Liquidity and Economic Downturns

Ali Mirjahangiri

University of California, Riverside

June 24, 2010

Abstract

This paper compares the fiscal, monetary and trade policies followed during the Great Depression of
1929-1933 and the Great Recession of 2007-Present. I will provide information that pertains to the
causes of both economic downturns as well as the outcomes of government involvement.

Keywords: the Great Depression, the Great Recession

1
1 Introduction
Most people are aware of the terms The Great Depression and The Great Recession; however, not many
people know the causes of these great economic downturns. Most people will erroneously attribute the
Great Depression to a single reason, a great stock market sell off during the fall of 1929, and will
erroneously attribute the current recession to a single reason; the housing market. While both of the
aforementioned causes may have played an important role in their respective economic downturns,
neither the stock market selloff nor the housing bubble is solely responsible for economic conditions.

The Great Depression and The Great Recession share many of the same characteristics; both had an
impact on the global marketplace, suffered from a lack of liquidity, loss of confidence, deflation, and
were unexpected. Many causes are still under debate by scholars, however the knowledge learned from
the Great Depression helped curtail the effects of what seemed to be another Great Depression.

In this paper, I will explain and analyze fiscal, monetary, trade policies and their affects on the overall
economic recovery during the Great Depression. I will also explain current fiscal and monetary policy
responses due to the current economic conditions. This paper will not focus on trade policy during the
current economic condition because no drastic changes have taken place when compared to the Smoot-
Hawley Act. Much of modern economic knowledge stems from the lessons learned during the Great
Depression; the application of the knowledge learned will show the response taken by the government
is justified and correct in addressing the current economic climate.

2 The Great Depression 1929-1933

The Great Depression’s start is generally marked as October 29, 1929. This infamous day has been
coined as “black Thursday.” However, to truly understand the causes, one must examine behaviors and
actions starting from the early 1920s. The stock market crash “changed the atmosphere within which
businessmen…were making their plans, and spread uncertainty where dazzling hopes of a new era had
prevailed.”1

The 1920s was a prosperous time for the United States Economy. However, due to the Great
Depression, many economic milestones of the 1920s are overlooked. An economy grows through three
channels; increased technological capacity, capital and human capital. The US experienced all three
during the 1920s, which caused rapid economic growth of 4.2% (RNGP).2

The affordability of cars allowed consumers to move further away than before. Citizens’ homes were not
as dependent upon trolley access3 and thus, created a higher demand for suburban homes and the
beginning of a housing bubble. The new infrastructure and utility demands fueled much of the
consumer spending.

1
(Friedman, 2008) P22
2
(Smiley, The US Economy in the 1920s, 2010)
3
(Smiley, The US Economy in the 1920s, 2010)

2
2.1 Fiscal Policy
The government’s fiscal policy was not as effective as some may perceive it as having been. The
government’s unsuccessful implementation of expansionary fiscal policy and the inability to use fiscal
policies reduced outside lag, contributed to the economic length of the economic downturn. During the
1930’s, the government increased spending while raising taxes. The government was concerned with its
budget deficit; much of modern economics is built upon what was learned during the Great Depression
and is now known as Keynesian economics. The Great Depression forever transformed the US
government’s role in the economy.

The Great Depression was a long and painful learning experience for the government. The government
implemented the Revenue act of 1932, which increased taxes in an attempt to balance the budget and
by doing so; the act caused a reduction in consumption. The Works Progress Administration hired
unemployed to work on government building projects and the Agricultural Adjustment Administration
gave large payments to farmers.

The New Deal was not as effective as people may perceive it to be. The increased government spending
and the simultaneous reduction in the money supply increased interest rates, and by doing so,
inadvertently reduced the demand for interest sensitive goods, generally durable goods such as new
homes and cars.

The Phillips Curve shows the relationship between unemployment and inflation. Generally, during a
recessionary period wages reduce by ten percent and allow people to keep their jobs. Unlike previous
economic downturns, the Great Depression’s wage rate remained constant due partly to President
Hoover’s policy4. The steady wages combined with reduced prices, increased real income of employees
and in turn increased real money demanded5.

2.2 Monetary Policy

The US uses a fractional reserve banking system that has the potential of “creating” money. During this
era, the United States also used the gold standard and had a fixed exchange rate. The three factors that
determine the money supply are the monetary base, reserve ratio and currency deposit ratio; denoted
as B, rr and cr respectively. (The money supply is defined as M=((cr+1)/(cr+rr)) x B).

The affects of monetary policy are neutral when analyzing the long run; however, monetary policy is
very effective during short run analysis. Monetary policy change has a lower inside lag compared to
fiscal policy. During the Great Depression, the monetary base increased 18% but because of the money
multiplier, the money supply actually fell 38% due to an increase in consumers cash demand to deposit

4
(Smiley, Great Depression, 2008)
5
(Friedman, 2008) P32

3
ratio6. The reduction in the money supply reduced money velocity by thirteen percent from 1929 to
19307.

The stock market crash of 1929 is commonly referred to as “Black Thursday.” Prior to “Black Thursday,”
the fed was using a contractionary monetary policy to increase the interest rates and try to curb stock
purchases on margin accounts. The Fed’s policy was tailored to reduce inflation. The contractionary
monetary policy did not effectively lower margin account stock purchases; rather, the increased interest
rates reduced the demand for interest sensitive goods as mention above and contributed to the drop in
prices. The drop in prices increased pessimism among employers and therefore, firms were not
confident to borrow because the continually lowering prices meant lower revenues and higher real
interest rates.

“Black Thursday,” while not the only reason for the Great Depression, contributed to the many variables
of the Great Depression. The inability of brokers to pay banks money owed from purchases of devalued
stocks on margin accounts contributed to many bank failures of the early 1930’s. The reduction in the
number of banks alone has a negative effect on the money multiplier. In addition to the reduction of the
multiplier, consumers became skeptical of banks, and removed much of the money deposited (↑cr).
This in turn reduced the money multiplier farther.

The Federal Reserve was aware of the consequences of a failing banking system; however due to its
outlook that bank failures are a management problem and not a system problem, the Fed’s inaction
helped propel the lack of liquidity farther8. The Fed’s lack of action is also accredited to four additional
factors. (1) The Federal Reserve had no feeling of responsibility towards non-member banks. The
majority of bank failures initially were smaller non-member banks, however, the non-member banks
held higher percentages of deposits. (2) Small non-member banks were deplored by big-city bankers. (3)
The bank failures of the last two month of 1930 were over eighty percent smaller non-member banks;
the Fed did nothing to help. (4) The few large member banks that failed were attributed to bad
management, and not a monetary system’s responsibility.9

In January 1932, the Reconstruction Finance Corporation was created to lend money to failing banks in
an attempt to stem bank failures. The RFC did assist failing banks in 1932; however, a provision required
banks that took loans to be published. This provision aided in bank runs in 1933; partly due to the public
becoming aware of failing banks, as well as banks not borrowing because of the fear of bank runs once
their respective bank was published10.

President Roosevelt called for a “Bank Holiday” from March 6 to March 13, 193311 due to the third bank
panic. This bank panic was similar to the two preceding bank panics; except in its severity. The money

6
(Mankiw, 2010) P553
7
(Friedman, 2008) P23
8
(Friedman, 2008) P105
9
(Friedman, 2008) P106
10
(Friedman, 2008) P53
11
(Friedman, 2008) P12

4
supply dropped twelve percent in two months12. All banks were closed and were not allowed to reopen
until they were deemed solvent. The holiday increased consumer confidence, and reduced bank rushes.

Friedman argues that if the Federal Reserve would have taking swift action with less hesitation, the
affects of the Great Depression would have been lessened. The increased gold inflow would have
increased the domestic money supply, and once the peak was reached, the gold outflow would have
eased Europe’s economic turmoil13. While Friedman makes an excellent and valid point, one has to take
into consideration that hindsight is twenty-twenty. One must also consider the political cycle during that
period, as well as economic thought during that period was not as vast as it was in 1963.

The gold exchange standard that was followed during this time has also been blamed partly for the
severity of the Great Depression. Friedman and Schwartz analyzed China, Spain and Japan, all countries
who did not use the gold exchange standard, and the economic affects were not as bad. China used a
silver standard and a fixed currency, however, the silver standard acting like a floating currency when
exchange with gold.14

2.3 Trade Policy

The government attempted to save domestic industries and firms by enacting protectionist trade
policies. In 1930, the Smoot-Hawley Tariff Act was enacted, against many economic scholars and
advisers, which increased tariffs for many goods. The protectionist trading policy that was adhered to
resulted in lower global trade and caused trading partners to retaliate. Thus, reducing US exports and
contributing to the Great Depression. The economic data does not show a drastic change in trade
balance once the policy was implemented, however, one can see the drastic change in overall trade
volume. From 1929 – 1933 the trade balance changed from a four-hundred million dollar surplus to a
one-hundred million dollar surplus. During the same period however, total US trade, sum of exports and
imports, declined sixty-seven percent, from 11.5 billion dollars to 3.9 billion dollars15.

2.4 Impacts and Outcomes of the Great Depression

The obvious impacts of the Great Depression were the negatively impacted lives of the people. With
unemployment rates as high as twenty five percent, the human suffering is unimaginable. Due to the
great losses endured by many, new laws and policy were enacted. Some of our current banking laws and
monetary policies stem from what was learned during the Great Depression. The thirties marked the
beginning of the end of fixed exchange rates and gold standard’s for many countries including the
United States; however, it would still take about forty years for America to change to the current
floating exchange system. Much of current macroeconomic knowledge and policy stems from our
experiences during the Great Depression. The knowledge learned during this period will prove to be
invaluable in policy decisions made during future contractions.

12
(Friedman, 2008) P89
13
(Friedman, 2008) P175
14
(Friedman, 2008) P239
15
(BEA, 2010)

5
Some of the government agencies and safety nets that we take for granted were created because of the
Great Depression. The Banking Act of 1933 created the Federal Deposit Insurance Corporation, which
insures deposits in banks. The deposit insurance increased consumer confidence in the banking system
and would prevent future bank runs during economic downturns. The act also separated investment
banks from commercial banks, repealed in 1999, to prevent future impacts on the nation’s monetary
base due to speculative trading. The Securities and Exchange Commission was created in 1934 as an
independent regulatory agency. Their main purpose is to protect investors while maintaining fair,
efficient, orderly markets.

The Social Security act of 1935 created social security and unemployment act. The act provided a
security blanket for the people that needed help the most. The act also created automatic stabilizers for
the economy. This ensured people who lost their jobs or the elderly that did not work, some form of
income. The guarantee of an income will encourage consumers to keep spending while allowing the
economy’s affect to be minimized.

3 The Great Recession December 2007-Present

Before I proceed, I will need to define “worst.” The current economic downturn we are experiencing is
not as bad as economic downturns that were experienced in the seventies and eighties if we only
analyze statistical information. However, when we analyze the magnitude of change given the short
time span, the Great Recession is worse than the Great Depression in some categories. Comparing the
onset of the Great Recession to the Great Depression, the money supply, world trade and GDP were
higher during the Great Depression than the Great Recession16; Due to the aforementioned data, the
Great Recession’s potential for negative impact is feared greatly.

Many factors may have led the US economy into its worst recession since the Great Depression.
Ironically, some of the major reasons that contributed to the Great Depression contributed to the Great
Recession; problems with the housing sector, money supply, and financial markets. The deregulation of
the financial markets, repeal of Glass-Steagall17 Act, allowed investment banks to commingle funds with
their commercial deposits. This allowed banks to take greater risks since they had more money to invest
and to use as a buffer.

Expansionary monetary policy is preferred during economic downturns; however, with the interest rates
being almost at 0% (liquidity trap), there is not much the Federal Reserve could do. Hence, we are left
with only fiscal forms of stimuli.

16
(Eichengreen & O'Rourke, 2009)
17
(Forbes)

6
3.1 Fiscal Policy
The government acted swiftly in an attempt to curb the affects of the economic downturn with
congressional bills. In 2008, a tax rebate check was mailed to taxpayers18 but the tax rebate was
ineffective; due to rising fuel and food costs the stimulus was offset. President Bush signed the bill, H.R.
1424, into law. H.R. 1424 is known for its creation of Troubled Assets Relief Program or commonly
referred to as TARP. TARP was created to purchase “toxic” assets from banks. The bill also included tax
breaks and credits, most notably for hybrid vehicles in an attempt to lower the demand for oil since oil
was at record high prices. The bill also extended unemployment benefits and increased the FDIC
incurred amounts from $100,000 to $250,00019. The increase of the deposit insurance increased the
confidence in the troubled banking system and reduced possible mass bank runs as people did during
the great depression.

The seven avenues of fiscal stimulus are: increased government spending, increased government
consumption, increased transfer payments, increased transfer payments to hand-to-mouth households
(due to higher MPC), decreased labor, consumption, and corporate taxes. The stimuli packages enacted
in 2008 and 2009 address all seven mechanisms.20

In 2009, The American Recovery and Reinvestment act was signed into law. This stimulus package was
$787 billion dollars. The act granted tax cuts and expanded social welfare programs like unemployment
insurance. The act also pushed for an increased amount of spending on infrastructure, health care,
education, and law enforcement. The majority of this bill was in tax cuts and credits. Companies were
given payroll tax credits for employees that were hired. The reduction in payroll taxes was designed to
reduce hesitations on rehiring employees.

The fiscal stimuli enacted will increase GDP. Tax cuts increase a person’s marginal propensity to
consume because they increase the amount of disposable income available. The tax cuts also provide a
higher multiplier for consumers21 and because of this; income taxes were not raised as they had been
during the Great Depression. Fiscal stimulus is also an important factor because the thought of declined
future government expenditures crowds in consumption in the present22. The eight thousand dollar tax
credit for first time homebuyers and “Cash for Clunkers” increased home and auto sales due to a
crowding in effect.

3.2 Monetary Policy

The Federal Funds rate was lowered to one percent in 2003 and increased the demand of credit. The
lowered interest rates gave consumers less reason to save for the future and more reason to consume
today due to intertemporal behavior. The easy credit translated into increased credit limits on current

18
(Aversa, 2008)
19
(White House, 2008)
20
(Günter Coenen, 2010)
21
(Günter Coenen, 2010)
22
(Giancarlo Corsetti, 2009)

7
credit cards and persons who were traditionally unable to purchase a home based on their credit scores,
were now able to purchase a home with few prerequisites and stated incomes; thus, creating
unsustainable growth via irresponsible lending and spending.

The affects of money are neutral in the long run; however, expansionary monetary policy works best in
the short run. An expansionary monetary policy works best in the short run because it lowers interest
rates and exchange rates. The lowered interest rates increase the demand for durable goods that are
sensitive to changes in the interest rates such as homes and cars. The lowered exchange rate increases
the demand for US products abroad as well because US products will be more affordable due to the
lowered exchange rates. The benefits are also due partly to the short inside lag in implementing
monetary policies. In response to the economic downturn, the Federal Reserve Bank lowered the
interest rate from five percent in 2007, to sixteenth of one hundred percent currently in an attempt to
spur economic growth23. However, monetary policy does have a longer outside lag, due to its
transmission mechanism, which means that the full effects of the monetary policy may take about a
year to start working. The Federal Reserve did not repeat its mistakes from the Great Depression; M2
money stock has increased every year.

3.4 Outcomes of the Great Recession

The Great Recession is not officially over yet. While we have posted GDP gains, the possibility of a
double dip recovery, or W, is still very possible. One of the biggest problems with the current recovery,
due partly to what was learned during the Great Depression, is the jobless recovery that we are
experiencing. While output has increased, unemployment has not decreased.

There is much talk about financial reforms and overhauls. June 25, 2010 was one of the first “major”
reforms. The passing of the bill was a step in the right direction, however, judging by the stock market’s
response on June 25, not strong enough as the DOW surged 172.54 points. The affects of the passing of
the “sweeping” reforms bill has yet to materialize since the bill recently passed on July 16, 2010.

The Great Recession will prove to be another great learning point for our macroeconomic policy. Given
the clichés of “history repeats itself” and “people never learn,” one has to admit that while the current
handling of the economic situation is far from perfect, thankfully people had learned when history
repeated itself.

4 Conclusion
It is evident that both the Great Depression and Great Recession were not caused by a single reason.
They were both a combination of several variables that worked together via an interlinked system to
cause their respective conditions. The Federal Reserve has obviously learned from its earlier mistakes
and has done a satisfactory job controlling our current recession. Ben Bernanke’s knowledge of the

23
(FRB, 2010)

8
Great Depression has proven to be a worthy asset. The swift intervention of the Fed assured a smaller
impact on our current economic state as would have been possible had the response been slower. The
money supply was swiftly increased and bank solvencies were handled as good as possible.

The acceptance of budget deficits has also helped reduce the affects of the current recession. The
current deficit has definitely increased; however, it is justifiable given the current economic status.
Something that many people do not understand is that “government deficits respond endogenously to
the fiscal actions because of automatic stabilizers, so that the post-stimulus change in the deficits is less
than the discretionary fiscal stimulus.”24 Yet we see politicians and policymakers criticize the current
administration for its response to our current economic catastrophe.

In summation, the current administration is facing economic conditions that have not been faced in
nearly a century. The swift responses of the Bush and Obama administrations have greatly reduced the
severity of the economic downturn. The new financial reform bill that was signed into law July 21, 2010,
is designed to stop speculative trading, irresponsible lending, and “too big to fail” bank bailouts. We will
have to wait and see how effective this round of “sweeping” reforms will be. We will never know what
could have happened if methods that are more conservative were followed, however, using the Great
Depression as our benchmark, the economy would have been in a much worse condition.

24
(Günter Coenen, 2010)

9
 Data Analysis Graphs
The X axis represents months since January of respective year (1929/2007). 2010 Q3 – 2011 data is
forecasted based on sources.

Unemployment Rate
30%

25%

20%

15%

10%

5%

0%
0 6 12 18 24 30 36 42 48 54
Number of months since January of respective years (1929/2007)

Great Depression Great Recession

Sources: (BLS, 2010) (CBO, 2010)

Change in Real Wages

114
112
110
108
106
104
102
100
98
96
94
92
0 6 12 18 24 30 36 42 48 54
Number of months since January of respective years (1929/2007)

Great Depression Jan 1929 - Jun 1933 Great Recession Jan 2007 - June 2011

Sources: (Rothbard, 2008) P 291 (BLS, 2010)

10
 % GDP vs Government Expenditures
30.0%

25.0%

20.0%

15.0%

10.0%

5.0%

0.0%
1929 - 2007 1930 - 2008 1931 - 2009 1932 - 2010 1933 - 2011

Great Depression Great Recession

Sources: (CBO, 2010) (BEA, 2010)

Year Over Year % Change M2 Money Supply

10.00%
5.00%
0.00%
-5.00%
-10.00%
-15.00%
-20.00%
-25.00%
-30.00%
1929 - 2007 1930 - 2008 1931 - 2009 1932 - 2010 1933 - 2011

Great Depression Great Recession

Sources: (St Louis Federal Reserve, 2010) (Hetzel, 2008) P 18

11
 Tax Rate Change 1929-1933
1200.0% 0.7

1000.0% 0.6
0.5
800.0%
0.4
600.0%
0.3
400.0%
0.2
200.0% 4.0% 4.0% 0.1
0.4% 1.1% 1.1%
0.0% 0
Total Change 1929 1930 1931 1932 1933
1929 - 1933

Low Income Tax Bracket High Income Tax Bracket Lowest Tax Bracket Highest Tax Bracket

Source: (Tax Policy Center, 2009)

Change in RGDP From Prior Year

6.0%
4.0%
2.0%
0.0%
-2.0%
-4.0%
-6.0%
-8.0%
-10.0%
-12.0%
-14.0%
1930 2008 1931 2009 1932 2010 1933 2011

Great Depression Great Recession

Source: (BEA, 2010)

12
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