by Alex Cukierman
The media and various commentators have recently likened the subprime crisis and its ramifications to date to the great depression of the thirties. There no doubt are similarities between the two crises. However it is important to realize that there also are important differences. Those differences lead one to believe that the persistence and severity of the current crisis, although serious, will be substantially milder than those of the great depression. Following a brief summary of the main similarities this blog focuses therefore on the differences between the two episodes.
What are the main similarities that lead to frequent comparisons between these two recessions? First, it is clear, by now, that the current crisis will become the most serious recession since the great depression. Second, both crises started in the financial sector and gradually spread to the real sector. During both crises many financial institutions either defaulted or had to be bailed out. Third, in both cases the crisis appears to have started with the bursting of a bubble. Fourth, in both cases banking credit dried up. Fifth, in both cases the lower zero bound on the policy rate became effective. Sixth, the crisis started in the US and subsequently spread to other countries.
But in spite of those striking similarities there also are substantial differences in policy responses and in policymaking institutions. The most important ones are that the responses of both fiscal and monetary policies today are much swifter and vigorous than they were during the first three years of the great depression. First, under Hoover’s, who presided over those years, the Federal budget was largely balanced. By contrast, the US budget was in deficit already at the inception of the current crisis and has been increasing steadily ever since. The plans of incoming president Obama suggest that this fiscal stimulus will continue and intensify under his administration. This will take the form of infrastructure investments, aid to states and tax cuts. In particular, a 775 Billions $ (over 5 percent of GDP) fiscal stimulus package is planned just for the first quarter of 2009 alone.
Second, monetary policy also differs quite a bit between the two crises. Friedman and Schwartz (1963) claim that, during the first three years of the great depression, the Fed tolerated and even reinforced a substantial shrinkage of the money supply. They argue that instead of pumping liquidity into the financial system in order to prevent the transformation of liquidity shortages into insolvency problems, the Fed often withdrew funds from problematic banks in order to shield its balance sheet from further losses. This policy precipitated many problematic banks into default, accelerated the downfall of others and contributed to further declines in the already dwindling supplies of money and credit. By contrast, during the last four months of 2008 the Fed poured huge amounts of liquidity into the banking system. It is clear that the lesson of the monumental monetary policy mistake committed during the early thirties has been strongly internalized by current policymakers at the Fed.
Third, there are two important differences in monetary institutions between the early thirties and the present. First there was no banking deposit insurance at the time. As a matter of fact deposit insurance was introduced only after Roosevelt became president in March 1933. By contrast, deposit insurance of up to 100 hundred thousands $ was a long time permanent fixture of the US financial structure much before the beginning of the current crisis. Furthermore, as the current crisis intensified, the ceiling on the insured amount was raised to 250 hundred thousands $. Had deposit insurance existed during the 1930-1933 period, many of the banking failure experienced at the time and the associated monetary disruptions would have been averted. Relatedly, there were no bank capital requirements during the great depression as is the case nowadays.
A second difference between monetary institutions in the two crises is that, during the first three years of the great depression, the US was on the gold standard. The maintenance of a fixed parity with gold collided with the use of monetary policy to offset domestic unemployment during the first three years of the great depression. For this reason the US abandoned the gold standard under Roosevelt. Obviously, since the $ is floating vis-a-vis other major currencies, no such constraint operates in the current crisis. In fact the $ depreciated substantially between summer 2007 and summer 2008.
Fourth, the fact that a relatively large number of banks disappeared during the great depression led to the destruction of banking “informational capital” about the credit worthiness of potential borrowers. One of the main intermediate outputs of the banking system is the creation of information about the credit worthiness of different borrowers. The creation of such information enables banks to distinguish between sufficiently good and sub-standard credit risks inducing banks to supply credit to the first group. This prevents the drying up of credit to this group and maintains the (individually rational) flow of credit to the real economy. The disappearance of many banks during the great depression led to the “destruction of borrower’s” credit ratings causing serious and protracted declines in the supply of credit by banks.
Bernanke (1983) argues convincingly that this mechanism was partly responsible for the propagation and the persistence of the recession to the real sector during the great depression. By contrast, during the current crisis, this adverse mechanism was largely avoided since the Fed either took over insolvent financial institutions or arranged their takeover by other financial institutions. As a consequence, to this point, the destruction of informational capital and the associated adverse impacts on the flow of credit have been small relatively to these costs during the great depression. But, on the flip side, there is during the current crisis, destruction of such capital due to the lack of transparency induced by the complicated structure of MBS’s (Mortgage Backed Securities) and other Collateralized Debt Obligations.
Fifth, the great depression was characterized by beggar thy neighbor policies. In mid 1930 the US Congress passed the Smoot-Hawley Tariff Act that raised tariffs on over 20,000 imported goods to record levels. Other countries retaliated by also imposing restrictions on imports and engaged in competitive devaluations. This led to a serious contraction of international trade. To this point major trading partners have largely avoided the temptation to engage on this path during the current recession. This is due, most likely, to institutional memories of the adverse consequences of such actions during the thirties. Paralelling this tendency there is substantially more coordination of monetary policy mainly through swaps agreements between central banks and related arrangements. Hopefully, the world’s major policymaking centers will continue to largely avoid such trade inhibiting policies. The likelihood that this will indeed be the case is better than during the great depression for two reasons. First is the demonstration effect of the adverse consequences triggered by such policies during the great depression. Second, since the current crisis is likely to be milder and shorter than the great depression, the temptations to engage in beggar thy neighbor policies are likely to be weaker.
Although obvious and well known the sixth difference is nonetheless quite important. The great depression started prior to the Keynesian revolution. As a matter of fact it triggered this revolution. Since then Keynesian policy prescriptions have been tried, criticized, digested and synthesized into more realistic modes of thinking and of policymaking. Much has been learned about their benefits and limitations. Consequently, today’s policymakers are better informed about the potential salutary effects of expansionary fiscal and monetary policies than Hoover or Roosevelt were when they launched their policies. Largely because of that the responses of both fiscal and monetary policies to date have been much swifter and more focussed than during the thirties.
Finally, during the great depression unemployment in the US peaked well above 20 percent and remained in this range for some time. During the current crisis the rate of unemployment rose to over 7 percent and the most pessimistic predictions for the current crisis put it at a peak of 10 percent.
During the current crisis the lack of transparency of MBS and other CDO’s brought interbank credit to a virtual standstill inducing a serious reduction in the availability of credit to firms and households and a flight to safety by savers and institutional investors. To date, the Fed and the Treasury Department backed by Congress have responded by injecting huge amounts of liquidity, recapitalizing banks and outright buying of MBS’s. Those actions have raised the US budget deficit and, no doubt, will raise it further during 2009.
Interestingly, the flight to safety enables the Treasury to borrow funds needed to finance the recapitalization of banks and related activities at low interest rates. Essentially, the Treasury and the Fed have become major financial intermediaries. In doing that they are replacing banks and other private financial intermediaries who have temporary lost their ability to intermediate funds effectively due to the opaqueness of financial instruments produced during the process of securitization.
The Fed and the Treasury are passively accommodating the desires of both users and suppliers of funds in the private sector. Final users require a steady stream of credit, banks require sufficient liquidity to operate effectively and shaken providers of funds currently look for safety rather than for high returns. By stepping in the Fed and the Treasury are accommodating both sides of the capital market and enabling the continuation of intermediation in spite of the panic that has taken hold of the financial industry. The Treasury and the Fed are in a unique position to do that since the first institution is backed by the power to tax and the second by the privilege to print money. When confidence returns to private financial intermediaries the need for the involvement of governmental institutions will abate. They will then be able to reduce their financial intermediation in parallel to the rising involvement of private financial institutions.
On top of this gigantic replacement of private sector financial intermediation by governmental agencies there also are upcoming purely fiscal expansionary packages planned by the incoming administration (described earlier). By contrast during the first three years of the great depression both fiscal and monetary policies were neutral at best and, by some accounts, outright contractionary. In particular, during those years, there was no entity that would step in and offset the drying up of financial intermediation by the private sector as is the case now. For all those reasons I believe that the above policies in conjunction with important institutional differences between the present and the thirties provide reasonable hope that, in spite of some striking similarities, the current crisis will be substantially milder and shorter than the great depression.