guys. some economic food for though. heehee. Yes. I am an economist! 🙂

· Great Depression (October 1929).

Prior to this, profits earned by selling bonds in the stock market were used to pay employees and invest in firms. When the stock market crashed, there was a collapse production and wealth. Together with spiralling uncertainty, numerous US firms went bankrupt. Under the Gold standard, the decline of the US economy affected other countries as well. To stop this, governments thought of imposing protectionist measures to protect the economy which actually lowered effective demand. The government also adopted the tight Monetary Policy (MP) which worsened this recession even more.

· World Recession (December 2007)

This was mainly due to housing bubble in the US. The banks were basically borrowing from investors to lend out to consumers for them to buy houses. When there were not enough people borrowing and paying, they allowed for sub-prime mortgages which are basically for people with no income, no jobs, and no assets. When people couldn’t pay these loans, the financial institutions became illiquid and there was a credit crunch. When massive mortgage foreclosures occurred, Banks and insurance companies went bankrupt. This led to the failure of key business and led to an increase in unemployment. Consumer spending declined and investors loss confidence in the economy hence lowering the GDP.

So, looking at the similarities between the great depression and the world recession, in terms of high unemployment rate, deflation, and economic decline, why did the recession not lead to a depression?

We see a few reasons for this, including global cooperation, international trade, the adopted MP and fiscal policy (FP) and how they handled the banking system.

· Global Cooperation

During the great depression, attempts to stop the depression were more unilateral. Despite the world monetary conference in 1933, the participating countries did not reach any agreement on how to address the depression. Conversely, in 2008, most governments had a general consensus that they would be preventing the recession. According to Former president George W. Bush, G7 nations pledge to take all necessary steps to stop the crisis. For example, there were moves by the UK to insure deposits, hence minimising the risk of bank runs which could have worsened the crisis. Fortunately, global interconnectedness makes governments more considerate of other countries before making any drastic decision.

· International Trade

In fact, international trade was one of the biggest differences between the great depression and the world recession. During the great depression, many governments engaged in beggar-thy neighbour policies to increase their local demand. This may have worked if only one country adopted it. But in reality when one country adopts protectionist measures, other countries retaliate. Since international trade cannot occur, effective demand decreased, hence worsening the recession.  On the other hand, international trade has become one of the more important features of the modern economy. As such, when the recession hit in 2008, there was a more mutual consensus to restrain protectionist measures to prevent further recession. WTO assisted in international trade, and G20 pledged to engage in fair trade and to avoid trade wars hence, helping to prevent the recession from turning into a depression.

Moreover, countercyclical polices were also employed to help in recovering the economy.

· Monetary Policy

In 1933, The fed only increased monetary base by 17% and no expansionary MP was adopted. This decreased the money supply by one third and led to a deflation of 25%. On the other hand, the fed lowered interest rate and increased money base by 125% from Sept 2008-May 2009. This aimed to increase investments and counterbalance the fall in consumer spending. This bolstered the fall in prices and maintained a low inflation of 0.5%.

· Fiscal Policy

Furthermore, in the 1930, the government was very adamant in keeping a balanced budgert. aS such, they had minimal tax cuts and government spending.  It took a longer time for military spending and job creation strategies to finally succeed in revitalising the economy and ending the depression Learning from this, the US government adopted large fiscal stimulus packages.  These, combined with quantitative easing as mentioned, were expected to stimulate economic activity and prevent a possible depression.

· Banking System

It is also crucial to realize the importance of the banking system which is so interconnected the failure of some may cause a domino effect.  In 1930’s, the government was more concerned with protecting the US dollar than hindering bank runs. Therefore, banks had to protect themselves with bigger capital reserves and fewer loans. This time, the government bailed out institutions which are deemed too big or too important to fail. This added more liquidity in the market and somehow lessened the uncertainty around and prevented further plummeting of the economy.

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