Question:
I have heard people compare the 2008 recession to the depression in the 1930s. But I have always been confused as to why. The depression was caused by issues with loans and no one being able to pay back (with interest) to the US. A recession is something different, right?
answer:
Hmmm. That is a good question. Simple answer is that both were comparable in many ways, but also different.
That’s as simple as it gets. The rest is kinda complicated, so hold on…time for the nuance!
So, the Great Depression was caused by a convergence of factors, one of which was financial. The 1920’s was a boom time for the American economy (we were the only song and dance in town. The other economies were blown up in World War I), so there was a lot of investment in the economy. A lot of this productivity was in the form of consumer goods. The 1920’s America saw the very first truly consumer based economy. Problem with consumer goods is that there’s only so many such goods that people need. Radios, for instance, were a huge consumer good at the time. Well, how many radios does a family need? So, for ten years, radio companies, for instance, expanded their sales. Then sales started to slow down, leaving the radio manufacturer with a warehouse full of unsold radios, so they slowed production, which means laying off workers. So there were fewer people to buy radios…which led to radio companies slowing down production, laying off more people with fewer people to buy radios ad nauseum. Well this was happening with all commodities, not just radios.
There was also a financial component. With increased sales in the 1920’s, the values of stock in those productive businesses increased. You also had a growing middle class with surplus funds to invest in stocks. So more people enter the stock market and that increases the value any more. There didn’t seem to be a limit. They were making money hand over fist in the stock market. So when they used all the money they could on stocks, they started “investing on margin.” That means they took out loans to invest the money in stocks. With the profits they made from the stocks, they could repay the loan and start again. That only works so long as stocks continue to rise, but as manufacturers cut production, top level stock investors stop investing. In 1929, the stock market collapsed, breaking the wealth of many households whose primary source of wealth was dividends, but also destroying the middle class investors who were holding worthless pieces of paper, but also loans they had to pay back. Massive numbers of people started defaulting on their loans.
This was a problem for banks. Banks stopped issuing loans. Some went out of business. Back in the 30’s, if you had money in a bank, even just a savings account, if it went out of business, you lost your money. Game over. So people panicked and started pulling their money out of the banks. This was a problem because banks don’t hold on to your money, they invest a big chunk of it. So when everyone shows up to pull their money out, the bank can’t cover that and the bank collapses. This is called a Run on the Banks.
This was a problem internationally because banks in the United States were also propping up the Germany and the rest of Europe’s economy. Because of the Guilt Clause of the Treaty of Versailles, Germany was required to make reparations to the Allied countries for World War I. Germany did this by accessing loans from the United States through what was called the Dawes Plan. Banks in the U.S. would issue loans to Germany, Germany would invest some of the money into its economy, but also use some to pay the United Kingdom and France and such. These countries were trying to rebuild after World War I, so they often took the money they received from Germany and purchased products from the United States. So you had a virtuous cycle of currency that was boosting the U.S. economy through an indirect stimulus. This works great until banks start going under, then they cut off their loans to Germany, who now can’t pay anyone else. Everyone’s economy crashes.
Then, if that wasn’t bad enough, there was also an environmental component. For decades the United States had been over farming in the Midwest. This culminated in severe droughts that devastated American agriculture. In many cases, farmers in the U.S. were in a perpetual state of debt, using the value of their farms as collateral to plant their season’s crop, then using the profits from bringing in the crop to pay down the loans. When the crops failed, the farms failed and the bank came and took up the land…often selling that land to your big food brands today.
Furthermore, the politics of the time was not well suited for dealing with a Depression. There was no General Theory with which to work (which we’ll talk about later). The President of the United States at the time, Herbert Hoover, really believed that the best thing he could do was be a responsible steward of the national finances. Remember, taxes were lower because there was less money in the economy, so Hoover cut spending. Just like a business, this means thousands of people with government jobs were sent home. They could no longer buy radios either. Hoover and Congress did try to raise revenue through tariffs. They passed the Smoot-Hawley. This counter-backfired because tariffs increase the price of goods. Not a good idea at a time when people couldn’t afford to purchase much goods to begin with.
So what does this have to do with the Great Recession. Well, the Depression was also a Recession by definition. A recession is negative economic growth for two successive quarters (six months). With the Great Depression, this created kind of an economic death spiral. The economy would shrink, people were laid off and production reduced as a response, which in turn caused the economy to shrink more. This continued until a massive intervention was instituted with the New Deal.
The Great Recession in 2008, this collapse was mostly financial, as opposed to the Great Depression, which had a financial component, but was mostly caused by over-production in manufacturing. The Great Recession was caused by over speculation in the housing market. Since World War II, the value of houses continued to rise steadily, meaning investing in real estate was one of the safest ways to grow wealth. In 2000, as a result of a small recession when the tech bubble burst, banks offered low interest on mortgages, making housing very lucrative. Mortgage rates stayed low throughout the early 2000’s, but investors came up with even more ways to make money from mortgage investments. This is way complicated for purposes of this explanation, but in a nutshell, investors started offering bonds based on housing investments. This artificially inflated the value of houses. Banks could issue a mortgage, then sell the mortgage to an investment company that would divide up the mortgages into investment packages and issue bonds on those investments. Don’t worry about the details. The bottom line is that the banks carried no risk for the mortgages that they were issuing because they were selling those mortgages to other companies who assumed the risk. So banks started issuing riskier and riskier mortgages. This artificially inflated the value of homes as people would buy numerous properties knowing they could flip the houses for profit. At a certain point, however, the value of houses reached a point where they became too risky for individuals to invest in. People stopped demanding mortgages, and the value of homes collapsed.
At the same time, households also had a chunk of outstanding debt that was not housing related. Namely credit cards, student loans and auto loans among other things. When things became unstable, they stopped borrowing. During such times, the Federal Reserve usually lowers interest rates in order to incentivize borrowing and stimulate the economy. During the Great Recession, however, Fed rates were already low and no matter how much they lowered them, people were already holding too much debt to take on any more. This is called a Liquidity Trap. People want to hold liquid or material assets rather than debt. Banks can’t offer negative rates. This is called the Zero Lower Bound, so the economy was stuck.
Just like with the Depression, we started a negative feedback loop for the economy. Businesses slowed investment. People held off on charging things to their credit cards. More workers were laid off, while those looking for jobs could not find them. This meant that fewer people could spend, which then led to more layoffs.
This became international because multi-national investment firms with holdings all over the world collapsed. These companies were not just invested in American real estate. They were doing the same things in other growing markets like Spain, for instance. When periphery countries like Spain and Greece collapsed, there was big trouble. Nations in the European Union, except the United Kingdom, do not have their own central banks. They rely on the European Central Bank for their money. The ECB said, “nope,” and stopped issuing loans, leaving the periphery to fall.
So the Great Recession was bad, but not as bad as the Great Depression. Why?
Well, mostly because we had learned a lot from the Great Depression. Namely we now have something called the General Theory designed by an economist named John Maynard Keynes. His theory suggested that during times of economic crisis, when the consumer market does not have the money to spend, then it is up to the government to be “irresponsible” (the opposite of Hoover’s assumption). The government needs to borrow and spend directly into the market until the economy is turned around. This sounds counter-intuitive, but it’s not. During times of recession, the government, especially the U.S. government, can borrow at very low rates, making it easier to pay back to debt when the economy becomes stronger. They can use that money to put people to work. When people return to work, they start making money. They start making money, they start spending money, and the economy grows. With the increased revenues from a growing economy, the government can then start paying the debt down. Furthermore, we had a New Deal that demonstrated that this strategy works. 1
So that’s what we did. First, the United States bailed out the big banks. This was very controversial and remains so. Regardless of how one feels, this was a huge fiscal stimulus (“fiscal” means government spending) into the economy that helped slow down the recession. It slowed, but it did not stop. When President Obama was elected with a Democratic congress he was able to secure a stimulus package, The American Recovery and Reinvestment Act of 2009, that provided hundreds of billions of dollars of stimulus into the economy. This infusion of cash into the economy was enough to end the recession and get the economy growing again. However, most Keynesian economists predicted that is was much to small to bring the rapid growth that was necessary. The ARRA was only about $400 billion. Most economists felt it had to be closer or even in excess of $1 trillion to bring the kind of growth needed for a fast turnaround. They were right. In 2010, because the economy was not growing fast enough to satisfy anyone, the Democrats lost the House of Representatives and their veto proof majority in the Senate to Republicans who were politically opposed to fiscal stimulus. That was it. No more fiscal interventions.
Another benefit is that we did not have a run on the banks. That’s because bank deposits under FDIC, a New Deal program, means that your deposits are insured by the Federal Government. They are safe. If your bank fails, you get your money back.
However, the Great Recession, like the Great Depression, also left permanent scars. For many people in the middle class, especially African Americans and other minorities who had only recently joined the middle class, they lost their most important assets, their properties. There was little effort to help homeowners stay in their homes. This created high levels of resentment that still linger to this day. After the Recession, many of us watched as big banks, having been bailed out by taxpayers, turned around and gave their officers big bonuses. The wealthy somehow managed to get wealthier while most everyone else continued to suffer stagnating wages and loss of opportunity. It became clear that the “deck was stacked” against working people, and we started questioning the validity of our institutions. In many ways, that helps explain some of the political polarization that exists today.
So, yes, a Recession and a Depression are slightly different. Every Depression has a Recession, a period of negative economic growth, but not every Recession has a Depression. A Depression can be defined as a sustained period of economic hardship. In terms of the Great Recession, the big problem was that some folks, namely the top upper class, experienced a Recession for which every effort was made to help them. The rest of us experienced a Depression for which little effort was made to help. This created frustration, resentment and delegitimizing our institutions that still impacts us today.
I hope this answered your question.
- To be fair, whether or not the New Deal “worked” is a matter of debate. Some suggest that the economy would have recovered anyway without government intervention and would have grown even faster if not for all of the government debt incurred during that time. I don’t think the data supports this conclusion, but I’ll leave that up to you. One little known fact is that President Hoover did start the process with government deficit spending to provide relief and suggested investing in public works, but it was too little too late for him. The New Deal picked up the mantel with esprit. A couple of things are certain about the New Deal, regardless of one’s opinion or position. First, the economy did grow. Secondly, the New Deal helped by demonstrating to the people that the government was doing something to help them. Many of the laws and programs created by the New Deal were flawed and problematic, but people who were looking for help felt a sense of relief that their government would not let them starve. We know this because the people continued to vote for Roosevelt three more times and continued to support New Deal programs until the end of World War II.
Mr. Andoscia's Classroom 