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Global Research

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Lessons from the Great Depression

Mon, Feb 23 2009, 10:12 GMT
by Allan von Mehren

Danske Bank A/S

• The current economic and financial crisis is often compared to the Great Depression, which lasted more than three and a half years between August 1929 and March 1933. During this period US unemployment rose from 3% to 25% and real GDP declined by 30%. In this paper we look more closely at why the Great Depression became so protracted and look at similarities and differences between it and the current crisis.

• Both crises were preceded by high credit growth and an asset price bubble, which led to substantial losses in the banking sector once the credit boom was over. A material break-down in credit intermediation has been a key characteristic of both crises. As research by Fed Chairman Bernanke has pointed out, this was a key reason why the Depression became so protracted. Hence the current crisis has the ingredients to become very long and deep as well.

• It can be argued that the shock hitting the US economy in this recession was bigger than the one that led to the Depression. The asset price bubble bursting this time was in the housing market, which tends to have larger economic impact than a bursting equity market bubble. The growth in credit running up to the crisis is likely to have been spread across more sectors as well and the development of complex financial products has added to the difficulties in solving the crisis.

• A key difference this time, however, is the policy response. While both monetary and fiscal policy was actually tightened during the Depression, adding to the downward spiral, policy has been eased substantially during this crisis. Efforts to ease the meltdown in credit intermediation were also absent during the Depression. Today, authorities have focused strongly on fighting the financial crisis and continue to make efforts to provide liquidity and capital to the banking system to get credit flowing again.

• The countries that left the Gold Standard first and eased monetary policy were the first to get out of the Depression. This gives further evidence to the thesis that the size of the policy response is of significance. The risk of Depression is highest in countries that don't realise the need for a substantial response - or realise it too late.

• The current financial crisis is clearly the most severe since the Depression. However, we believe the lessons learned from the mistakes made in the 1930s are a key reason why the US and global economies should avoid a depression this time. A continued deleveraging in the financial sector should continue to put strong downward pressure on the economy, however, and the road back to sustainable growth around trend will be slow. With an expected length of 20 months (we expect it to end in mid-2009) this is likely to turn out to be the longest recession since the Depression.

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Published on  Mon, Feb 23 2009, 10:15 GMT