ECON2182 Paper

1

From: Heather Abrams

Reference: ECON 2182-10

Subject: Term Paper

Date: 12/14/15

Economies in Crisis; the Role of Governments & Central Banks

Purpose

This paper will examine and compare the intervention strategies enacted and actions

taken during the Great Depression and the global financial crisis of 2007-2009 (the Great

Recession). In doing so, readers will see that the two crises share several key intervention

features, despite occurring nearly eighty years apart. These include the U.S. Federal Reserve's

failures to stabilize conditions (Krugman, Melitz, & Obstfeld, 2014; Richardson & Troost, 2009;

Meltzer, 2012), government policy reactions (Atesoglu, 2013; Eichengreen, 2004), and the

ripples across the globe mid- and post-crisis (Temin, 2010). In reviewing literature on the crises,

this paper will arrive at recommendations for dealing with future global economic crises to

provide a smoother and faster recovery.

Source Qualifications

The sources presented in this paper include journal articles from the Journal of Post

Keynesian Economics, Canadian Journal of Economics, The Journal of Economic History, New

Political Science, Cato Journal, Journal of Political Economy, and Daedalus. The Journal of

Post Keynesian Economics presents a Keynesian bias, which would favor expansionary fiscal

policy to alleviate recessions. The Canadian Journal of Economics is the leading economic

journal in Canada, which provides a reputable international perspective. The Journal of

Economic History essentially relates to what its name implies: it publishes research related to

ECONOMIES IN CRISIS; THE ROLE OF GOVERNMENTS & CENTRAL BANKS 2

economic events in history. The American Political Science Organization, a nonpartisan political

science-oriented professional association, publishes New Political Science. The Cato Institute, an

independent, public policy think tank, publishes the Cato Journal. The eponymous Journal of

Political Economy, not surprisingly, focuses on research related to economic theory and related

policy. Daedalus is the journal of the American Academy of Arts and Sciences, devoted to

publishing a wide variety of interdisciplinary research. Additionally, the paper will present

information from Paul Krugman, Marc Melitz, and Maurice Obstfeld's text, International

Economics: Theory & Policy.

Analysis

In order to begin to understand the Great Depression, it is critical to first investigate its

causes. The Great Depression and its subsequent worsening can generally be linked to declining

output, the stock market crash in 1929, and Federal Reserve inaction (Eichengreen, 2004, p. 2).

Chang-Tai Hsieh and Christina D. Romer (2006) agree, calling the Great Depression a result of

monetary contraction in the United States, with U.S. money supply falling "33 percent between

the business cycle peak in August 1929 and the trough in March 1933" (p. 140). These slow

output conditions made the U.S. and its global partners vulnerable targets for economic disaster.

Many economists agree that once the Great Depression was underway, the Federal

Reserve should have enacted expansionary policies to reduce the negative effects and slow the

global decline. Gary Richardson and William Troost (2009) echo this belief, stating, "the Federal

Reserve System missed an opportunity to take inexpensive actions that would have stemmed the

initial wave of banking panics and altered the course of the contraction" (p. 1071). These missed

opportunities include the Federal Reserve serving as a lender of last resort or instituting

expansionary monetary policy. Economic literature of various schools of thought shows that "the


Federal Reserve refused to act despite the overwhelming monetary and real decline" (Hsieh &

Romer, 2006, p. 172). Thus, economists can conclude that the Federal Reserve failed to act

appropriately during the Great Depression, despite many opportunities to do so.

Additionally, it should be noted that the problems of the Great Depression hurt more

countries than simply the United States. Prior to the 1929 stock market crash, national output

was already on the decline for major economies such as those of Argentina, Australia, Brazil,

Canada, Germany, and Poland (Eichengreen, 2004, p. 3). Barry Eichengreen (2004) of the

University of California, Berkeley claims the gold standard accounts for a lot of these

international problems: central banks across the world, already experiencing weak balances of

payments and wary of losing gold reserves to capital flight, "had to respond by raising rates even

more sharply to calm skittish investors" (p. 4). Different causes of the depression across borders

should be taken into account as well: "in the case of the United States, there is no denying the

role of policy mistakes in the onset of the Depression, whereas for other countries international

transmission via capital and gold flows played the more important part" (Eichengreen, 2004, p.

24). Hsieh and Romer (2006) disagree, however, finding that differences in interest rates

between the U.S. and other countries on the gold standard did not rise and forward exchange

rates hardly shifted (p. 172). Post-crisis, Eichengreen claims that the banking crisis and monetary

flight were the main causes of downward market motion in the U.S., as opposed to "other

countries [where] the disintegration of the gold-exchange standard had more profound effects"

(p. 24). Regardless of how much policy mistakes or gold flows differed from country to country,

it is clear that not all countries experienced the same negative effects from the Depression.

Shifting to the time period of 2007 to 2009, Nancy S. Love and Mark Mattern (2011) of

New Political Science claim that the Great Recession "was triggered by increasing defaults and


foreclosures in the subprime mortgage markets that eventually spread to other mortgage markets,

corporate bonds, and commercial real estate" (p. 401). "In a hastily organized rescue, the Fed

bought $30 billion [in] 'toxic' assets in order to persuade the bank J.P. Morgan Chase to buy Bear

[Stearns] at a fire-sale price," Paul Krugman, Marc Melitz, and Maurice Obstfeld (2014)

summarize in International Economics: Theory & Policy. However, the "Fed was criticized for

not wiping out Bear's shareholders (to deter moral hazard) and for putting taxpayer money at

risk" (Krugman, Melitz, & Obstfeld, 2014, p. 616-617). A moral hazard occurs when a person or

organization "takes less care to prevent an accident if [they] are insured against it" (Krugman,

Melitz, & Obstfeld, 2014, p. 610). In the case of the Great Recession, governments created a

moral hazard for banks by essentially guaranteeing that they were "too big to fail" and could not

go under. This led banks and financial institutions to take on excessively risky assets, which led

to high volumes of defaults on loans, a major precursor to the start of the Great Recession.

Again looking at the crisis through an international lens, it is important to point out that

amidst the Great Recession, many "countries sought emergency funds through the International

Monetary Fund (IMF)," an instrument that had not been available in the time of the Great

Depression (Love & Mattern, 2011, p. 402). Even before 2008, the world economic system faced

"a self-reinforcing circle of tightening credit, falling consumer demand, and job cuts on a global

scale" (Love & Mattern, 2011, p. 402). Peter Temin (2010) supports this idea, stating that just a

year prior to start of the Great Recession, "the global financial system had entered into ... an

'adverse feedback loop.' One failure induced another; a worldwide financial panic ensued" (p.

120-121). It is therefore sensible to presume that this situation set the stage for a collapse in U.S.

markets, which then caused global panics and crashes.


The Great Recession has some differences from the Great Depression. Temin (2010)

finds that the "housing market was only a minor player in the drama of the Great Depression, but

it had a starring role in" the Great Recession (p. 117). Temin also points out that politically, "An

important difference between the past [Great Depression] and current [Great Recession]

economic calamities is that because the present crisis is only a recession–not a depression–

Obama does not have the opportunity for reform that Roosevelt did" (p. 121). Here, Temin refers

to Roosevelt's ability to pass major government works projects, namely the New Deal, to

improve employment and increase national income, which President Obama struggled to do,

constrained in his "ability to moderate the recession's effects on ordinary people" (p. 123).

Temin (2010) also finds that the Roosevelt Administration made great strides to improve

employment and income through expansionary fiscal policies. However, once the U.S.

government saw what it interpreted as signs of recovery after the worst of the Great Depression,

it actually reduced government-spending programs, which unsurprisingly resulted in a plummet

in demand and employment (p. 121). In fact, in France, the government enacted "expansionary

fiscal initiatives" and sustained them for a longer time period than the U.S., which "enabled the

Bank of France to maintain interest rates at artificially low levels," and thus France experienced

much milder effects than the U.S. (Eichengreen, 2004, p. 23-24). For the most part, governments

across the globe avoided these same mistakes during the Great Recession, with "Expansive

monetary and fiscal policies ... effective enough to preclude a repetition of the Great Depression"

(Temin, 2010, p. 123). However, H. Sonmez Atesoglu (2013) presents a dissenting view from

the Keynesian perspective, expressing that "government spending was far from large, and has

been continuously less than required for full employment of the economy during all the years of

the Great Recession" (p. 535). For the most part, however, evidence shows that the U.S.


government, in tandem with its global partners, did enact a variety of fiscal expansion programs

in efforts to ebb financial disaster.

Looking at both crises together, it becomes clear that there are major similarities.

Regardless of the time period and specific historical occurrences, "the open American economy

is prone to collapse every once in a while" (Temin, 2010, p. 123). Additionally, "Favorable

conditions" — such as government spending and robust growth — "can eliminate 'great'

economic contractions for a generation or so, but American exuberance appears to chafe under

these conditions" (Temin, 2010, p. 123). Additionally, both crises serve as prime evidence that a

lack of transparency serves the Federal Reserve poorly when economies are in trouble. In fact,

Allan H. Meltzer (2012) finds that in "its 100-year history, the Fed has never announced its

policy as lender of last resort" (p. 261). Meltzer goes on to claim that this lack of transparency

"has serious consequences. Uncertainty increases when no one can know what the Fed will do"

(p. 261). Time and time again, the Federal Reserve has failed to properly alleviate crises;

summarized succinctly, "Overresponse to short-run events and neglect of longer-term

consequences of its actions is one of the main errors that the Federal Reserve makes repeatedly"

(Meltzer, 2012, p. 255). In the case of the Great Depression and Great Recession, the Fed

disregarded the long-term consequences of not alleviating economic problems, causing the

problems to worsen for both the U.S. and, subsequently, its global neighbors. The final similarity

that is important to note is the reactions and results faced by the rest of the world — beyond the

borders of the United States — during and after the crises. In both cases, other countries had

already been in poor positions, such as declining output and demand, that made them all the

more susceptible and vulnerable to external shocks. The disturbances in the U.S. rippled across

the world, negatively impacting the markets of other countries.


Conclusions

The evidence synthesized heretofore points to the conclusion that both the Great

Depression and Great Recession were exacerbated most obviously by Federal Reserve inaction.

While the Great Depression of the 1920s-1930s is often attributed to the dramatic stock market

crash, versus the bank failures and defaults on extremely risky assets associated with the Great

Recession of 2007-2009, both crises originated in the U.S. but created problems globally. Also,

government spending in both financial meltdowns provided some foundation for recovery,

although arguably it worked more successfully during the Great Depression than the recent Great

Recession due to a different set of U.S. political circumstances and a perceived lower severity of

the Recession than the Depression. However, government-spending programs were highly

effective in some other countries, as demonstrated with the France example.

Ultimately, these crises together remind the United States Federal Reserve how critical

both its actions and transparency are for stemming panic and resetting the financial course.

Looking forward, the Fed should focus on increasing transparency of both its procedures and of

its actions. Governments should also continue to emphasize expansionary fiscal policies as a

method for reducing stress and decline post-shocks. Although, economists should remember that

this method that follows a Keynesian model and inherently carries certain biases because of its

origin. And lastly, economies should be wary of global conditions that create ripe environments

for crises to hit hard and spiral downward. World leaders and economists should continue to be

wary of market signals of decline, and should remain vigilant and proactive in fighting economic

crises from the start.


References

Atesoglu, H. S. (2013). Government spending and the Great Recession. Journal of Post

Keynesian Economics, 35(4), 529-536. doi:10.2753/PKE0160-3477350402

Eichengreen, B. (2004). Viewpoint: Understanding the Great Depression. Canadian Journal of

Economics, 37(1), 1-27. doi:10.1111/j.0008-4085.2004.001_1.x

Hsieh, C., & Romer, C. D. (2006). Was the Federal Reserve Constrained by the Gold Standard

during the Great Depression? The Journal of Economic History, 66(1), 140-176.

Retrieved from http://www.jstor.org.proxygw.wrlc.org/stable/3875109

Krugman, P. R., Melitz, M. J., & Obstfeld, M. (2014). International Economics: Theory &

Policy. New York City, NY: Pearson Education.

Love, N. S., & Mattern, M. (2011). The Great Recession: Causes, Consequences, and Responses.

New Political Science, 33(4), 401-411. doi: 10.1080/07393148.2011.619815

Meltzer, A. H. (2012). Federal Reserve Policy in the Great Recession. Cato Journal, 32(2), 255-

263. Retrieved from http://ssrn.com/abstract=2240981

Richardson, G., & Troost, W. (2009). Monetary Intervention Mitigated Banking Panics During

the Great Depression: Quasi-Experimental Evidence from a Federal Reserve District

Border, 1929-1933. Journal of Political Economy, 117(6), 1031-1073.

http://dx.doi.org/10.1086/649603

Temin, P. (2010). The Great Recession & the Great Depression. Daedalus, 139(4), 115-124.

doi:10.1162/DAED_a_00048

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