Term Paper: Great Depression and the Current Recession Occurred

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¶ … great depression and the current recession occurred and their similarities and differences.

Comparison Between The great depression And The Recession Of 2008

In many ways and from many perspectives, the recent recession has been compared to the Great Depression of the 1930's. Many have stated that this most recent economic episode is the "worst since the Great Depression." There are many similarities but the depth of the Great Depression far exceeds that of the current 2008 recession. At its worst point during the current recession, unemployment reached 10.1%, which is a daunting number but fails in comparison to the 25%

of the American workforce which was unemployed during the Great Depression. Even during the recession of 1981, unemployment of 10.8% was higher than at the high point of the current recession. Although not as severe, the current recession does present certain similarities and several contrasting characteristics to the Great Depression. Certainly similar to the 1930's, the U.S. government was quick to attack the problem. Fortunately, the policies initiated to address the current crisis differ then that employed in the 1930's.

Monetary and Fiscal Policies

The Great Depression was caused by a severe monetary contraction. During the Great Depression, the government unfortunately failed when trying to address the unemployment of 25% of the American workforce. Many economists have gone even further to suggest that some of the policies perpetuated the Great Depression and made it more severe than it might have been otherwise

. This time around the government has taken those lessons to heart as seen by the large interest rate cuts and drastic fiscal policies. The government has learned that a positive monetary and fiscal policy must be undertaken in order to expand the monetary base and revive the faltered economy. However, given the point on the timeline that we are currently on in terms of this recession, the question that must be raised is whether the large fiscal injection from the Obama administration will help. Given the size and scope of the fiscal stimulus a bad decision now could restrain economy and our means to affect other fiscal policies in the future.

Comparing the interest rates cuts during the two crises, the government responded with a more drastic interest rate cuts during the Great Depression, not knowing that the monetary contraction was primarily responsible for the economic slowdown. Consequently the monetary supplies, due to monetary policies, increased at a faster rate during the last 2 years, while monetary contraction was experienced during the Great Depression.

From a fiscal perspective, one key change in policy was the willingness after the Great Depression to allow the government to run at a deficit. Before the Great Depressions the government operated under a balanced budget premise and only after President Roosevelt did it become acceptable to allow the federal government to run a deficit. Although some economists argue that fiscal policy that puts the government in a deficit puts undesirable debt on the shoulders of future generations and puts an undesirable increase in demand on rapidly expanding economies.

In conclusion, the environment of the current recession is different from that of the Great Depression, and we can hardly draw conclusions for monetary and fiscal policy makers due to two reasons. First, interest rate policy was different in Great Depression. In order to undermine speculation, central banks increased interest rates and tightened monetary policy during the Great Depression. During the current recession, interest rates were relatively low at the beginning and even lower during the crisis. Second, fiscal policy was rarely used during the Great Depression.

Although in the 1930s, running the government at a budget deficit became an accepted principle. Two thoughts regarding fiscal policy must be considered. The first regards the consequences about debt burden. Although the government could very well be correct to react to the current crisis with fiscal policy initiatives, especially since monetary policy is fairly ineffective with interest rates at or near 0%

. However, the size and scope of the Obama administration's fiscal policy negatively impact the future by burdening future generations with higher taxes, diluting their work. The lesson from the Great Depression is that too little fiscal policy is bad, but perhaps the lesson of the current recession will be that too much fiscal policy is bad as well.

Debt & Mortgage Crisis

Trade instruments in the form of structured investment vehicles (SIV), such as mortgage backed securities (MBS) and collateralized debt obligations (CDO), began trading in 1999, and was unregulated. The strategy of the SIVs is to issue short-term, low yielding commercial papers (asset side of the SIV) and collateralize them with high yielding securities (debt side), such as mortgage papers

. The risk inherited in these investment vehicles is the obligation to roll over the liabilities they hit their maturity by issuing new commercial papers on top. This only becomes a problem when the market perceives a risk and the obligations cannot roll over because it is now illiquid, which is what happened in 2007. The problem intensified with the fact that, in order to increase profitability, banks levered these vehicles with debt. The SIVs were backed with mortgages, which became unattractive with increasing foreclosures rates across every market in the U.S. The increasing foreclosure rates was caused by the slowdown in home prices, weak economic conditions in many major markets and growth in the volume of risky adjustable rate mortgage loans. The markets realized the toxicity of the SIVs that were backed up with home owner loans that would go unpaid and therefore, the investors were unwilling to buy these mortgage-backed securities. But once the housing bubble burst, banks tried to get rid of bad credits triggering a downward spiral of debt values. This led to fire sales of the subprime mortgage papers. Another consequence, banks were also not willing to provide credit to individuals and businesses, because the banks feared declining debt values. So businesses were unable to purchase raw materials or maintain their workforce, which lead to a rise in unemployment.

There was a similar banking crisis during the Great Depression. The call money market in New York was a major cause of the Great Depression

. Call money is loaned by a bank that must be repaid on demand unlike a term loan. Call money lacked visibility and investors were unable to distinguish between speculation and commercial purposes. The same can be said for the SIVs, since the investors could not evaluate the credit worthiness of the collateral backing the SIV. Second, huge amounts of bad loans were created during the Great Depression. During this era, farmers' land was over-mortgaged and when the corn prices declined due to large international imports, the debts defaulted. Many rural banks failed, also, which triggered nationwide bank runs. The same is true for the current recession. Beginning in 2005, U.S. home prices declined due to weak economic conditions, thus creating a situation in which mortgage loans defaulted. Though this time around the run on the bank did not occur as the government quickly moved to fortify the FDIC and raised the insured funds from $100,000 to $250,000 to instill confidence in the financial institutions.

The cause of the both the Great Depression and the current recession is the risky practices of the banks; creating not only uncertainty, but paralyzing the real economy.

Conclusion

There are four key reasons why the recession which began in 2008 will not develop into another Great Depression. First, bank deposits are now insured. In reality, one of the initial things President George W. Bush did at the start of the recession was to increase the amount your bank account is insured by the Federal Deposit Insurance Corporation (FDIC). The general public will not suffer the loss of all their money because a bank fails like… [END OF PREVIEW]

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