Introduction
The severity and suddenness of the financial crisis of 2008-09 had taken the world in surprise. It had an immense impact on the economies around the world. A major casualty was the labor force. Unemployment had increased alarmingly. The astounding fact about the great depression was that the economists and financial analysts failed to predict a crisis that took such a great proportion to engulf the almost the entire world. It raised doubts on the effectiveness of Economics as a predictive science and made the profession of economists questionable in the intellectual spheres. The depression have been mitigated with a host of high dose fiscal and monetary measures but it gave us the context of rethinking macroeconomics. Since only a few economists could apprehend the approaching depression it raises doubt on the macroeconomic theories on which our analysis and predictions were based upon. It gave us scope to remodel macroeconomic theories to understand the economic and financial structure of this ever changing world. We also observe that the world economy has not yet been able to rebound to the pre-crisis level of income and employment. Most of the economies have stagnated at low growth rate and low inflation. This situation has been termed as ‘secular ‘stagnation’ by a number of economists like Larry Summers. The objective of this article is to analyze the event of great depression in the light of efficacy of the counter-cyclic economic policies and analyzing the aftermath of the depression in the light of new economic thinking. We begin with a discussion on the causes of the great depression in section II. We then evaluate the corrective measures taken, in section III. In the fourth section we discuss the issue of secular stagnation and Bernanke’s views on secular stagnation. We critically discuss the role of macroeconomic theory in explaining the great depression and suggest some policy measures in the fifth section. The sixth section is the concluding part or our discussion.
Causes of the Great Depression
The great depression-its causes-effects are much discussed issues. We all know that the immediate cause of the depression was the subprime crisis. But that was not the only cause. In fact the period after the boom of 2002-07 was one of complacence that prepared the ground for the severe crisis of 2008-09. The labor market performances in the developing countries were quite weak with stagnation in the wage rate, growth of the informal sector, and increase in the number of casual and contractual labor. All these labor market factors led to increase in inequality and decline in the share of wages in the national income .
In most of the developing country the boom period was not accompanied by an increase in the income of the households. Thus the consumption expenditure did not increase significantly. The US was an exception where increase in consumption had led to the increase in the current account deficit . The developing countries also faced sky-rocketing food prices as well as energy prices. This price spiral led to increase in the rate of poverty in these countries. Thus we see that the boom period did not lead to a sustainable growth trajectory and in fact led to the weakening of the macroeconomic structures of the economies around the world. Thus the world economy was unable to bear the financial shock of 2008 and toppled immediately. Let us now discuss the immediate causes that led the economy into the great depression.
A financial market bubble was created in the US through the US housing market that was based on sub-prime lending. The easy money policy in the US and lose regulatory structure of the financial market led to unrestricted flow of credit into the economy. A major portion of the credit went for residential housing and commercial real estate . The mortgage against which the loans were taken was sold by one financial institution to another. This was sub-prime lending. The institutions also issued mortgage-backed securities (MBS). Thus we find the introduction of new financial product that led the financial sector into danger. The loans were against MBS and no real capital as collateral. As the Fed increased the rate of interest the debtors were unable to service the debt. The mortgage contract regulations in the US allow the banks to take the charge of the mortgaged property in the event of non-payment of loans. Since the mortgages were securitized, the non-payment of loans led to the accumulation of bad debts or non-performing assets. These properties could not be sold by the banks as there were no takers. The increase in the bad debt eventually led to the break-down of the financial institutions.
If we delve deeper into the problem we find that a number of interconnected factors had given a combined effect to take the global economic crisis to a huge proportion. First of all, the rate of interest just prior to the crisis was quite low leading to huge increase in consumption expenditure on housing and other durables which were mainly loan financed. Secondly, the lacunas in the financial regulatory system and government’s reluctance to its amendment led to the overuse and misuse of financial resources and power. Thirdly, the large current account deficit was seen as a danger signal by many economists. Thus a number of factors had prepared the ground for the crisis that the world slipped into in 2008-09.
Effectiveness of Recession fighting Fiscal and Monetary Policy
The governments of the recession affected countries around the world took immediate steps to combat the recessionary trend. Quantitative easing policy was taken. The central banks purchased government bonds in the open market to inject more money balances into the economy. The rate of interest was also reduced to induce more credit flow and loan financed expenditure.. Government expenditure was also increased along with a cut in the taxes. But the recession required more comprehensive policy that could address the problems of the jobless, providing more social benefit schemes to the families suffering from low income. The recession reflected deficient demand conditions. This could not be remedied through reduction in tax as the increase in disposable income led the households to save more due to the atmosphere of uncertainty that existed. Thus increased expenditure and monetary easing were able to check the recession taking a more severe turn. Some economies have recovered and maintained a steady growth path subsequently. But a number of economies could not restore themselves to the pre crisis rate of employment and growth. It has been observed that economies have a tendency to stagnate at a stage below the full employment level of output giving rise to the debate on secular stagnation. In the next section we are going to present the main arguments for and against the notion of secular stagnation.
Secular Stagnation
According to the theory of secular stagnation as conceived by Alvin Hansen in 1938, after reaching a certain point in development an economy comes to a stage when population growth slows down and there is limited scope for further technological innovation. At this juncture investment and consumer spending slows down making the economy stagnate at less than full employment growth rate . But this theory was proved wrong when the economies achieved high growth level in the post-war period. Observing the recent falling trends in population growth, low capital intensity as well as falling relative price of capital Larry Summers has argued that the secular stagnation concept of Hansen is true in today’s context.
Low consumption and investment will put a downward pressure on aggregate output. Low rate of capital formation and unemployment will reduce the productive capacity of the economy. To bring out the economy from this impasse the Fed can further reduce the interest rate to the negative zone and allow some inflation to move beyond target or it can boost the financial sector to increase consumer spending and business activity by allowing the financial bubble to recur. In that case full employment can be achieved at the cost of price rise or financial instability.
Bernanke has argued that the US economy is not facing secular stagnation as it is well on the path towards full employment. Bernanke opines that with a low or negative interest rate any investment would be profitable so there is no question of low capital formation. Bernanke further points out that booms are not always associated with financial bubbles as suggested by Larry Summers. Bernanke also points out that even if investment slows within the country there will be ample opportunity to invest in the rest of the world in profitable ventures to get good return on investment and that can keep secular stagnation at bay.
Failure of Macroeconomics and Policy Recommendations
The subprime crisis of 2008-09 teaches us a lesson on what the economic activities can lead to when we ignore the financial activities in our economic modeling and policy making. Conventional macroeconomics had failed to predict a crisis of such a proportion as it could not incorporate financial market imperfections in the macroeconomic decision taking. Thus macroeconomic should be integrated with financial market models to obtain more real predictions about future economic conditions. The uncertainties of the financial market should be aptly modeled to get robust estimates about the economy both in the short and long term..
Conclusion
The Economic crisis of 2008-09 was not cyclical in nature that conventional macroeconomic theory could predict and explain. It was not even self correcting in nature like the cyclical movements. It emerged entirely from a financial market bubble that was not in the capacity of our macroeconomic theory to estimate. This crisis has taught us new lessons. Modern macroeconomics has learned to incorporate financial time series analysis to achieve better predictive capacity. With a robust theory at hand we can suppose that future financial crisis can be avoided through timely predictions of such crisis.
Works Cited
Bernanke, Ben S. Why are interest rates so low, part 2:Secular stagnation. 31 March 2015. English. 22 March 2016.
Positive Money. Financial Crisis and Recessions. 2016. English. 22 March 2016.
Verick, Sher and Iyanatul Islam. "The Great Recession of 2008-2009: Causes, Consequences and Policy Respnses." Discussion Paper. 2010. English.
