Financial Crisis: Beyond 1929 2008 Comparison

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Abstract

This report compares the great depression of 1929 with the financial crisis of 2008. The basis of comparison is with respect to outset, causes, effects and nature. The report describes the general factors that are likely to cause financial crisis. It also includes the various forms of financial crises that are likely to be experienced in the economy. These forms of financial crises are mostly the causes of major financial crises in the world.

Introduction

Financial crisis is associated with loss of money value by the financial institutions and financial markets. When there is bank panics for example, currencies lose value and they fail to perform their purpose as medium of exchange. In some situations, crisis in stock markets and bursting of financial bubbles also may cause financial crisis. The lack of stability and proper management of financial institutions and financial markets have contributed to the rise of financial crisis in the world today (Kohn 2003, p.704). He argues that financial markets have evolved over the last couple of years and they are now offering a varied of services. This has made their operations more complex and any mismanagement can result to financial crisis. According to Kohn (2003, p.704) financial markets includes government securities, mortgages, and equity markets among others. The recent financial crisis was attributable to failure of mortgage markets in United States. Mortgage market failure is caused banks to collapse in the United States which contributed to 2008 global financial crisis. As stated by Rochet (2008, P.336), countries have advanced systems to prevent banking crisis but they still do occur causing great financial damage to the global economy. He argued that the main causes of banking crisis are poor regulation and political pressures that encourages bailing out of the failing banks. Bailing out of the financial institutions is very risky and can cause financial crisis like the US 2008 financial crisis. This financial crisis started in US and later turned out to be global

This paper seeks to compare the financial crisis of 1929 and that of 2008. The basis of comparison will be causes, effects, participants and nature. We will first look at general factors that are likely to cause financial crisis, various forms of financial crisis and the objectives or relevance of comparing the financial crisis of 1929 and beyond (2008).

Factors contributing to financial crisis

A close examination of the financial crisis that have occurred in the world helps find out the factors that are likely to cause financial crisis whether global or national. According to Rochet (2008, p.336), political interference in the banking system is the main cause of crisis in the banking system that causes financial crisis. The political authorities have the power to influence banking regulators making them to take unsound actions that are likely to cause financial crisis (Klein, 2001, p.36). For instance, they may mislead banking authorities to bail out failing banks where in real sense the deal will fail. It could be reasonable to allow failing banks to fail instead of bailing them out. This action demeans the credibility of banking authorities as they are forced to take the long step. The financial market discipline is also compromised leading to crisis.

Though political interference was pointed out as the main cause of financial crisis, Rochet (3008, p.336) has other factors like lender of lass resort, poor risk management, and poor regulation of solvency among others. Lender of last resort is exercised by central banks where they extend credit to commercial banks in the event of difficulties like bank run. Credit is extended when it is established that a bank is unable to get credit in other means and that failure to get loan will destabilize the operations of the bank and affect the economy. Central bank in this case acts as the intimate source of credit to these banks. In case banks are unable to pay these loans, they will cause central bank to suffer cash drain and therefore unable to lend to other banks which end up collapsing. Lack of proper solvency regulation is also likely to cause financial crisis as financial institution becomes insolvent and collapses. There are other factors like poor prudential regulations and improper risk management that causes banks to take excessive risks. These risks make them to collapse thus contributing to financial crisis. According to Dewatripont and colleagues (2010, p.160), argues that financial crisis of 2008 was due to poor prudential regulations that limits financial innovation.

Another factor likely to cause financial crisis is borrowing form financial institutions to finance investments. If these investments fail to work, the investors are unable to pay their debts thus causing the financial institutions to collapse. It is proven right that leverage usually precedes financial crisis. A good example is Wall Street crash of 1929 that happened due to people borrowing to invest in stocks whose prices are quite unstable (Klein, 2001, p.34). For instance the drastic fall of share prices in the New York stock exchange in October 1929 caused investors to lose their money. They were therefore unable to repay the debt causing the financial institutions to collapse. Most banks collapse due to having more bank loans than deposits. If in such situations bank customers withdraw their money almost at the same time, banks will suffer cash drain and collapse. This is because withdrawals are made more frequently than loans are recovered (Bonner & Wiggin 2006, p.23). When one bank falls, the investors expect that banks other banks will fall and therefore they withdraw from investing into them. This causes many banks to fall and the effect may spill over to other financial institutions.

Forms of financial crisis

Banking crisis is basically a result of bank run. Bank run happens when the bank deposits are withdrawn suddenly by the customers and at a rate higher than the rate of recovering loans. If this situation persists in the economy, bank panic arise that cause financial crisis. Bonner & Wiggin (2006, p. 52) pointed out four forms of financial crisis that includes, international financial crisis, speculative bubbles and crashes and wider economic crisis. Banking crisis is also a form of financial crisis.

Market forces are responsible for the speculative bubbles and crashes. This happens when assets are held for speculative purposes; that is their prices expected to go up in future but later falls. Investors holding stocks for speculative gain may decide to sell them at the same time causing their prices to go down due to supply exceeding demand. Investors suffer loss. Wall Street bubble burst of 1929 sets a good example in this case (Klingman, 1989, p.39). International crisis occurs due to sudden devaluation of currency or sovereign default.

The relevance of comparing the 1929 great depression and 2008 financial crises

There has been great debate by analysts whether the current financial crisis is similar to the great depression of 1929. There is therefore dire need to compare them in order to understand whether they are similar or not. The relevance of this comparison is to help the analyst device good mechanisms to curb the occurrence of such crisis in future.

The other reason for comparing the two is to analyze the causes of financial crisis. This will also help economists to know the best ways to recover the economies from the crisis. This is by comparing the methods used in 1929 and the ones used today in order to realize the most apt in solving the financial crisis. Comparison will also end the disagreement among the economists about the two crises and get then concentrate in building global economy rather than dwelling much on the debate.

Through this comparison, it will be easier to identify the key players in both financial crises and the sectors of the economy that are mostly affected by the crises.

Comparison between 1929 great depression with 2008 financial crisis

The outset of the two financial crises

The 1929 was the most widespread financial depression that hit almost all economies of the world. It started about a decade before the outbreak of the Second World War (Shachtman, 1979, p.23). It started in 1929 and its effects continued to the late 1930s. The great depression started in United States before it spread to almost the whole world. It is believed that the crisis started with the fall of the US stock market after the price of stock fell greatly on 29^th, October 1929. The day was named black Tuesday because the stocks were performing quite well until that date when their prices fall. Investors lost their wealth that was invested in stocks as they could only sell them at a loss (Peter, 2001, p.28). The prices of commodities increased thus causing the real income of individuals to fall. Their purchasing power also declined with decline in their real income. The demand for exports reduced greatly causing international trade to fall by over 60%. Most companies suffered great loss and were unable to recruit more employees. In the US where the depression started, there was 25% increase in general unemployment level. This was also experienced in other countries where unemployment increased by over 33%. The most hit was the agricultural sector where farmers lost nearly 60% of their profits due to fall in the price of crops.

The 2008 financial crisis also started in the US as a result of insolvency in the banking system. Economists say that the crisis started in 2005 with the busting of the housing bubble in the US that caused many people to default their mortgages. This caused the financial institutions especially banks to collapse. The housing prices were increasing at a high rate thus encouraging investors to take mortgages to build and sell houses. The mortgage rate was low but it begun to rise at around 2007 and price of housing begun to fall. People were unable to finance the mortgage and the value of houses could not repay them because it had fallen. The demand for houses also fell and financial institutions could not sell the houses to recover their money. This made them to collapse and this resulted to financial crisis. The effect spread to the rest of the world though derivatives where US banks started selling the mortgage burden to local and international banks. As a result, the key businesses in the economy collapsed and consumer wealth went down. There was inflation in almost the whole world causing the real income of individuals to go down.

The nature of 1929 and 2008 financial crises

The two are global financial crisis because they were experienced in almost all countries of the world. They started in America and spread to the rest of the world. They both started with the poor performance of the stock markets and other financial institutions. The stock markets in almost all parts of the world felt suffered great loss and lead to poor performance of the economy as whole. Both were global phenomenon and the study cannot be constrained to the United States. The crises started in the United States but spread to the rest of the world through trade and capital flows. The commodity prices also played a role in transmitting the crises to the rest of the world. This is because the commodities were sold to other countries internationally at a high price.

The effects of the crises were also global and similar like decline in industrial production in the whole world and high prices of the product.

Major causes of the crises

It is important here to note the key players in the two financial crises. The crisis of 1929 started with the crash of stock markets in United States that caused investors to suffer great loss. The stock market suffered $14 billion on October 29, 1929 when the crisis started. Within a period of two months the stock market had lost over $40 billion in profit (Shachtman, 1979, p.23). The banking system in US also failed with over 9000 banks collapsing at around 1930s. The fall in the banking system was due to collapse of the stock markets. The investors who had borrowed to buy stocks were unable to pay the loan after the black Tuesday fall in stock prices. The banks collapsed and the bank customers lost their deposits and savings. The level of expenditure declined as credit was limited in the banking system. The purchasing power of people declined and the level of consumption declined. This caused fall in general production and employment level fell by 25% as firms made huge loses and could not hire more employees. To protect local industries, America imposed a high tariff on imports in order to discourage imports. Exporters internationally felt the effect of the crisis through commodity crisis. This is how the crisis spread to the rest of the world.

The trend in 2008 financial crisis also hit the financial markets although it started with the failure of the banking system. The governments resorted in to bailing out collapsing banks but this did not help. The stock markets around the world suffered loses and collapsed. The burst of the housing bubble in US was the main cause of the financial crisis. The US government reduced the mortgage rates in order to encourage people to buy houses. People were taking mortgages at very low interest rates to build houses for sale because the price of housing was very high. The interest rates later fell making it hard for the investors to repay the mortgage. The supply of houses exceeded demand and the price of houses went down. Banks collapsed because they were unable to recover their money. The investors also lost their money and surrendered the houses to banks

The key participants in both financial crises are the stock markets, banks, the commodity markets, individuals and institutional investors and the governments

In 2008 financial crisis, there are other participants like pension funds, hedge funds, investment banks, insurance companies among other financial institutions. There are also financial products mortgage loans, asset backed securities among others.

Comparison with respect to effects

Most of the effects of 1929 great depression are similar to those of 2008 financial crisis. Firstly, the two financial crises resulted to the decline in the performance of the whole economy. The economic growth of many countries slowed down (Krugman, 2009, p.136). It firs started in the United States where the two financial crises started and then the rest of the world. The decline of the performance of the economy was due to the decline in the performance of individual sectors of the economy.

In the two financial crises, there decline in agricultural production and increased food prices (Dewatripont et al, 2010, p.162). This is attributable to poor performance of the economy that contributed to the demand of agricultural products. The international markets were affected and the demand for products declined greatly. Farmers suffered huge losses.

The purchasing power of individuals also declined causing low demand for exports. Economies that rely on exports performed poorly and international trade declined. Countries lost their export gains and most of them had the budget deficit increased. Declined in international trade was also as a result of United States imposing a high tariff on imports in order to boost the growth of local industries. This discouraged imports and the export market declined making exporter to lose a lot of money.

In both financial crises, there was increase in the general unemployment level. According to Dewatripont and colleagues (2010), In the 1929 financial crisis, the level of unemployment increased by 25% in the global economy with some countries experiencing over 33% increase. In the 2008 financial crisis, the level of unemployment increased to about 10.2% globally. This increased the dependency ratio as many people had to rely on the few employed for basic needs. The standard of living for individuals also decreased due to high dependency ratio.

The real GDP for many economies decreased due to decrease in general production level. The US real GDP for both goods and services decreased due to high prices of commodities. The annual decline was estimated at 6% compared to prior periods. The gross international production level also decreased at the same rate as for domestic economies. The other common effect is the collapse of major financial institutions like banks, insurance companies and the stock markets. For instance about 9000 banks collapse during the 1929 financial crisis (Thomas and Morgan, 1979, p.59). There was also collapse of insurance companies during 2008 financial crisis. For instance, AIG insurance company together with some other financial institutions like mortgage firms collapsed. This devastated the global economy and destabilized international, regional and local trade.

Conclusion

The two financial crises, 1929 great depression and 2008 financial crisis were global phenomenon that affected the performance of economies in the entire world. They are similar in many respects like causes, effects and nature among others. The two financial crises were very severe and they affected the global economies severely. The ongoing debate by economists is which of the two financial crises was more severe that the other.

Reference list

Bonner W. & Wiggins A. 2006. Empire of debt: the rise of an epic financial crisis. New Jersey: John Wiley and sons, Incl.

Dewatripont, M., Rochet, J. & Tirole, J. 2010. Balancing the banks: global lessons from The financial crisis. Princeton NJ: Princeton University Press.

Klein M. 2001. Rainbows End: The Crash of 1929. New York: Oxford University Press.

Klingman W. 1989. 1929: The Year of the Great Crash. New York: Harper & Row

Kohn M. 2003. Financial Institutions and Markets (2nd Ed. Oxford: Oxford University Press

Krugman P. 2009. The Return of Depression Economics and the Crisis of 2008. London: W.W. Norton Company Limited

Peter G. 2001. Famous First Bubbles: The Fundamentals of Early Manias. Cambridge: MIT Press

Rochet J. 2008. Why Are There So Many Banking Crises?: The Politics and Policy Of Bank Regulation. Princeton NJ: Princeton University Press

Shachtman, T. 1979. the Day America Crashed. New York: G.P. Putnam

Thomas G. and Morgan W. 1979. the Day the Bubble Burst: A Social History of the Wall Street Crash of 1929. Garden City, NY: Doubleday

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