Previous Crises

Chapter 1
Previous Crises


The global financial crisis that struck during the first decade of the 21st century was not the first economic crisis that the world has ever encountered, nor will it be the last. For whatever reason economic crises continue to occur and have often been mistaken for the boom–bust economic cycle. The current crisis has been described as the worst financial and economic crisis the world has encountered since the Great Depression of the 1930s. The GFC has, like other economic and financial crises, caused real economic damage.

The aftermath of the GFC has been substantial by any measure. World GDP and industrial production for both developed and developing countries have fallen considerably. It was not uncommon for industrial production figures to record falls of over 20% on an annualized basis.1 Similar declines were recorded in the United States, the epicentre of the crisis. Global GDP growth rates were also adversely impacted. While much of the world recorded positive growth rates in the lead-up to the crisis, negative GDP recorded at the end of 2008 and during 2009 easily eclipsed positive growth rates recorded in the previous quarters. The crisis led to a significant and prolonged decline in industrial production and GDP output, which was described by the International Monetary Fund as the “Great Recession.”

The world had suffered considerably through the Great Depression of the 1930s, as well as during and after World War II. The recession that took hold after the war affected many nations and resulted in a significant and widespread downturn. However, during the 1950s and 1960s most countries, particularly developed economies, enjoyed a global economic boom. It was not until the 1970s OPEC oil crisis that the world entered into a period of economic downturn with rising inflation. The OPEC oil crisis preceded the Vietnam War and the two combined to produce a significant malaise for the world’s largest economy, the United States.

The malaise continued for much of the 1970s and early 1980s, until a new economic boom took hold, only to falter with the equity market crash of 1987. This stock market collapse was the most severe and pronounced equity market decline since the great crash of 1929. In a single day equity indices fell over 50%, with some individual companies almost having their entire market value wiped out. The 1987 crash, commonly called “Black Monday,” sparked fears that the world would be heading into another depression. Policymakers were acutely aware of the potential for the stock market crash to develop into a much larger contagion. However their ability to respond quickly was hampered by persistent high inflation.

The dot-com bubble of the late 1990s burst in 2000. In the lead-up to the new millennium, speculators, investment banks and pension funds had poured billions of dollars into new technological ventures. The NASDAQ Composite Index was viewed as the new engine and driver for US dominance and superiority in technology and wealth creation. Technological startups were no longer valued on fundamental terms. It was argued that with the creation of a new economy, all of the old rules relating to fundamental or inherent value were no longer relevant. Hence, conventional wisdom and valuation methods based upon profitability or discounted cash flows were not applied and instead, non-conventional valuations premised upon turnover or revenue were used. All of this proved to be illusory when the dot-com bubble burst in 2000.

The terrorist attacks on 11 September 2001 also sparked widespread fear in financial markets. Following steep declines in equity markets on Wall Street and other international indices, and fearing a significant downturn in the real economy, the US Federal Reserve aggressively cut interest rates. The move to increase private sector liquidity was designed to stave off any economic downturn and restore confidence to a now insecure US consumer. The US Federal Reserve also adopted a range of measures designed to increase liquidity in the US economy.

Some commentators have argued that the US Federal Reserve’s action to help restore confidence in the US economy following the terrorist strikes contributed to the great crash of 2008–2009.2 It has been suggested that a prolonged period of low interest rates led to the creation of a dangerous and unsustainable housing bubble in the United States. We know now that the spectacular unravelling of the housing bubble during 2007–2008, which had its genesis in sub-prime mortgage lending, had devastating consequences for the entire global economy.

The 1930s Great Depression

The Great Depression was appropriately named. The significant repercussions from the economic decline which followed were felt all over the world. Industrial production and GDP fell dramatically as factories, shipyards, retail stores, mining, construction and manufacturing all effectively collapsed. Recorded unemployment rose mercilessly to over 30% in key economies. The US and Europe, the great engines of economic growth, stopped growing and went into reverse at an alarming rate. The high levels of unemployment, the slump in industrial and factory output, the loss of income and wealth, the bankruptcies and foreclosures and widespread economic despair were evident everywhere. The catchcry now was that capitalism was dead and could not recover from the prolonged crisis. Social despair and crisis followed and alternatives to capitalism were born and embraced.

Popular belief laid the blame for the Great Depression with the Great Crash of Wall Street in 1929. It has been suggested that the collapse on Wall Street on Black Tuesday “caused” the Great Depression because the stock market crash led to significant investor losses and large financial collapses. The Great Crash of 1929 no doubt had a considerable negative impact on the US financial system and overall economy. And, yes, the Crash on Wall Street led to an almost complete, simultaneous panic on other international bourses and exchanges. What was not entirely clear, and was the subject of much ideological debate, was whether the Great Depression had other causes or triggers as well.

Two central theories emerged which attempted to explain the causes of the Great Depression. One explanation that was put forward was the demand-driven thesis, largely attributed to the prominent economist John Maynard Keynes.3 The demand-driven hypothesis suggested that declining consumer and investment demand were key triggers, which led to significant decline in industrial output and economic growth. Since the US economy during the 1920s was largely driven by manufacturing and construction, declining consumer demand would have a substantial adverse effect on industrial output. Consumer and investment demand had fallen because of rising unemployment. Hence, as consumer and investment demand fell, so did industrial output. As output and economic growth slowed, unemployment rose and a feedback loop was created. Unaddressed and left to market forces, the feedback loop would be self-perpetuating, causing further declines in consumer demand, production, employment and wealth.

The Keynesian supporters further argued that the key to addressing the Great Depression crisis was to stimulate consumer demand. By increasing consumer expenditure and creating the conditions for consumers to spend their income on output, economic growth would improve. As economic growth and industrial production increased, so too would employment. In the demand-driven world, the economic boom–bust cycle would require governments to intervene to smooth out the highs and lows to ensure economic stability.

The Keynesian theorists placed great emphasis on the Wall Street crash for generating the initial decline in US economic output. Black Tuesday, as it had been described, caused much panic and contributed to heavy financial losses for investors. The panic that began on Wall Street soon spread quickly through financial, credit, and commodity markets. The US government did not react initially to the Crash on Wall Street. Nor did policymakers attempt to address the uncertainty and market volatility on the New York Stock Exchange.

The delay from government and policymakers was later compounded by anti-speculation measures that were adopted by the US Federal Reserve. The famous monetarist and supply-side economist Milton Friedman stressed the importance of the policy failure and restrictive monetary policy stance of the US Federal Reserve during the Great Depression.4 The current Chairman of the US Federal Reserve, Ben Bernanke, writing in 1983, also commented on the apparent failures of governments to deal adequately with the Great Depression between 1930 and 1933.5 According to Bernanke, the Wall Street Crash in 1929 was simultaneously associated with large bank failures in the US financial sector.6 The simultaneous occurrence of these events led to another adverse condition, namely the deterioration in the macroeconomic environment in the US economy.

All of these compounding developments led to an alternative theory that was put forward to explain the causes of the Great Depression, commonly called monetary, or supply-side, economics. The monetarists believed that the significant decline in the money supply in the United States in the late 1920s and early 1930s contributed to the Depression crisis in the United States as well as elsewhere. The decline in the money supply was a direct consequence of the large bank failures in the US between 1930 and 1933. As banks went under, so did depositors, who lost all of their bank deposits, and bank shareholders, whose capital was worthless. This led, in turn, to a feedback loop, with lower liquidity and bank lending, which exacerbated the economic downturn at the height of the Great Depression. The failure of thousands of financial institutions and banks in the US during the 1930s was a unique feature of the Great Depression. According to Bernanke, the number of commercial banks that were left operating by 1933 was only about half of those operating in 1929.7 The banks that had survived the collapse continued to suffer heavy losses, with some barely remaining financially viable.8

The causes for the bank collapses in the US in the 1930s were not entirely clear. Some banks were marginally viable and so, with the macroeconomic environment deteriorating, it was inevitable they would collapse. Bank collapses had begun to occur with a number of smaller rural banks in the 1920s as the agricultural sector started to contract sharply.9 With the deterioration in the macroeconomic environment in the US, depositors with major commercial banks panicked and began to withdraw their deposits at an alarming rate, causing a run on the banks. According to Bernanke, the banking crisis in the early 1930s differed from previous banking crises both in “magnitude and in the degree of danger posed by the phenomenon of runs.”10

Bernanke provides a detailed chronology of the banking crisis that occurred between 1921 and 1936.11 The banking crisis in the interwar years had its origins in Eastern Europe and the Baltic states in the 1920s. Banks began to fail in Sweden, The Netherlands, Denmark and Norway.12 This was quickly followed by other bank failures in Austria, Spain, Poland, Japan and Germany between 1923 and 1930. The first large reported bank failure in the United States was the Bank of the United States in December 1930.13 Further bank runs were recorded for Italy, Argentina, Poland, Hungary and Germany.

Most damaging for the United States was a series of runs on regional banks, which culminated in over 1,800 banks failing across the Midwest and West Coast of the United States.14 The panic runs by depositors continued in the United States with a series of bank failures in Chicago in 1932, as well as other bank collapses along the East Coast of the United States.15 The damaging runs on banks and other financial institutions created an environment of insecurity and fear that continued to undermine the health and wellbeing of the US and global financial system.

The second key feature of the Great Depression was the high bankruptcy rates among farmers, small- to medium-sized businesses, and households.16 Households had large debts, driven largely by sizeable residential mortgages that were used to purchase the family home. Households had also become indebted with the growth of the consumer instalment debt that was another important feature of the financial and banking crisis of the 1930s.17 The rise of small business debt was also occurring during the lead-up to the Great Depression. The increase in leverage for households, farmers and small- to medium-sized businesses introduced a new dimension and level of vulnerability to the strength of the US and European economies.

With the deterioration in the macroeconomic environment that had begun in the US and Germany, consumers and businesses that had fuelled the debt-driven boom in the 1920s were now vulnerable to any large-scale economic downturn. With unemployment rising and economic growth and industrial production dramatically falling, consumers could not spend their way out of the crisis. Instead, consumption and business investment fell, which, as Keynes pointed out in his landmark thesis, was a key ingredient in prolonging the Great Depression.18

A third key element of the Great Depression was the simultaneous weakening of the US economy. The Wall Street Crash of 1929, along with the household and business debt crisis and the banking crisis, which caused numerous bank runs, all came to a head with falling economic activity. The banking crisis exacerbated an already weakened macroeconomic environment and, according to Friedman and Schwartz, led to a “change in the character of the contraction.”19 What began as a manageable downturn in 1929 and early 1930 soon evolved into a much larger and more dangerous downward spiral.

The US had previously experienced recessions with the consequent rise of unemployment and contraction in economic activity. However, with the Great Depression the economic downturn that began in 1929 was soon coupled with a crisis in the US financial system, mass bankruptcies, failing banks and spiraling deflation. There is little doubt that taken as a whole, the conditions were ripe for a perfect storm wherein economic activity would decline substantially, leading to more bank collapses, bankruptcies, higher unemployment and further deflation. With a stressed financial system, deteriorating industrial production and rising unemployment, it would be difficult for the US or Europe to emerge from the crisis without clear stimulus policies and direct government intervention.

The problem with government policy and direction at the time was the continued belief by policymakers that the market would self-correct without any government intervention. This laissez-faire approach had its genesis in the belief that freely operating markets would deliver the most optimal outcome for society. Supporters of the free-market principle argued that government intervention would lead to price and wealth distortions and inefficient and sub-optimal allocation of resources. Hence, during 1929–1933, US policymakers and the US government did little to stem the tide of the crisis. According to Keynes, the indifference and inaction by government, along with the self-perpetuating belief in classical economics, were misleading and disastrous.

As unemployment rose to unprecedented heights and poverty and civil unrest began to mount, the US government decided to act. Under the leadership of President Franklin Delano Roosevelt the US Congress passed the New Deal. Under the New Deal a variety of work programs were approved, some of which were designed to create employment on national infrastructure projects. Between 1933 and 1936 the New Deal also saw a number of new regulatory bodies created which were designed to enhance regulation of securities markets, banking and telecommunications, labour relations, housing and welfare. Some of the New Deal initiatives continue to exist today, including the Federal Deposit Insurance Corporation (FDIC), the Securities Exchange Commission (SEC),20 the Social Security Act 1935 and the Federal Housing Administration (FHA).

The SEC was given the task of enforcing new securities regulation in US equity markets. Congress later enacted similar legislation for US commodity markets.21 The SEC regulated initial public offerings of securities on federal exchanges through the Securities Act 1933, whilst the Securities Exchange Act 1934 was designed to regulate the issue of securities on secondary markets. The SEC would regulate all federal exchanges, as well as broker dealers and companies that were listed on the New York Stock Exchange. The overall aims of the Securities Acts and the SEC were to ensure market integrity and to promote investor confidence for exchange-traded securities. The SEC was to achieve these aims by preventing corporate abuses and fraudulent activity through the enforcement of civil and criminal penalties which had been enacted as part of the enhanced securities regulation.

The Federal Deposit Insurance Corporation was a New Deal initiative designed to improve depositor confidence with banks and other deposit-taking institutions. President Roosevelt established the FDIC on the 6 June 1933 when the Banking Act 1933 was passed into law. Initially, the Banking Act provided that deposits of up to $US2,000 per depositor were guaranteed under the standard maximum deposit insurance (SMDI) from 1 January 1934. This was later increased to $US5,000 in 1935 with the Banking Act 1935. The SMDI was further increased in 1950 to $US10,000. In 1966 the SMDI was increased again to $US15,000 per depositor and in 1974 it was further increased to $US40,000. By 1980 the SMDI was set at $US100,000 and was further temporarily extended to $US250,000 per depositor in 2005 by the Federal Deposit Insurance Reform Act 2005. Following the current GFC, the $US250,000 limit was extended again by President Obama until 31 December 2013. From 1 January 2014, the SDMI limit will revert back to $US100,000.