ECONOMIC DEPRESSION

BY M. N. Khan
MEANING

In economics, a depression is a sustained, long downturn in one or more economies. It is more severe
than a recession, which is seen as a normal downturn in the business cycle. A depression is
characterized by abnormal increases in unemployment, restriction of credit, shrinking output and
investment, numerous bankruptcies, reduced amounts of trade and commerce, as well as highly
volatile relative currency value fluctuations, mostly devaluations. Price deflation or hyperinflation are
also common elements of a depression.

LIST OF PREVIOUS DEPRESSIONS

• GREAT DEPRESSION

The most well-known depression is the Great Depression that affected most of the economies
in the world throughout the 1930s. The depression began during the Wall Street Crash of 1929, and
the crisis quickly spread to most national economies. Between the years of 1929 and 1933, GDP
decreased by 33% and unemployment rates increased to 25%. Possible causes for the Great
Depression include the stock market and the bank panics of October 1930.

People standing in que for food to be served

A long-term effect of the Great Depression has been the departure of every major currency from
the Gold Standard.

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• PANIC OF 1837

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 The Panic of 1837 was an American financial crisis, built on a speculative real estate market. The
bubble burst on May 10, 1837 in New York City, when every bank stopped payment in gold and silver
coinage. The Panic was followed by a five-year depression, with the failure of banks and record high
unemployment levels.

People on street unemployed

• LONG DEPRESSION

The Long Depression, known at the time as the "Great Depression", lasted from about 1873
to 1896. It affected much of the world and was contemporaneous with the Second Industrial
Revolution.

CURRENT DEPRESSION FROM LATE -2000S

In 2008–2009 much of the industrialized world entered into a deep recession sparked by a financial
crisis that had its origins in reckless lending practices involving the origination and distribution of
mortgage debt in the United States. Sub-prime loans losses in 2007 exposed other risky loans and
over-inflated asset prices. With the losses mounting, a panic developed in inter-bank lending. The
precarious financial situation was made more difficult by a sharp increase in oil and food prices. The
exorbitant rise in asset prices and associated boom in economic demand is considered a result of the
extended period of easily available credit, inadequate regulation and oversight, or increasing
inequality. As share and housing prices declined many large and well established investment and
commercial banks in the United States and Europe suffered huge losses and even faced bankruptcy,
resulting in massive public financial assistance. A global recession has resulted in a sharp drop in
international trade, rising unemployment and slumping commodity prices. Social unrest and
political changes have appeared in the wake of the crisis.

In December 2008, the NBER declared that the United States had been in recession since December
2007, and several economists expressed their concern that there is no end in sight for the downturn and
that recovery may not appear until as late as 2011. The recession is the worst since the Great
Depression of the 1930s. The unemployment rate has been increasing since September 2008. For April
2009 alone, a net total of 539,000 jobs have been lost in the United States. The unemployment rate in
the United States is currently at 8.9%. The IMF has warned about "worrisome parallels" between the
current global crisis and the Great Depression, despite the unprecedented steps already taken by central
banks and governments worldwide.

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INDICATIONS BEFORE THE PRESENT ECONOMIC CRISIS

• COMMODITY BOOM

The decade of the 2000s saw a global explosion in prices, focused especially in commodities
and housing, marking an end to the commodities recession of 1980-2000. In 2008, the prices of many
commodities, notably oil and food, rose so high as to cause genuine economic damage, threatening
stagflation and a reversal of globalization.

The decade of the 2000s saw a global explosion in prices, focused especially in commodities and
housing, marking an end to the commodities recession of 1980-2000. In 2008, the prices of many
commodities, notably oil and food, rose so high as to cause genuine economic damage, threatening
stagflation and a reversal of globalization.

Increasing Oil and gasoline rates

• HOUSING BUBBLE

By 2007, real estate bubbles were still under way in many parts of the world, especially in the
United States, United Kingdom, Netherlands, Italy, Australia, New Zealand, Ireland, Spain, France,
Poland, South Africa, Israel, Greece, Bulgaria, Croatia, Canada, Norway, Singapore, South Korea,
Sweden, Argentina, Baltic states, India, Romania, Russia, Ukraine and China.[citation needed] U.S.
Federal Reserve Chairman Alan Greenspan said in mid-2005 that "at a minimum, there's a little 'froth'
(in the U.S. housing market) … it's hard not to see that there are a lot of local bubbles". The Economist
magazine, writing at the same time, went further, saying "the worldwide rise in house prices is the
biggest bubble in history". Real estate bubbles are invariably followed by severe price decreases (also
known as a house price crash) that can result in many owners holding negative equity (a mortgage debt
higher than the current value of the property).

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 Hike in housing Prices

• INFLATION

In February 2008, Reuters reported that global inflation was at historic levels, and that
domestic inflation was at 10-20 year highs for many nations. "Excess money supply around the globe,
monetary easing by the Fed to tame financial crisis, growth surge supported by easy monetary policy
in Asia, speculation in commodities, agricultural failure, rising cost of imports from China and rising
demand of food and commodities in the fast growing emerging markets," have been named as possible
reasons for the inflation.

World wide Inflation

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CAUSES

• DEBATE OVER ORIGINS

On October 15, 2008, Anthony Faiola, Ellen Nakashima, and Jill Drew wrote a lengthy article
in The Washington Post titled, "What Went Wrong". In their investigation, the authors claim that
former Federal Reserve Board Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and
SEC Chairman Arthur Levitt vehemently opposed any regulation of financial instruments known
as derivatives. They further claim that Greenspan actively sought to undermine the office of the
Commodity Futures Trading Commission, specifically under the leadership of Brooksley E. Born,
when the Commission sought to initiate regulation of derivatives. Ultimately, it was the collapse of
a specific kind of derivative, the mortgage-backed security, that triggered the economic crisis of
2008.

• SUBPRIME LENDING AS A CAUSE

Based on the assumption that subprime lending precipitated the crisis, some have argued that
the Clinton Administration may be partially to blame, while others have pointed to the passage of the
Gramm-Leach-Bliley Act by the 106th Congress, and over-leveraging by banks and investors eager to
achieve high returns on capital.

Some believe the roots of the crisis can be traced directly to subprime lending by Fannie Mae and
Freddie Mac, which are government sponsored entities. The New York Times published an article that
reported the Clinton Administration pushed for subprime lending: "Fannie Mae, the nation's biggest
underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to
expand mortgage loans among low and moderate income people" (NYT, 30 September 1999).

In a 2000 United States Department of the Treasury study of lending trends for 305 cities from 1993 to
1998 it was shown that $467 billion of mortgage credit poured out of CRA-covered lenders into low-
and mid-level income borrowers and neighborhoods. (See "The Community Reinvestment Act After
Financial Modernization," April 2000.)

• GOVERNMENT INTERVENTION AS A CAUSE

In 1992, the 102nd Congress and the George H. W. Bush administration weakened regulation
of Fannie Mae and Freddie Mac with the goal of making available more money for the issuance of
home loans. The Washington Post wrote: "Congress also wanted to free up money for Fannie Mae and
Freddie Mac to buy mortgage loans and specified that the pair would be required to keep a much
smaller share of their funds on hand than other financial institutions. Whereas banks that held $100
could spend $90 buying mortgage loans, Fannie Mae and Freddie Mac could spend $97.50 buying
loans. Finally, Congress ordered that the companies be required to keep more capital as a cushion
against losses if they invested in riskier securities. But the rule was never set during the Clinton
administration, which came to office that winter, and was only put in place nine years later.

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 OVER-LEVERAGING, CREDIT DEFAULT SWAPS AND COLLATERALIZED DEBT OBLIGATIONS

Another probable cause of the crisis and a factor that unquestionably amplified its magnitude
was widespread miscalculation by banks and investors of the level of risk inherent in the unregulated
Collateralized debt obligation and Credit Default Swap markets. Under this theory, banks and investors
systematized the risk by taking advantage of low interest rates to borrow tremendous sums of money
that they could only pay back if the housing market continued to increase in value.

The average recovery rate for high quality CDOs has been approximately 32 cents on the dollar, while
the recovery rate for mezzanine CDO's has been approximately five cents for every dollar. These
massive, practically unthinkable, losses have dramatically impacted the balance sheets of banks across
the globe, leaving them with very little capital to continue operations.

• CREDIT CREATION AS A CAUSE

The Austrian School of Economics proposes that the crisis is an excellent example of the
Austrian Business Cycle Theory, in which credit created through the policies of central banking gives
rise to an artificial boom, which is inevitably followed by a bust. This perspective argues that the
monetary policy of central banks creates excessive quantities of cheap credit by setting interest rates
below where they would be set by a free market. This easy availability of credit inspires a bundle of
malinvestments, particularly on long term projects such as housing and capital assets, and also spurs a
consumption boom as incentives to save are diminished. Thus an unsustainable boom arises,
characterized by malinvestments and overconsumption.

Other observers have doubted the role that the yield curve plays in controlling the business cycle. In a
May 24, 2006 story CNN Money reported: “…in recent comments, Fed Chairman Ben Bernanke
repeated the view expressed by his predecessor Alan Greenspan that an inverted yield curve is no
longer a good indicator of a recession ahead.

OTHER CAUSES

Many libertarians, including Congressman and former 2008 Presidential candidate Ron Paul
and Peter Schiff in his book Crash Proof, claim to have predicted the crisis prior to its occurrence.
They are critical of theories that the free market caused the crisis and instead argue that the Federal
Reserve's expansionary monetary policy and the Community Reinvestment Act are the primary causes
of the crisis. Alan Greenspan, former Federal Reserve chairman, has said he was partially wrong to
oppose regulation of the markets, and expressed "shocked disbelief" at the failure of the self interest of
the markets. It has also been debated that the root cause of the crisis is overproduction of goods caused
by globalization (and especially vast investments in countries such as China and India by western
multinational companies over the past 15–20 years, which greatly increased global industrial output at
a reduced cost). Overproduction tends to cause deflation and signs of deflation were evident in October
and November 2008, as commodity prices tumbled and the Federal Reserve was lowering its target
rate to an all-time-low 0.25%. On the other hand, Professor Herman Daly suggests that it is not
actually an economic crisis, but rather a crisis of overgrowth beyond sustainable ecological limits. This
reflects a claim made in the 1972 book Limits to Growth, which stated that without major deviation

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from the policies followed in the 20th century, a permanent end of economic growth could be reached
sometime in the first two decades of the 21st century, due to gradual depletion of natural resources.

EFFECTS

• OVERVIEW

The 2008-09 recession is shaping up to be the worst post-war contraction on record:

• Real gross domestic product (GDP) began contracting in the third quarter of 2008, and
by early 2009 was falling at an annualized pace not seen since the 1950s.
• Capital investment, which was in decline year-on-year since the final quarter of 2006,
matched the 1957-58 post war record in the first quarter of 2009. The pace of collapse in
residential investment picked up speed in the first quarter of 2009, dropping 23.2% year-on-
year, nearly four percentage points faster than in the previous quarter.
• Domestic demand, in decline for five straight quarters, is still three months shy of the
1974-75 record, but the pace – down 2.6% per quarter vs. 1.9% in the earlier period – is a
record-breaker already.

TRADE AND INDUSTRIAL PRODUCTION

In middle-October 2008, the Baltic Dry Index, a measure of shipping volume, fell by 50% in
one week, as the credit crunch made it difficult for exporters to obtain letters of credit.

In February 2009, The Economist claimed that the financial crisis had produced a "manufacturing
crisis", with the strongest declines in industrial production occurring in export-based economies.

In March 2009, Britain's Daily Telegraph reported the following declines in industrial output, from
January 2008 to January 2009: Japan -31%, Korea -26%, Russia -16%, Brazil -15%, Italy -14%,
Germany -12%.

Some analysts even say the world is going through a period of deglobalization and protectionism after
years of increasing economic integration.

• UNEMPLOYMENT

The International Labour Organization (ILO) predicted that at least 20 million jobs will have
been lost by the end of 2009 due to the crisis — mostly in "construction, real estate, financial services,
and the auto sector" — bringing world unemployment above 200 million for the first time. The number
of unemployed people worldwide could increase by more than 50 million in 2009 as the global
recession intensifies, the ILO has forecast.

The rise of advanced economies in Brazil, India, and China increased the total global labor pool
dramatically. Recent improvements in communication and education in these countries has allowed
workers in these countries to compete more closely with workers in traditionally strong economies,

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such as the United States. This huge surge in labor supply has provided downward pressure on wages
and contributed to unemployment.

Unemployment graph showing increasing unemployment

FINANCIAL MARKETS

For a time, major economies of the 21st century were believed to have begun a period of
decreased volatility, which was sometimes dubbed The Great Moderation, because many economic
variables appeared to have achieved relative stability. The return of commodity, stock market, and
currency value volatility are regarded as indications that the concepts behind the Great Moderation
were guided by false beliefs.

There were several large Monday declines in stock markets world wide during 2008, including one in
January, one in August, one in September, and another in early October. As of October 2008, stocks in
North America, Europe, and the Asia-Pacific region had all fallen by about 30% since the beginning of
the year. The Dow Jones Industrial Average had fallen about 37% since January 2008.

The simultaneous multiple crises affecting the US financial system in mid-September 2008 caused
large falls in markets both in the US and elsewhere. Numerous indicators of risk and of investor fear
(the TED spread, Treasury yields, the dollar value of gold) set records.

Russian markets, already falling due to declining oil prices and political tensions with the West, fell
over 10% in one day, leading to a suspension of trading, while other emerging markets also exhibited
losses.

Political Communists and others rallied in Moscow to protest the Russian government's economic
plans. Protests have also occurred in China as demands from the west for exports have been
dramatically reduced and unemployment has increased.

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 Tokyo share market falling down

POLICY RESPONSES

• NATIONAL FISCAL POLICY RESPONSE TO THE LATE 2000S RECESSION

The financial phase of the crisis led to emergency interventions in many national financial
systems. As the crisis developed into genuine recession in many major economies, economic stimulus
meant to revive economic growth became the most common policy tool. After having implemented
rescue plans for the banking system, major developed and emerging countries announced plans to
relief their economies. In particular, economic stimulus plans were announced in China, the United
States, and the European Union. Bailouts of failing or threatened businesses were carried out or
discussed in the USA, the EU, and India. In the final quarter of 2008, the financial crisis saw the G-20
group of major economies assume a new significance as a focus of economic and financial crisis
management.

UNITED STATES POLICY RESPONSES

The Federal Reserve, Treasury, and Securities and Exchange Commission took several steps on
September 19 to intervene in the crisis. To stop the potential run on money market mutual funds, the
Treasury also announced on September 19 a new $50 billion program to insure the investments,
similar to the Federal Deposit Insurance Corporation (FDIC) program. Part of the announcements
included temporary exceptions to section 23A and 23B (Regulation W), allowing financial groups to
more easily share funds within their group. The exceptions would expire on January 30, 2009, unless
extended by the Federal Reserve Board.

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 • MARKET VOLATILITY WITHIN US 401(K) AND RETIREMENT PLANS

The US Pension Protection Act of 2006 included a provision which changed the definition of
Qualified Default Investments (QDI) for retirement plans from stable value investments, money
market funds, and cash investments to investments which expose an individual to appropriate levels of
stock and bond risk based on the years left to retirement. The Act required that Plan Sponsors move the
assets of individuals who had never actively elected their investments and had their contributions in the
default investment option. This meant that individuals who had defaulted into a cash fund with little
fluctuation or growth would soon have their account balances moved to much more aggressive
investments.

Starting in early 2008, most US employer-sponsored plans sent notices to their employees informing
them that the plan default investment was changing from a cash/stable option to something new, such
as a retirement date fund which had significant market exposure. Most participants ignored these
notices until September and October, when the market crash was on every news station and media
outlet. It was then that participants called their 401(k) and retirement plan providers and discovered
losses in excess of 30% in some cases. Call centers for 401(k) providers experienced record call
volume and wait times, as millions of inexperienced investors struggled to understand how their
investments had been changed so fundamentally without their explicit consent, and reacted in a panic
by liquidating everything with any stock or bond exposure, locking in huge losses in their accounts.

LOANS TO BANKS FOR ASSET-BACKED COMMERCIAL PAPER

During the week ending September 19, 2008, money market mutual funds had begun to
experience significant withdrawals of funds by investors. This created a significant risk because money
market funds are integral to the ongoing financing of corporations of all types. Individual investors
lend money to money market funds, which then provide the funds to corporations in exchange for
corporate short-term securities called asset-backed commercial paper (ABCP). However, a potential
bank run had begun on certain money market funds. If this situation had worsened, the ability of major
corporations to secure needed short-term financing through ABCP issuance would have been
significantly affected. To assist with liquidity throughout the system, the US Treasury and Federal
Reserve Bank announced that banks could obtain funds via the Federal Reserve's Discount Window
using ABCP as collateral.

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 MONEY MARKET CHART

LEGISLATION

The Secretary of the United States Treasury, Henry Paulson and President George W. Bush
proposed legislation for the government to purchase up to US$700 billion of "troubled mortgage-
related assets" from financial firms in hopes of improving confidence in the mortgage-backed
securities markets and the financial firms participating in it. Discussion, hearings and meetings among
legislative leaders and the administration later made clear that the proposal would undergo significant
change before it could be approved by Congress. On October 1, a revised compromise version was
approved by the Senate with a 74-25 vote. The bill, HR1424 was passed by the House on October 3,
2008 and signed into law. The first half of the bailout money was primarily used to buy preferred stock
in banks instead of troubled mortgage assets.

In January 2009, the Obama administration announced a stimulus plan to revive the economy and to
create more than 3.6 million jobs in two years. The cost of this initial recovery plan was estimated at
825 billion dollars (5.8% of GDP). The plan included 365.5 billion dollars to be spent on major policy
and reform of the health system, 275 billion (through tax rebates) to be redistributed to households and
firms, notably those investing in renewable energy, 94 billion to be dedicated to social assistance for
the unemployed and families, 87 billion of direct assistance to states to help them finance health
expenditures of Medicaid, and finally 13 billion spent to improve access to digital technologies. The
administration also attributed of 13.4 billion dollars aid to automobile manufacturers General Motors
and Chrysler, but this plan is not included in the stimulus plan.

GLOBAL RESPONSES

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 Responses by the UK and US in proportion to their GDPs. Most political responses to the
economic and financial crisis has been taken, as seen above, by individual nations. Some coordination
took place at the European level, but the need to cooperate at the global level has led leaders to activate
the G-20 major economies entity. A first summit dedicated to the crisis took place, at the Heads of
state level in November 2008 (2008 G-20 Washington summit).

The G-20 countries met in a summit held on November 2008 in Washington to address the economic
crisis. Apart from proposals on international financial regulation, they pledged to take measures to
support their economy and to coordinate them, and refused any resort to protectionism.

Global economy spending policy

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