Compare and Contrast the Causes of the Great Depression and the Subprime Crisis in the Us and the Factors That Drive the Persistence of the Economic Downturn.

Introduction

The Great Depression from 1929 to 1939, and the Sub-prime Crisis from 2007 up to present, both represent how failure in monetary policy could result in a financial crisis, and how it could result in a prolonged economic downturn or a weaker-than-normal economic recovery.

The Great Depression is here broadly defined to include not only the downturn from 1929 to 1933, but also the exceptionally weak recovery between 1934 to 1939, as suggested by Cold and Ohanian (1999), for the reason that the recovery up until 1939 still failed to bring the economy to it pre-downturn level. It also allows us to have a better understanding of the factors that lead to weakened recovery.

Economists of different steams have produced different explanations for the downturn. The most notable one is the monetarists' view that the Fed's failure to provide liquidity when needed was the major reason why it turned into a great depression that was much severer and devastative that it should have been. Friedman and Schwartz (1963) produced convincing evidence showing that decline in output is usually preceded by drop in money supply, and the Fed's inaction when there were bank runs on thousands of banks, including some large banks like the New York Bank of the United States led to severe contraction in money supply made the downturn a disaster.

While this monetarist view will be discussed in our report, we do not rule out the possibility that there were other contrasting or complementary causes that allowed the crisis to develop, like debt deflation as suggested by Irving Fisher (1933), and nominal wage inflexibility as suggested by John Maynard Keynes (1935).

There is a possible explanation for the persistent economic downturn during Great Depression as debt deflation, which points to the excessive use of leverage by banks that fuelled speculative activities and asset bubbles, and when stock market crashed on Black Tuesday (October 29, 1929), together with bank failures and money contraction, and even decrease in the general price level, quality of assets on the balance sheet deteriorated, and liabilities become more burdensome in real terms, which represents a negative financial accelerator. Firms' expectation of the future profitability was hard hit, and therefore directly discouraging firms from making investment.

Perhaps as Cold and Ohanian suggested, the US economy could have recovered from the economic downturn soon enough, and there were other factors preventing the economy from robust recovery. These factors include the reserve requirements and the National Industrial Recovery Act, which we will address in the report as well.

As far as the current sub-prime crisis is concerned, it had its origin similar to the one that led to the Great Depression - monetary contraction, which this time happened to the shadow banking system instead of the retail bank level. The Federal Reserve was able to identify the problem, perhaps thanks to Chairman Ben Bernanke, who himself has done a lot of research on the Great Depression. Nonetheless, it does not stop the economy clinging to a double-dip recession, with Chairman Bernanke admitting that the recovery is weaker than expected (2011). We shall see why the drop in housing prices in the United States led to the contraction of the money balance, notably in the shadow banking system, and the problem of government failure like deliberately low interest rate environment, moral hazard and so on, with reference to the "triggers and vulnerabilities" as identified by Ben Bernanke.

The report attempts to address first the respective backgrounds of each crisis and their causes, followed by the discussion of actions that were taken by the central bank or the government in response, and the factors contributing to the prolonged economic downturn. We hope this report shall reveal how economic history repeats itself, and how people should learn from it to prevent the next from repeating again.

Causes of Great Depression

What caused the great depression is a controversial topic among economists along these decades. One of the arguments is that the major cause of the Great Depression is the failure of the monetary policy of the Federal Reserve as raised by Milton Friedman and Anna Schwartz (1963), echoed by Ben Bernanke (1983). It is argued that the stock market crash October 29, 1929 was only a trigger, and the economic downturn that followed was mainly caused by monetary contraction, the consequences of poor policy-making by the Fed and the ensuing crisis in the banking system. The major events that caused or reinforced the economic downturn are as follows:

Crash of Stock Market

The collapse of the stock market was a significant mark for the start of the Great Depression. From the level in 1921, stock prices have risen more than four folded and reached the peak in 1929. In a bullish market, investors are filled with bullish sentiment and still believed that the stock market would grow to another high level despite the fact that the wholesale market recorded zero growth . In the fall of 1929, the stock price finally reached the level of which no reasonable profit could be expected of by purchasing the stock, leading to the burst of the stock market bubble occurred on 'Black Tuesday'. Stock prices dropped drastically, inducing more and more investors to liquidate their stock holding.

Some banks appeared to have taken excessive risk by engaging not in traditional banking business of borrowing and lending but instead making huge investment in the stock market, or making risky loans. Without sufficient reserve for tackling emergent changes, they were unable to react to the sudden burst of stock market bubble. As businesses and households both have investment in the stock market to a greater or lesser extent, the stock market crash reduced their ability to make investment or consumption, therefore driving the economy into a recession.

For the comparison, between their peak in September and the low in November, U.S. stock prices(measured using the Cowles Index) declined 33 percent and people lose their savings and feel poorer thus in turn reduced their expenditure.

The Banks failures

Some early economists believe that the stock market crash was the origin of the Great Depression, but to the monetarists it represented only a symptom rather than the cause itself - it was only a result of tightening monetary policy that began in early 1928 and the ensuing rise in interest rates up until the stock market crash.

According to the monetarists and other economists including Bernanke, the troubled monetary policy adopted by the Fed caused the economic downturn and transformed it to the Great Depression