Great depression & financial crisis

Saturday, March 16, 2013

Group 4 _ Section C

Anand Kumar 12P127
Bhoomi Ashwin 12P131
Chirayu Gandhi 12P135
Rakshit Sharma 12P160
Saurabh Saxena 12P167
Soumyajit Sengupta 12P171

1


Background
Causes/Triggers
Impact
Recovery Steps
Recovery
• Differences
Comparison • Similarities

2


3


 Severe economic depression which preceded World
War II

 Started in the US on October 29th , 1929 with the fall of
US stock market

 Impacted the major European and Asian economies of
the world

 Lasted till early 1940’s – longest, most widespread and
deepest depression of 20th century
4


High Tariff
Barriers

Monetary Stock Market
Policy crash
Great
Depression

Over
Inequality
Production

5


 Farm:
 The production rose to very high level to meet the demand during
WW-I but the consumption dropped in 1902’s

 The prices of the agricultural land and crops fell and the average
annual income of farmers dropped to $273

 30% of Americans were dependent on farming

 Industry:
 Factories were producing products at a higher rate but the wages of
workers were not increasing in the same proportion

 Consumers were buying less than the and their was overproduction

6


 Monetary contraction, the consequence of poor
policy-making by the American Federal Reserve
System and continued crisis in the banking system
responsible for Great Depression

 The Federal Reserve, by not acting, allowed the money
supply to shrink by one-third, transforming a normal
recession into the Great Depression

 Led to the closure of more than 11000 banks and
increased conservatism in remaining banks in
extending credit

7


 The American stock markets were the most visible
symbol of prosperous American economy in 1920’s
 Stock prices rose steadily in 1920’s and in 1929 Dow
peaked at its highest level of 381 points
 The industries were not performing well and in the
stock market there were 2 major problems:
 Speculation
 Margin

 On October 29th, 1929 the stock market
plummeted leading to a loss of $30 billion
8


 Nation’s wealth grew steadily in 1920’s but it was
not distributed evenly

 The income rose to 75% for the top 1% and for the
remaining it was only 9%

 80% of Americans had no savings at all

 70% of families had annual earning < $2500

9


 During initial stages of Great Depression, the
USA's main goal emerged to protect American jobs
and farmers from foreign competition

 So, the Smoot-Hawley Tariff Act was enacted in
1930

 But it led to the worsening of depression by
reducing international trade and causing
retaliatory tariffs in other countries

10


 There are various approaches for explaining
the cause of the first downturn in 1929:
 Demand-driven
Keynesian
Breakdown of international trade
Debt deflation
 Monetarist
 Inequality
 Productivity shock
 Austrian School
 New classical approach

11


 Keynesian:
 Lower aggregate expenditures in the economy contributed to a massive decline in
income and to employment that was well below the average
 To keep people fully employed, governments have to run deficits when the economy
is slowing

 Debt deflation:
 Predominant factor leading to the Great Depression was over-indebtedness and
deflation
 Margin requirements were only 10% - People took the loan to invest in stock market,
but when the market crashed they were unable to repay these loans – leading to
default

 Breakdown of international trade:
 American Smoot-Hawley Tariff Act responsible for worsening the situation of the
crisis
 American exports declined from about $5.2 billion in 1929 to $1.7 billion in 1933

12


 Monetary contraction, the consequence of poor
policy-making by the American Federal Reserve
System and continued crisis in the banking system
responsible for Great Depression

 The Federal Reserve, by not acting, allowed the money
supply to shrink by one-third, transforming a normal
recession into the Great Depression

 The Federal Reserve Act limited the amount of credit
the Federal Reserve could issue

13


 Root Cause: Global over-investment in heavy
industry capacity compared to wages and earnings
from independent businesses

 Solution: Redistribute purchasing power,
maintain the industrial base, but re-inflate prices
and wages to force as much of the inflationary
increase in purchasing power into consumer
spending

14


 The first three decades of 20th century witnessed
rapid growth in productivity and production
capacity

 According to this school of thought “The Great
Depression” was a result of these long term trends

15


 Austrian School:
 The key cause of the Depression was the expansion of the money
supply in the 1920s that led to an unsustainable credit-driven boom

 This inflation of the money supply that led to an unsustainable boom
in both asset prices by the late 1920’s and led to economic contraction

 New classical approach:
 Initial severe decline but rapid recovery in productivity, relatively little
change in the capital stock, and a prolonged depression in the labor
force

 focuses on the decline in productivity that caused the initial decline in
output and a prolonged recovery due to policies that affected the labor
market

16


17


Change in Economic Indicators from 1929-1932

United States Great Britain France Germany

Industrial
–46% –23% –24% –41%
production

Wholesale
–32% –33% –34% –29%
prices

Foreign trade –70% –60% –54% –61%

Unemployme
+607% +129% +214% +232%
nt

18


 In March 1933, the country was virtually leaderless
 The banking system had collapsed.
 He provided dynamic leadership in a time of crisis

 Series of economic programs enacted in the USA
between 1933 and 1936

3R’s - Relief, Recovery and Reforms
 Relief for the unemployed and poor
 Recovery of the economy to normal levels
 Reform of the financial system to prevent a repeat depression

19


 Specialists and experts, mostly
college professors, idea men

 New Economists: government spending,
deficit spending and public works,
government should prime economic pump

 Roosevelt Cabinet: included conservatives,
liberals, Democrats, Republicans, inflationists,
anti-inflationists -- often conflicting,
compromising, blending ideas

20


 Primary Aim of this Deal was to Achieve Economic
Recovery
 Philosophy: economic nationalism
and economic scarcity (i.e., raise prices by creating the
illusion of scarcity)
 Objectives: higher prices for
agriculture and business
 Beneficiaries: big business and
agricultural business

21


 Purpose: recovery of industry
 Created a partnership of business,
labor, and government to attack
the depression with such measures as
price controls, high wages, and codes of fair
competition

Purpose: relief
Gave money to states and
municipalities so they could
distribute money, clothing,
and food to the unemployed 22


 Purpose: the recovery of agriculture
 Paid farmers who agreed to
reduce production of basic
crops such as cotton, wheat,
tobacco, hogs, and corn

 Money came from a tax on
processors such as flour millers
and meat packers who passed the cost on to the
consumer 23


 Purpose: relief

 Gave outdoor work to
unemployed men between
the ages of 17 and 29

 They received $30 per month,
but $22 went back to the family

24


 Primary aim: permanent reform

 Philosophy: international
economic cooperation and
economic abundance

 Objectives: increased
purchasing power and
social security for public

 Beneficiaries: small farmers and labor 25


 Purpose: reform
 Gave money to states for
aid to dependent children,
established unemployment
insurance through payroll deduction,
set up old-age pensions for retirees.
National Labor Relations Act
 Purpose: reform
 Put restraints on employers and
set up a National Labor Relations Board
to protect the rights of organized labor
to bargain collectively with employers. 26


 Purpose: recovery for agriculture
 Paid farmers for conservation
practices, but only if they
restricted production of staple crops.

U.S. Housing Authority
 Purpose: recovery and reform
 Used federal funds to tear down
slums and construct better housing.

27


 Attacked soil erosion
 Built dams and planted trees to prevent floods
 Reclaimed the grasslands of the Great Plains
 Developed water power resources
 Encouraged regional reconstruction projects
like the TVA and Columbia River project

Human Rehabilitation
 Established the principle that government has
responsibility for the health, welfare, and security,
as well as the protection and education of its citizens
 Embraced social security, public health, housing
 Entered the domain of agriculture and labor

28


 The Depression ended when the U.S. entered World War II in
December 1941
 Massive war spending doubled the GNP
 Military Keynesianism brought Full Employment
Military Keynesianism: the position that the government should
increase military spending in order to increase economic growth.
 The mobilization of manpower following the outbreak of war in 1939
ended unemployment
 Spending on the New Deal was far smaller than spending on the war
effort, which passed 40% of GNP in 1944
 Massive war spending doubled economic growth rates, either masking
the effects of the Depression or essentially ending the Depression
 Businessmen ignored the mounting national debt and heavy new
taxes, redoubling their efforts for greater output to take advantage of
generous government contracts.
29


30


31


 Worst financial crisis since the Great Depression of the 1930s
 Global economic decline which began in August, 2007 after BNP
Paribas terminated withdrawals to hedge funds citing a liquidity
crunch in the UK. This was the liquidity crisis which marked the
beginning of the Financial Crisis.
 It took a sharp downturn in September, 2008
 Resulted in the threat of total collapse of large financial institutions,
bailouts of banks by national governments and stock market crashes
 Resulted in prolonged unemployment, decline in consumer wealth and
caused the global recession of 2008-2012 and also contributed to the
European Sovereign Debt Crisis

32


 Sub-Prime Lending

 The term “sub-prime” refers to those borrowers who neither have
the assets, nor a reliable income source, hence, have greater chances
of loan default
 Bankers and the middlemen got carried away to the extent that
special financial products were created to cloak the sub-prime loans
with respectability

33


 Growth of the Housing Bubble
 From 1997 to 2006, the price of the typical American house
increased by 124%
 Resulted in many homeowners refinancing their homes at lower
interest rates or financing consumer spending by taking out second
mortgages secured by the price appreciation
 By September 2008, average U.S. housing prices had declined by
over 20% from their mid-2006 peak
 As prices declined, borrowers with adjustable-rate mortgages could
not refinance to avoid the higher payments associated with rising
interest rates and began to default

34


 Easy Credit Conditions
 Lower interest rates encouraged borrowing(Between 2000 to 2003,
the Federal Reserve lowered the federal funds rate target from 6.5% to
1.0%)
 downward pressure on interest rates was created by the high and rising
U.S. current account deficit, which peaked along with the housing
bubble in 2006

 Weak and Fraudulent Underwriting Practices
 loans not meeting an issuer's minimal underwriting standards were
subsequently securitized and sold to investors

35


 Predatory Lending
 Practice of unscrupulous lenders, enticing borrowers to enter into
"unsafe" or "unsound" secured loans for inappropriate purposes
 Example
 Advertisement stated that 1% interest would be charged but the
consumer would be put into an adjustable rate mortgage (ARM)
in which the interest charged would be greater than the amount
of interest paid. This created negative amortization, which the
credit consumer might not notice until long after the loan
transaction had been consummated

 Deregulation
 Regulatory framework did not keep pace with financial innovation

36


 Over-Leveraging/Increased Debt Burden
 Financial institutions were over burdened with debt, increasing
their appetite for risky investments and reducing their resilience in
case of losses.
 Incorrect Risk Pricing
 Risk Pricing refers to the incremental compensation required by
investors for taking on additional risk, which may be measured by
interest rates or fees
 Lack of transparency about banks' risk exposures prevented
markets from correctly pricing risk before the crisis

37


 Financial Innovation/Complexity
 Development of financial products designed to achieve particular
client objectives, such as offsetting a particular risk exposure (such
as the default of a borrower) or to assist with obtaining financing
 Examples
 Adjustable-rate mortgage(ARM)
 Bundling of subprime mortgages into mortgage-backed
securities (MBS)
 Collateralized debt obligations (CDO) for sale to investors, a
type of securitization
 Form of credit insurance called credit default swaps (CDS)

38


 Boom & Bust of Shadow Banking
 The riskiest, worst performing mortgages were funded through the
"shadow banking system“
 Competition from the shadow banking system pressured the more
traditional institutions to lower their own underwriting standards and
originate riskier loans
 Run on the shadow banking system was the "core of what happened" to
cause the crisis
 These entities became critical to the credit markets underpinning the
financial system, but were not subject to the same regulatory controls
 Further, these entities were vulnerable because of maturity mismatch of
short term borrowings and long term investments

39


 Commodities Boom
 Rapid increases in a number of commodity prices followed the
collapse in the housing bubble
 The price of oil nearly tripled from $50 to $147 from early 2007 to
2008, before plunging as the financial crisis began to take hold in
late 2008
 An increase in oil prices tends to divert a larger share of consumer
spending into gasoline, which creates downward pressure on
economic growth in oil importing countries, as wealth flows to oil-
producing states

40


 Global Economy contracted by 3% in 2009
 2nd quarter,2008: Greece, Estonia, Latvia, New Zealand, Ireland
 3rd quarter,2008: Japan, Sweden, Hong Kong, Singapore, Italy,
Turkey and Germany(fifteen nations in the EU went into
recession)
 4th quarter,2008: United States, Switzerland, Spain and Taiwan
 Ukraine went into Depression in 2008 at -20% GDP growth
 China and India experienced a slowdown

41


 Real GDP decreased by 6% y-o-y in 2008-09
 Domestic demand decreased at record pace-2.6% q-o-q
 Inflation rose to 5.6% in 2008 from 4% in 2007
 Capital investment declined y-o-y at levels unprecedented since the
post war levels of 1957-58
 Unemployment rate increased to 10.1% in early 2009, from 5% in early
2008
 Average work hours per week declined to 33 hours, lowest since 1964

42


 Housing Prices declined by 20% in 2009
 Aviation sector gravely impacted: 4 airlines closed down in a week’s
span
 Wealth decreased by over 25% for all Americans combined
 63% of ALL Americans had a decrease in net worth
 77% of the RICHEST Americans had a decrease in net worth
 50% of the POOREST Americans had a decrease in net worth

 Stock Market
 DOW JONES Industrial Average declined to 6600 in 2009 from a high of 14000 in
2007(a fall of more than 50% in 18 months)
 S&P 500 declined by 45% in 2008 from its 2007 high

43


 Numerous financial institutions went under or were bailed out, the
most prominent among them being:
 New Century Financial(Largest Sub-Prime Lender)
 Bear Sterns(consequently acquired by JPMC after it lost $15billion in 2 days)
 Citibank($18.1billion write-down in its sub-prime mortgage exposure)
 Merrill Lynch($14.1billion write-down, acquired by BoA for $50billion)
 Freddie Mac & Fannie Mae(Largest bailout in history after the US Government took
over)
 Lehman Brothers(filed for bankruptcy in 2008 after share prices decreased by 85%
and acquisition talks with BoA failed)
 AIG(Losses due to $11billion of CDS portfolios, US Government took over with a stake
of 80% after loaning it $85billion)

44


 Median Income declined to $49,445 in 2010 from a high of $52,823 in
2007 leading to an increase in the BPL families in USA
54000
52823
53000
52000
 National Income Pie 51000
49445 2007
50000
 Upper Class: 29% in 1969 to 46% in 2010 2010
49000
 Middle Class: 61% in 1969 to 45% in 2010 48000
47000
 Lower Class: 10% in 1969 to 9% in 2010
Median Income

Income-1969 Income-2010

10% 9%

29%
Upper Class Upper Class
46%
Middle Class Middle Class
Lower Class 45% Lower Class

61%

45


 Stock prices CRASHED worldwide leading to eroding of investor
wealth and confidence

 Run on Financial Institutions leading to their bankruptcy

 Led to the Political and Economic Instability of the European Union

 European Sovereign Debt Crisis is still an issue

 Countries like Jamaica, Estonia, Latvia which relied heavily on foreign
investment suffered when credit inflow dried up and their debt levels
rose to unprecedented levels

46


 Iceland faced both stagflation and depression which led to national
bankruptcy and ultimately the fall of the government in 2009

 Countries like Japan, which were dependant on exports to US and UK
also suffered due to decreased demand for its goods

 Countries like India and China, however were insulated from the worst
effects of the crisis, primarily due to high domestic demand and lower
cost manufactured goods exports respectively

 Composition of world financial holdings has shifted away from equity
investments like stocks and toward government debt

47


 Government announced a package consisting of tax breaks and
government backed refinancing to help homeowners avoid foreclosures
in August, 2007

 US Federal Reserve resorted to an expansionary monetary policy by
cutting interest rates in 2007 from 5.25% to 4.75% and further to 4.5%
and injected $41billion in the banking system

 US Treasury announced a $50billion package to insure investments in a
bid to stop a potential run on money-market mutual funds

 Temporary exemptions allowing financial groups to share funds more
easily among its members

48


 Termination of short-selling of financial stocks

 Tightened rules on sub-prime lending

 Announced a $150billion stimulus package and interest rates were cut
to 3.5% after the stock market crashed on Jan 21, 2008 which was
further reduced to 3% in Feb, 2008

 $700billion package to buyout toxic loans of banks in 2009 and finally
interest rates were reduced to 0.25% following which they lost the most
important regulatory tool

49


 USA proposed a regulatory plan in which the Federal Reserve was given
more powers as a market regulator. The Plan proposed the following:

 Fed Reserve allowed to examine the books of any financial institution

 Organization would be set up which will oversee and regulate all the banks

 Another body will regulate business conduct, consumer protection and investor
protection.

 A commission would be created to establish stricter criteria for firms involved in the
mortgage market.

 Securities and Exchange Commission, which regulates companies with publicly
traded shares, would be merged with the Commodities Futures Trading
Commission, which oversees commodities trading

50


 Rating Agencies were also reformed and agreements with
S&P, Moody’s, Fitch was announced which included:

 fee reforms

 disclosure reforms

 loan originator reforms

 due diligence reforms

 credit agency independence

 representatives and warranties reforms

 Increased regulations on shadow banking systems and derivatives

51


 China cut its interest rate in 2008, for the first time since 2002. It
announced a $586billion stimulus package in November,2009.

 Indonesia cut its repo rate overnight in 2008 to 10.25% from 12.25%

 Bank of Japan pumped in $29.3billion on Sep 21, 2008; Reserve Bank of
Australia injected $3.45billion on the same day

 RBI injected $1.3billion in February,2008, the most in a month ever

 European Central Bank injected €95billion into the European Banking
System in 2007. Central Banks across the world injected €300billion to
prevent a credit market seizure

 Household tax rebates were introduced in Europe

 European Commission announced a €200billion stimulus package for the
EU at the country level in 2009 52


 India cut its repo rate from 9% to 4.75% in 2008-09 and announced a
$60billion stimulus package to boost the economy along-with duty cuts
in 2009

 UK Government announced a ₤500billion bank rescue package in 2009

 Basel III norms were implemented which increased capital
ratios, limits on leverage, narrow definition of capital (to exclude
subordinated debt), limit counter-party risk and new liquidity
requirements

 G-20 set up to validate the feasibility and conduct discussions among
the world’s major economies to find ways to counter the crisis
 Pledged to fight against all forms of protectionism

 Pledged to maintain trade and foreign investments

 Pledged to stimulate demand and employment

 Pledged to provide more liquidity and recapitalization of the banking system 53


 By mid-2012, Iceland recovered and is regarded as one of Europe's recovery
success stories largely as a result of a currency devaluation that has effectively
reduced wages by 50%, making exports more competitive
 In the United States, jobs paying between $14 and $21 per hour made up about
60% those lost during the recession, but such mid-wage jobs have comprised
only about 27% of jobs gained during the recovery through mid-2012. In
contrast, lower-paying jobs constituted about 58% of the jobs regained
 Unemployment Rates have decreased to 8% from 10% in 2008-09
 Anemic recovery that has yet to pull per capita annual real GDP back to the
level of 2008

54


 Limited deleveraging of household and government sectors has
occurred in the last 5 years
 U.S. housing prices are still falling in many areas and credit to small
and medium- size businesses is restrained
 GNP has increased by 5.5% in the period from 2009-2011 following a
fall of 5.6% from 2007 to 2009
 Low aggregate demand, uncertainty and government policies are
causes for slow speed of recovery

55


Great Depression Financial Crisis
 Stock Market crash was of  Stock Market did not crash as
greater magnitude(90% decline much(40% decline in 18
in 33 months) months)
 GNP contracted by 30%  GNP contracted by 5.6%
 Lasted for 3.5 years(1929-1933)  Lasted for 1.5 years(Dec,07-
Jun,09)
 Money Supply decreased  Money Supply increased
 Unemployment Rate=25%  Unemployment Rate=10%
 Debt at 300% of GDP  Debt at 350% of GDP
 40% of Banks failed  Very few Banks failed
 Regulated Federal Reserve  Deregulated Federal Reserve
 Oversupply of Cars and Radios  Oversupply of Houses
 WW2 helped the economy  No engine of recovery like WW2
 Recovery took 8 years(1933-1941)  Full recovery not in sight yet 56


 Exorbitant rise in asset prices in period prior to event

 Cheap credit available

 Inadequate regulation

 Caused by massive debt

 Low aggregate demand due to insufficient stimulus by monetary and
fiscal policy(cited by Krugman,2010)

 High unemployment rates

 Continued uncertainty about economic policy(cited by Pirong-
Becker,2011)
57


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Great depression & financial crisis

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