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CRISES HISTORY RESEARCH GROUP
WORKING PAPERS IN CRISIS HISTORY / NO. 2
The Great Depression(s) of 1929-1933 and 2007-2009?
Parallels, Differences and Policy Lessons
Peter Eigner and Thomas S. Umlauft
First draft: December 2014
This version: May 2015
1088 Budapest, Múzeum krt. 6-8. II. 247.
valsagtortenet.elte.hu
1
WORKING PAPERS IN CRISIS HISTORY
No. 2 / May 2015
The Great Depression(s) of 1929-1933 and 2007-2009?
Parallels, Differences and Policy Lessons
Peter Eigner and Thomas S. Umlauft
2
Abstract
This paper provides a comparative analysis of the Great Depression (1929-1933) and
the Great Financial Crisis (2007-2009) by contrasting the crises' main driving forces
and how they relate to each other with respect to the United States. To this end,
causes, consequences and measures undertaken during the crises are evaluated and
dissected. The analysis reveals striking parallels between the Great Depression and
the Great Financial Crisis. Causal factors in both crises were a flawed design of the
banking system (unit banking, too-big-to-fail), a real estate boom and high debt
burdens of both households and financial institutions, as well as pronounced
economic inequality. Measures taken during each of the crises differed markedly,
however. Whereas the political approach to the Great Depression was long
characterised by inaction, the response during the recent crisis proved to be swift and
aggressive, which prevented a repeat of the Great Depression by attenuating the
immediate adverse effects on the economy. However, strong evidence exists that the
response may only have deferred the adjustment process initiated by the crisis of
2007-2009. This paper presents empirical observations supporting the view that the
structural problems which led to 2007-2009 are still existent today and continue to
threaten financial stability.
Keywords: Global Financial Crisis, financial crisis of 2007-2009, Great Depression
of 1929-1933, banking system, real estate boom, subprime boom, inequality, Federal
Reserve, too-big-to-fail, deposit insurance, lender-of-last-resort
JEL: B1, B2, B53, D31, E42, E52, E58, E63, E65, E66, G01, G21, G28, H12, H23, N12,
N22, N42
___________________________________________________________________________
Discussion draft prepared for the "Multiple Economic Crises in Historical
Perspective" panel at the Fourth European Congress on World and Global History
Conference 4 until 7 September 2014, Paris, France
3
The charm of history and its enigmatic lesson consist in the fact that, from age to
age, nothing changes and yet everything is completely different.
Aldous Huxley
4
1. Introduction
The Great Financial Crisis of 2007-2009 was the most severe economic crisis since the
Second World War. Only the Great Depression was similar in severity and length.
The question remains, however, whether or not the two episodes are comparable.
Aiginger (2010) contrasts several indicators and arrives at the conclusion that the
Great Depression was significantly more severe than the recent crisis in all but one
respect (the stock market decline). Romer (2009) even claims that the recent crisis
"pales in comparison with what our parents and grandparents experienced in the
1930s." Eichengreen and O'Rourke (2009), on the other hand, assert that we are
"tracking or doing even worse than the Great Depression", particularly from a global
perspective. Finally, former Federal Reserve Chairman Ben Bernanke stated in a
Financial Crisis Inquiry Commission hearing (2011, p. 354): "As a scholar of the Great
Depression, I honestly believe that September and October of 2008 was the worst
financial crisis in global history, including the Great Depression."
It is now abundantly clear that the recent crisis has not had effects similar to those of
the Great Depression. From 1929 to 1933, nominal U.S. GDP contracted by 29%,
prices declined by 25%, unemployment reached 25%, more than 9,000 banks
suspended operation1 and some areas of the U.S. even experienced a return to the
bartering system (King 1933). However, a differing degree of crisis intervention and
legislation during and after the two episodes render a direct comparison problematic.
This paper therefore approaches the problem of comparability from a different angle.
It analyses the broad macroeconomic setting in which the crises were embedded, and
assesses whether the two crises had the same potential deleterious effects, aside from
their extrinsic manifestations. In other words, similarities in the overall settings
within which the two crises erupted are evaluated and compared. This approach
goes well beyond academic vanity, as it permits an assessment of the inherent
It should be noted that "suspension" is not synonymous with "failure". Bank management
during that time often pre-emptively and voluntarily suspended operation before insolvency
occurred.
1
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destructive power of both crises. If the two crises were to be found comparable in
terms of potential severity, the crisis response and post-crisis legislation deserve
special attention. Indeed, Bernanke concluded in hearings before the FCIC (2011) that
the Great Financial Crisis would have exceeded the calamity of the Great Depression
if it had been left on its own. The notion that the Great Financial Crisis had the
potential of being more destructive than the Great Depression is prevalent in U.S.
government circles, which also claim that government actions averted another Great
Depression. As Jeffrey Shafer, a former Federal Reserve and Treasury official, stated
(quoted by Egan 2014): "Arguably the financial shocks of 2008 were bigger than those
of 1929. The outcome was not as disastrous because the policy responses were quite
different." In "Stress Test", a particularly one-sided picture of the U.S. government's
response to the crisis and its efficacy, former Treasury Secretary Geithner (2014,
introductory chapter) subsumes: "And no one I know – neither critics who thought
we were foolish nor supporters who thought we might know what we were doing –
imagined that we would put out the financial fire so quickly and actually make
money on our investments."
The important question arising in this context is, of course, whether the crisis
intervention was in fact successful, as purported by government officials. More
specifically, it remains to be evaluated whether government actions such as bailing
out banks and other financial institutions only prevented the crisis from developing
into another depression at the cost of future financial instability.
In our view, one may not reasonably preclude the possibility that government and
central bank actions during the recent crisis will have consequences similar to those
taken after the dot.com bubble. While the dot.com bubble and the subprime bubble
are viewed as distinct phenomena by many scholars, it is instructive to point out that
the former crisis laid the groundwork for the latter. In order to prevent deflation after
the internet bubble burst, the Federal Reserve aggressively lowered interest rates to
boost spending. Deflation, as feared by then-Federal Reserve chairman Alan
6
Greenspan, failed to materialise, but the Fed kept interest rates too low for too long.
Artificially low interest rates boosted housing activity and led to over-building and
at the same time induced financial institutions and households to over-leverage (see,
for example, Taylor 2009a). Therefore, the Federal Reserve, by attempting to
ameliorate the dot.com bubble's bursting, laid the foundations for the crisis of 20072009. The parallels between the post-dot.com and the post-2007-2009 financial crisis
eras, in our opinion, are disquieting.
This paper does not attempt to provide a complete account on the variety of
(possible) reasons for the Great Depression and the Great Financial Crisis. Instead, it
focuses on salient parallels and on the noteworthy differences between 1929-1933 and
2007-2009, as well as on the crisis and post-crisis policy approaches. We identify
three important basic settings which played important roles in causing the crises: (1)
Both crises were preceded by a rapid rise of real estate prices and by increasing
household indebtedness, as homeowners became increasingly leveraged and
mortgages became gradually more risky; (2) In both historical situations, the time
before the crises was accompanied by high inequality and a probably attendant high
indebtedness; (3) In both crisis episodes, the bursting of the bubble severely impacted
a vulnerable banking sector. During the Great Depression, the banking industry
reacted with a high number of bank failures, whereas the government resorted to a
historically unique bailout of the world's largest banks in the recent crisis. The key
difference between the two episodes thus derives from the government's and the
Federal Reserve's approach to handling the crises. While during the Great
Depression governmental involvement remained minimal up to the end of the crisis,
the government's response to the recent crisis was swift and profound. To the extent
that the actions undertaken during 2007-2009 were almost exclusively aimed at
providing extraordinary financial assistance to the financial sector, the question
remains whether the measures were sufficient.
7
The remainder of this paper is structured as follows: Chapter 2 will give an overview
of the crises parallels, and chapter 3 will describe the major differences between the
Great Depression and the Great Financial Crisis. Chapter 4 will conclude by
summarising the main arguments developed in the paper.
2. The Crisis Parallels
2.1.
Flawed Financial Sector Design
In both crises, 1929-1933 and 2007-2009, an ill-designed and fragile banking system
played a crucial role in causing, prolonging and intensifying the financial turmoil.
When the Great Depression erupted in 1929, the U.S. banking system was markedly
different from both the one today and from the systems of other countries at that
time. While in the rest of the Western world banks with branch networks had been
the norm, the United States was dominated by a large number of so-called unit
banks. Unit banking describes a banking system in which banks are prohibited from
operating branch networks. As a result, unit banking leads to a fragmented banking
system, dominated by a high number of individual banks with no office networks.
As a direct corollary to branching restrictions, banks in the United States were
severely impeded in diversifying loan portfolios, which made them susceptible to
location-specific shocks (Cherin and Melicher 1988). A growing body of research
suggests that the prevalence of unit banking rendered the U.S. banking system
particularly vulnerable to the depression of 1929-1933 and precipitated the large
number of bank failures (White 1984; Calomiris 1990, 1992; Wheelock 1995; Calomiris
and Mason 1997, 2003; Mitchener 2004).
Although the early 1900s experienced a weak trend towards more branching, the
overall level remained dramatically low. From 1900 to 1929, the percentage of banks
which operated branches increased from approximately 1% to 3%. However, the
average number of branches managed by branch-operating banks continued to be
8
low, increasing from 1.37 in 1900 to 4.39 in 1929 (Figure 1). International experience
corroborates the notion that branch banking systems proved to be more resilient than
the U.S. system to the shocks in the 1920/30s. Banking systems which allowed banks
to operate branch networks fared significantly better during the Great Depression
and prevented a widespread bank collapse comparable to the one witnessed in the
United States.
Figure 1: Branch Banking in the Early 1900s
3,50%
5,00
4,50
3,00%
% of Banks
2,50%
3,50
3,00
2,00%
2,50
1,50%
2,00
1,50
1,00%
Number of Branches
4,00
1,00
0,50%
0,50
0,00%
0,00
1900
1905
1910
1915
1920
1921
1922
1923
State & National Banks Operating Branch Networks
1924
1925
1926
1927
1928
1929
Average Number of Branches per Bank
Data: Committee on Branch, Group, and Chain Banking (1932, p. 6); Comptroller of the Currency (1931, p. 3)
The general consensus holds that nationwide branch banking protected the Canadian
banking system during the Great Depression. The fact that the Canadian economy
was closely connected to that of the U.S. and shared many of the latter's
characteristics, while at the same time allowing branch banking, invites a comparison
of the two systems in order to evaluate the role unit banking played during the 1920s
and the Great Depression. By 1920, more than 30,000 commercial banks existed in the
United States, but only 18 in Canada. These 18 Canadian banks operated 4,676
branches, whereas American banks collectively had only 1,281 branch offices. The
1920s agricultural shock led to different adjustment processes in the two countries:
9
Between 1920 and 1929, the United States experienced 6,008 suspensions (including
failures and voluntary liquidations) and 3,963 mergers. In contrast, only one bank
failed in Canada during the decade, while the necessary contraction in the banking
industry was carried out by the surviving banks, which reduced their number of
branch offices by 13.2%, comparable to the 9.8% decline in bank offices in the United
States. Just as Canada's branch banking system allowed a more adequate response to
the 1920s shock, Canada managed to withstand the Great Depression significantly
better than the U.S. Despite many similarities with the United States, Canada
suffered no bank failures during 1929-1933. Although the number of bank offices fell
by 10.4%, this number was significantly below the 34.5% of all bank offices which
permanently closed in the United States. Branching had permitted Canadian banks to
mobilise funds to meet runs, while at the same time holding only marginal excess
reserves (White 1984, p. 131-132). White (p. 131) therefore concludes: "A system of
nationwide branching probably could have reduced or eliminated bank failures by
establishing intermediaries with loan portfolios that were sufficiently diversified to
manage regional risks." Subsequent research has yielded similar findings. Bordo
(1985) compares five industrial nations over time and observes that the United States
was more susceptible to banking crises and, at the same time, was the only country
whose banking system was based on unit banks. Therefore, Bordo (1985) concludes
that the lack of branch networks may explain the perennial menace of banking crises
in the United States. Grossman (1994) examines the "exceptional stability" of the
banking systems in Britain, Canada and ten other countries during the Great
Depression in a dataset comprising 25 countries across Europe and North America
and finds that the banking structure, together with exchange-rate policies, accounted
for banking system stability/instability.
10
Figure 2: Bank Suspensions and Deposits in Suspended Banks 1929-1933
50,00%
45,00%
40,00%
35,00%
30,00%
Suspensions as % of All Banks
25,00%
Deposits in Suspended Banks as % of Total
Deposits
20,00%
15,00%
10,00%
5,00%
0,00%
1929
1930
1931
1932
1933
Total
Data: FDIC (1984, p. 36)
As can be inferred from Figure 2, the banks which failed during 1929-1933 tended to be
small unit banks. Overall, 46.90% of all banks failed during the Great Depression.
These banks, however, held only 20.56% of overall bank deposits, implying a less
than average size of failing banks. Indeed, the high bank failure rate in the 1920s
affected mainly banks with less than $25,000 capital, located in towns with a
population of 2,500 or less (Friedman and Schwartz 2008, p. 249).
As outlined above, the banking system in existence on the eve of the Great
Depression had materially contributed to the banking malaise in the early 1930s. The
main policy lesson derived from the 1930s experience was that banking is inherently
fragile (see, for example, Friedman and Schwartz 2008). In order to prevent bank
panics as well as the attendant bank runs, which have been widely seen as the
ultimate reason for banking fragility, the Banking Acts of the 1930s introduced
deposit insurance through the creation of the Federal Deposit Insurance Corporation
(FDIC). Insuring deposits and thereby reducing the incentive for bank customers to
trigger or participate in bank runs provided banks with a stable source of funds
11
which, it was hoped, would in future prevent a repetition of the high number of bank
failures experienced during the Great Depression.
Policymakers' approaches to the financial sector prior to the crisis of 2007-2009
suffered from similar shortcomings, albeit of an almost diametrically opposed
nature. As discussed above, post-Depression legislation had introduced deposit
insurance. As the accompanying danger of moral hazard was well-known from
previous bank-obligation insurance experiments in several states,2 lawmakers
simultaneously attempted to minimise competition in the banking industry, for
example by a limitation of interest rate competition, separation of commercial and
investment banking and imposition of geographical restrictions and restrictive bank
chartering practices. Less competition had increased bank charter values and, as a
corollary, decreased the banks' propensity for risk-taking, as failure would lead to
the loss of valuable bank charters and the economic rents accompanying them. Over
time, however, bank charter values successively decreased, as post-Depression era
restrictions fell victim to the passage of time.
The link between government-provided safety nets for the financial sector,
deregulation and financial instability is well-researched and empirically confirmed
around the world (Demirgüç-Kunt and Detragiache 1999; Kaminsky and Reinhart
1999; Mehrez and Kaufman 2000). As the frequency of banking crises and bank
failures increased, authorities resorted to punctual relief by picking winners and
losers. One of the most striking phenomena during the past decades, often
characterised as "laissez-faire", has been the propensity of central banks,
governments and their agencies to extend generous emergency support to failing
banks – and occasionally to the banking system in general – whose bankruptcy was
believed to potentially jeopardise the economy: the too-big-to-fail (TBTF) doctrine.
For historical accounts on the first wave of bank obligation systems (1829-1866), see
Golembe and Warburton (1958) and for the second wave (1908-1929) American Bankers
Association (1933) as well as Robb (1921). For a concise account on the failure of early deposit
insurance systems in the United States, see Thies and Gerlowski (1989).
2
12
The most widely used indicator for measuring the too-big-to-fail phenomenon is size.
By this indicator, the TBTF problem has risen significantly during the past decades.
From 1970 to 2010, the top five banks in the United States increased their market
share from just 17% to 52% (Rosenblum 2010, p. 6). After the bailout of Continental
Illinois in 1984, which had given birth to the term "too-big-to-fail", Charles Schumer
(1984) of the House Banking Committee asked:
If the Government believes that some institutions are so important that it must step in
to guarantee all deposits, is it wise for us to further destabilize the system by allowing
banks to enter the securities, insurance and real estate businesses? The banks most
interested and capable of getting into these volatile businesses are those, like
Continental, that we have determined are too important to fail. Combining high-risk
activities and complete Federal insurance will prove to be explosive.
Despite such warnings, regulators and lawmakers aggravated the TBTF problem by
successively eroding long-standing restrictions from the post-Great Depression era,
aimed at confining federal insurance of deposits. As discussed in Umlauft (2015),
particularly the Gramm-Leach-Bliley Act of 1999 and the Commodity Futures
Modernization Act of 2000 provided banks with the opportunity to grow in size as
well as complexity. As a direct corollary, the TBTF problem was materially amplified
in scale and scope until the crisis broke in 2007. Between 2001 and 2007, the largest
five U.S. banks had increased their share of industry assets by 50%, from about 30%
to more than 45% (Figure 3).
13
Figure 3: Share of Top 5 US Commercial Banks of Total Assets Held by Commercial Banks, 2001-2007
50,00%
46,01%
44,05%
45,00%
41,76%
39,52%
40,00%
35,00%
33,14%
31,80%
30,40%
30,00%
25,00%
2001
2002
2003
2004
2005
2006
2007
Data: Board of Governors of the Federal Reserve System
Focussing on size alone, however, leaves out other important aspects. The
complexity of financial markets played a key role in compounding the recent crisis.
Indeed, all bailout measures were justified on the notion that the complex nature of
banking made necessary an unprecedented degree of government intervention in the
private sector.3 By many indications, the complexity of financial institutions had
grown significantly until immediately before the crisis. For example, the largest five
U.S. banks dominated the derivatives market and collectively held 97% of all
derivatives by year's end 2007 (OCC 2008). Moreover, subsequent to the elimination
of the Gramm-Leach-Bliley Act, the size and importance of non-bank subsidiaries
increased dramatically, making bank holding companies more complex and thus
more difficult to wind down (Avraham, Selvaggi and Vickery 2012).
In addition to the exacerbated problem of TBTF, large, complex financial institutions
were given wide discretionary authority to measure risk and determine adequate
Complexity played a determining role in deciding on government bailouts, and
policymakers repeatedly based their decisions to extend government assistance for troubled
institutions on the complexity of their respective business model and the risk the failure of
these institutions would pose to the economic system.
3
14
capital ratios under Basel's internal ratings-based approach. In combination with
short-term compensation practices, which fostered short-termism,4 large banks took
inordinate risks, inadequately backed by capital.5
Given the points raised above, the central role large, complex financial institutions
played in the 2007/2009 crisis are not surprising. As Wilmarth (2009) points out, a
leading group of seventeen large complex financial institutions (LCFIs), mostly
universal banks, dominated the securitisation market. Those LCFIs originated
consumer and corporate loans, packaged loans into ABSs and CDOs, created overthe-counter (OTC) derivatives based on these loans and distributed these securities to
other market participants, and often retained significant amounts for themselves.
Pinto (2010, p. 29) provides evidence for a strong positive relationship of bank size
and the share of non-performing loans. Whereas the share of non-performing loans
of banks with assets below $5bn amounted to approximately 3%, the share of the
very largest banks with a balance sheet size of at least $1tr accounted for 17.36%
(Figure 4).
For an excellent analysis of incentive problems arising from executive remuneration at
financial institutions, see Bebchuk and Spamann (2009). For empirical evidence on the
positive relationship between risk-taking and incentive compensation, see, for example,
Balachandran, Kogut and Harnal (2010) and Guo, Jalal and Khaksari (2014). Bebchuk, Cohen
and Spamann (2010) provide an interesting case study of compensation practices at Lehman
Brothers and Bear Stearns, demonstrating that the claim that these firms' top executives'
wealth was largely wiped out as their firms collapsed is unfounded.
4
Umlauft (2015) links the development of aggressive remuneration practices and
successively riskier funding techniques of large, complex financial institutions to the
prevalence of government guarantees for TBTF institutions.
5
15
Figure 4: Share of Non-Performing Loans by Bank Size Group
20,00%
18,00%
17,36%
16,00%
14,00%
12,00%
9,30%
10,00%
7,50%
8,00%
6,00%
3,72%
4,00%
3,64%
3,09%
2,54%
2,38%
2,26%
2,06%
$250m $499m
$100m $249m
$50m $99m
$0 - $49m
2,00%
0,00%
> $1tr
$100bn 999bn
$50bn $99bn
$5bn $49bn
$1bn $4.9bn
$500m $999m
Data: Pinto (2010, p. 29)
Consequently, write-downs as a percentage of total assets at TBTF banks were
significantly higher than at non-TBTF firms (Bhagat and Bolton 2014). As a direct
corollary, the largest group of banks in the U.S. with assets exceeding $10bn were
about 50% more likely to have negative net income in 2008 than other size groups
(Figure 5).
Figure 5: Banks with Negative Net Income by Bank Size Group, 1984-2013
16,0%
14,0%
12,0%
10,0%
8,0%
6,0%
4,0%
2,0%
0,0%
Assets > $10 Billion
Assets $1 Billion - $10 Billion
Assets < $100 Million
All Insured Institutions
Assets $100 Million - $1 Billion
Data: FDIC – Quarterly Banking Profile (various years)
16
As a result of the close relationship between banks' size and degree of risk-taking, the
largest financial institutions required a disproportional share of government bailout
funds. Barth, Prabha and Swagel (2012, p. 13) calculate that 94% of the TARP's
$425.4bn Capital Purchase Program went to 35 large, complex financial institutions
(32 large banks as well as Fannie Mae, Freddie Mac and AIG), while smaller
institutions, numbering 675, received the remaining 6%. According to an OECD
study, the world's largest banks would have required an additional $3.6tr to
withstand the crisis without capital injections and other bailout measures (BlundellWignall, Atkinson and Roulet 2013).
At variance with the widely held opinion that the 1920s was a decade of rampant and
unbridled laissez-faire capitalism, in truth the policy approach in the early 1900s, at
least with regard to the financial industry, was overly restrictive. The policy
framework in place at the beginning of the 20th century had impeded the
development of an efficient banking sector based on branch banking. Instead, the
banking system relied on a countless number of unit banks susceptible to regionspecific shocks, which rendered the system vulnerable to the bank failures of the
1920s and early 1930s. By contrast, the financial system's vulnerability in the early
2000s was a function of an overly permissive approach to financial industry
regulation. In this context, it was ignored that the generous financial safety net
introduced after 1933 conferred fiduciary duties upon the government to regulate
financial institutions and constrain inordinate risk-taking at taxpayers' cost. Instead,
regulators put misplaced trust on the self-regulating powers of financial markets,
ignoring the well-known and perennial epiphenomenon of government-provided
safety nets: moral hazard.
Although the government approach towards the financial sector in the early 1900s
and the early 2000s differed markedly, policymakers' reasoning was equally and
fundamentally shaped by ideological convictions. Until 1933 – and beyond – the
United States' population was concerned about an accumulation of power in large
17
financial institutions and a – perceived – undue influence of Wall Street in industrial
America. Politicians responded to that distrust by actively restricting the growth and
power of financial institutions, fostering a splintered financial system (Roe 1994,
Umlauft 2014). A banking system based on small banks was seen as the financial
equivalent of the egalitarian ideals perceived by most United States citizens as their
birthright. As we have seen during the recent crisis, excessive concentration of
financial power in the financial industry may indeed lead to disastrous outcomes.
Policies up to 1929, however, had led to another extreme: a fragmented, anachronistic
and ultimately highly fragile banking system which paved the way for the banking
malaise of the late 1920s and early 1930s.
Ideology also played a key role in shaping the financial and banking systems extant
as of the outbreak of the recent financial crisis in 2007. Around the mid-1900s, there
was a deep and widespread ideological turn towards a belief in market efficiency.
Economics as an academic field became defined much more by mathematical
models, rational agents and, by and large, a belief in efficient markets. Within the
social sciences, the universal notion of the efficacy of markets led to a wholly nonreflective endorsement of them in the financial sector. In the latter part of the 20 th
century and the early 2000s, regulators and policymakers increasingly came under
the spell of the financial industry and bought into the premise that the financial
industry may best be governed by self-regulation. As Johnson (2009) notes, over time
"the American financial industry gained political power by amassing a kind of
cultural capital—a belief system." As a result, "[a] whole generation of policy makers
has been mesmerized by Wall Street, always and utterly convinced that whatever the
banks said was true." Buiter (2008, p. 106) observes that regulators had fallen victim
to "cognitive regulatory capture" by internaliing "the objectives, interests and
perception of reality of the vested interest they are meant to regulate and supervise
in the public interest." The financial industry took advantage of the paradigm shift in
order to lobby for fewer restrictions and an expansion of asset powers. Such was the
zeitgeist dominated by the existence of efficient markets, that it was ignored that
18
distinctive government involvement in the financial sector had rendered the banking
industry by and large incompatible with fundamental laws and principles of
capitalist systems. Deposit insurance, the Federal Reserve's lender-of-last-resort
function, the too-big-to-fail doctrine and other measures had severely undercut
market discipline and thus necessitated government regulation of the banking sector
– particularly of the very largest financial institutions, whose liability side possessed
a 100% government guarantee through explicit as well as implicit means.
As described above, a flawed banking sector architecture can be identified as the
main culprit leading to 1929 and 2007. The chief difference between the banking
systems during the Great Depression and the Great Financial Crisis seems to lie in
the diverging degree of market discipline in effect during the two episodes.
Historically, banks' economic viability had been reflected by their willingness to
subordinate risk-taking and profit generation to accommodate risk-intolerant
depositors (Calomiris and Mason 1997, 2003; Calomiris and Wilson 2004). On the
other hand, the Pecora Investigations (1932-1934) revealed a wide range of abusive
practices and conflicts of interest in banks with securities affiliates. In this context, it
was widely believed that banks with security affiliates systematically exploited their
clients by marketing low-quality securities to the ignorant public. The view that
conflicts of interest were a prevalent feature of the combination of commercial and
investment banking activities gained popular support. However, these accusations
were later found to be grossly over-exaggerated (Benston 1990), and subsequent
empirical studies demonstrated that commercial banks with securities affiliates had,
on average, underwritten higher-quality issues with lower default probabilities than
specialised investment banks (Kroszner and Rajan 1994, 1995; Puri 1994, 1996;
Flandreau, Gaillard and Panizza 2010), proving a significant degree of market
discipline. Apart from the Federal Reserve's lender-of-last-resort function, which
may have introduced a moderate degree of moral hazard into the financial system,
the regulatory framework of the early 1920s did not provide noteworthy incentives
19
for excessive risk-taking, due to externalities. In addition to the practically nonexistent government safety net for the financial industry, double liability had
moderated risk appetite by shareholders and bank managers (Grossman 2001). By
the early 2000s, however, a plethora of measures taken to stabilise the financial
system
(deposit
insurance,
the
too-big-to-fail
doctrine,
lender-of-last-resort,
Greenspan put) had led to a diametrical result by greatly diminishing market
discipline and at the same time providing strong incentives for inordinate risk-taking
owing to moral hazard.
In order to fully account for the deficiencies of the respective banking systems extant
in the 1920s and the early 2000s, a short review of Taleb's (2012) concept of
"antifragility" is instructive. According to Taleb, things may be classified as either
fragile, robust or antifragile. The fragile is susceptible to damage from external
influences, while the robust resists shocks and stays unharmed from external
impacts. The antifragile, on the other hand, gains from shocks. Taleb argues that the
property of antifragility stands behind everything that has changed with time, such
as nature.6 It is obvious, with regard to the banking system both before the Great
Depression and the Great Financial Crisis, that policymakers attempted to make a
fragile system – prima facie as a result of government interference – resilient by
rendering its individual components robust. Before 1929, several states had
introduced deposit insurance in order to mitigate the inherent fragility pertinent to a
banking system based on unit banks, i.e. vulnerability to regional shocks and
susceptibility to bank runs. Likewise, particularly large, complex banks before the
Great Financial Crisis had repeatedly been extended extraordinary government
assistance in times of crisis, out of fear of the repercussions the failure of large,
Besides evolution, Taleb (2012, p. 3-4) identifies "culture, ideas, revolutions, political
systems, technological innovation, cultural and economic success, corporate survival, […] the
rise of cities, cultures, legal systems, equatorial forests, bacterial resistance…even our own
existence as a species on this planet" as inherently antifragile.
6
20
complex financial institutions would have on the financial system and the economy
in general.
Here arises the principal problem with the policy approaches to the banking system:
Nature, as other antifragile systems, gains its antifragile quality from its subsystems'
fragility. Nature's individual parts exhibit pronounced susceptibility to adverse
impacts, such as climatic, faunal or floral change. However, fragility on the sub-level
is a necessary requirement for ensuring the total system's adaptability. By allowing
sub-system fragility to proliferate, nature ensures its antifragile property in the
aggregate. A similar concept is generally accepted with regard to the economic
system. Schumpeter's (2008, p. 83) "creative destruction" stipulates that innovation
destroys and subsequently replaces obsolete parts of the economic system and thus
"revolutionizes the economic structure from within, incessantly destroying the old
one, incessantly creating a new one". Yet, the idea of Schumpeter's "creative
destruction" is blatantly absent with regard to the banking system.
Not surprisingly, various government interferences, by targeting specific identified
problems, have rendered the banking system as a whole less resilient, and hence
prone to unanticipated developments, by prohibiting a process of creative
destruction. Deposit insurance, for example, was seen as a viable solution to prevent
liability-side problems of banks in the wake of the Great Depression. However,
deposit insurance had already been tried in two waves in individual states in the U.S.
since the 1830s. All of these bank-obligation insurance systems eventually collapsed
or were suspended. Although bank-obligation insurance was seen as a remedy for
the unit banking system's fragility, it further destabilised the financial system with
two factors. First, deposit insurance increased moral hazard by inducing banks to
hold less capital and take on more risk than without deposit insurance. Calomiris
(1990), Alston, Grove and Wheelock (1994) and Chung and Richardson (2006) show
that deposit insurance states experienced more bank failures than states without in
21
the 1920s.7 Second, by providing banks with a relatively stable funding source,
deposit insurance contributed to overbanking, or an excess number of banks per
capita (Wheelock 1993). Overbanking was often cited by contemporary observers as
an influential factor for the high number of bank failures during the 1920s (see, for
example, Federal Reserve 1937). Wheelock (1993) provides empirical evidence that
states with the highest number of banks per capita in 1920 experienced the highest
bank failure rates. Hence, measures undertaken until 1929, although aimed at
stabilising the banking system, proved to have the opposite – a destabilising – effect.8
Similarly, before the recent crisis, the financial – and particularly the banking
system's – "health" relied to a significant degree on explicit and implicit government
guarantees. Thus, external factors (government safety net), instead of internal factors
(capital, accounting transparency, etc.), played an important role in stabilising the
system. While the largest banks' business models had never been riskier than before
2007 (e.g. off-balance sheet activities), their capital ratios were at all-time lows. In
2007, the average leverage ratio of the world's largest financial institutions was well
in excess of 30, which corresponds to an equity ratio of below 3%. Recurrent bailouts
of the largest financial institutions (TBTF doctrine) gave the system a stable
appearance, as long as the government upheld the commitment to the TBTF doctrine.
When market participants had reason to question that assumption's validity (that
TBTF banks would not be subjected to bankruptcy), uncertainty and ultimately chaos
ensued.
Lehman Brothers forcefully illustrates the important role of government guarantees
with regard to "stabilising" the financial sector in contemporary banking. When
Lehman Brothers, contrary to market expectations, was allowed to fail in September
2008, it precipitated a dramatic deterioration in the interbank market. From
Studies examining intrastate variance of bank failures confirm that banks with deposit
insurance fared significantly worse than banks whose deposits were not insured. See Hooks
and Robinson (2002) for the Texas experience and Wheelock and Wilson (1994, 1995).
7
Umlauft (2014) argues that the establishment of the Federal Deposit Insurance Corporation
(FDIC) proved to be an important driver for establishing the too-big-to-fail doctrine.
8
22
September to October, the TED spread, a banking stress indicator measuring the
difference between interbank interest rates and 3-month Treasury bills, more than
tripled from 135bps to 464bps. This worsening was not, however, the result of
Lehman Brothers' failure per se, but rather the consequence of the commotion of
TBTF beliefs and market participants' subsequent readjustment of probabilities of
TBTF bailouts (Afonso, Kovner and Schoar 2011). The recent crisis profoundly
challenges the validity of ad-hoc attempts by governments and regulators to shield
market participants from market forces, a prevalent phenomenon during the past
decades – dubbed the "Soviet-Harvard delusion" conducted by "Harvard-Fragilistas"
and identified as "an insult to the antifragility of systems" by Taleb (2012, p. 5).
Although to some people this may seem overly Darwinistic, it should now be beyond
doubt that government interferences to insulate large, complex banks from market
discipline has introduced a substantive degree of moral hazard into the system. The
fact that the crisis affected mainly those institutions which possessed the most
pronounced insulation from market forces may be seen as a confirmation of that
assertion. Instead of providing a functioning and working regulatory framework, it
seems that regulators often relied on moral principles to ensure the working of the
financial system. These subsequently turned out to be costly misassumptions.
As Posner (2010, pos. 20) aptly remarks:
If the regulatory framework is defective, it must be changed, because competition will
not permit businessmen to subordinate profit maximization to concern for the welfare
of society as a whole, and ethics can't take the place of regulation.
Although the notion that banking is inherently fragile is now widely accepted, it
would be well worth reconsidering, in light of recent experiences, the factors which
render it so, i.e. to find out whether measures intended to stabilise the banking
system may ultimately further debilitate it.9 As White (2013, p. 473) notes, the idea
that banking is naturally fragile is "implausible anti-Darwinian [and] defies the
Already in 1936, Vera C. Smith (p. 7) pointed out: "It is not unlikely that the bolstering up of
banking systems by their Governments is a factor which makes for instability."
9
23
Darwinian principle of natural selection". More importantly, White points out that,
were financial institutions inherently fragile and prone to collapse, financial
institutions should be expected to have collapsed and consequently disappeared over
time. The inherent-fragility view is therefore hard-pressed to explain how modern
banking survived over the past 700 years, and even more how – from its ascent in
12th-century Italy to the emergence of government safety nets in the 20th century – it
was able to flourish and spread across the world.
Summarising, during both periods, ideology played a key role in shaping the
financial architecture and in creating a non-optimal banking system. During both
periods, non-optimal banking legislation and the resulting defective banking
structure contributed materially to both the 1929 and 2007 crises. Although ideologyinduced banking legislation underwent a material change between the two crises,
banks proved to be the main crisis catalyst both during 1929-1933 and 2007-2009.
2.2.
Real Estate Bubbles and Excessive Debt
Another parallel between 1929-1933 and 2007-2009 concerns the accumulation of
private debt before both crises, which is most profoundly reflected in the
accumulation of mortgage debt. Both historical periods leading to the crises were
accompanied by rapidly rising house prices and a rising degree of financial leverage
which fuelled the housing boom.
The Roaring Twenties are well-known for their achievements in literature, theatre
and art. The 1920s are also commonly associated with economic prosperity as well as
fraud,10 and, in the United States, with a prolonged real estate boom. Particularly the
The term "Ponzi scheme" derives its name from Charles Ponzi who operated a fraudulent
business scheme in the 1920s, supposedly based on arbitrage involving international reply
coupons and postage stamps. Another example is Ivar Kreuger, who built an international
conglomerate based on accounting fraud in the midst of the Great Depression, until the
scheme collapsed in 1932. For an excellent historical account on Ivar Kreuger, see Partnoy
(2010).
10
24
Florida land boom of the 1920s – and the Ponzi schemes accompanying it – remains
in the cultural memory. Unfortunately, Florida did not have a housing price index,
but that Florida experienced a massive real estate boom is indicated by the value of
building permits issued at that time. Between January 1919 and September 1925, the
nominal average value of building permits in Miami increased by 8,881%, from
$89,000 to $7,993,500 (Vanderblue 1927). Recent research confirms that the real estate
boom was not confined to Florida. Nicholas and Scherbina (2009) developed a real
estate price index for Manhattan for the period 1920-1939, showing that real housing
prices increased by 54% between the fourth quarter of 1922, after the post-war
recession had ended, and its peak in mid-1926. The fact remains, however, that
reliable nation-wide real estate data is not available for the 1920s, which would
enable us to meaningfully compare it to the recent boom. Regrettably, the widelyused Case-Shiller index shows a strong deflationary bias in the early years. 11 In order
to obtain comparable datasets for both periods, we follow White (2009) who
constructed a house price index using housing unit starts and values of newly
constructed home units. The data obtained shows that the 1920s experienced a
significant appreciation of house prices.
See White (2009, p. 8-9) for a short discussion on the shortcomings of Shiller's data
pertaining to the early 1900s.
11
25
Figure 6: Real Values of Newly Constructed Houses, 1921-1927 and 2001-2007 (1921/2001=100)
150
140
130
120
110
100
90
1921/2001
1922/2002
1923/2003
1924/2004
1921-1927
1925/2005
1926/2006
1927/2007
2001-2007
Data: Economic Report of the President 2013, Table B-55 and B-56 and for 1921-1927 from Carter et al. (2006),
Table Dc510 and Dc257
According to the data (Figure 6), real house prices increased by more than 40% from
1921 to 1926. This is in line with estimated rises in house prices in Washington D.C.
(median asking price of single family homes), a region which is not considered to
have experienced a boom, but where real house prices rose 38% from 1920 to the
peak (White 2009, p. 9). It cannot, however, a priori be ruled out that the boom may
have been a catching-up after the First World War and thus may have been the result
of a crowding-out, as resources transferred to the government during war time may
have led to a decrease in non-essential investment and consumption. White (2009)
provides a simple examination of what would have happened without the First
World War and what actually happened: he forecasts both housing starts as well as
real values of newly-constructed residential constructions by regressing on real GDP
figures and comparing the results with actual housing starts and values thereof.
White's (p. 14) findings suggest that "there was more to the boom than a simple
postwar recovery."
All facts and indicators point to a vigorous real estate boom in the 1920s. A look at
mortgage debt indicates that the population was more than willing to buy into
booming house prices and to participate in the bubble. Compared to the pre-First
26
World War period, mortgage financing in the 1920s increased in significance from
40% to 60%. While mortgage debt had increased by an annual average of 6.73% in the
decade preceding the twenties boom, the pace increased to 13.92% in the decade
1920-1929. During the 1920s, the ratio of residential mortgage debt to disposable
income more than doubled from about one eighth to two fifths, and the ratio of nonfarm residential mortgage debt to non-farm residential wealth (aggregate loan-tovalue ratio) increased from about 10% to approximately 30% (Grebler, Blank and
Winnick 1956, p. 165 and 168). The rapid increase in household mortgage debt and
the rising aggregate loan-to-value ratio "offers indirect evidence of a fundamental
revision in home owners' and probably lenders' attitudes concerning mortgage
indebtedness during the twenties" (Grebler, Blank and Winnick 1956, p. 164).
Mortgage debt was so prevalent at the onset of the Great Depression that thenSecretary of the Treasury Mellon observed that "[t]here is a mighty lot of real estate
lying around the United States which does not know who owns it" (as quoted by
Hoover 1952, p. 39). That mortgage debt played a critical role in the Great Depression
is further corroborated by the fact that federal measures during and beyond the
Great Depression to ameliorate the adverse effects of the crisis on the population
directly or indirectly affected the housing market (Wheelock 2008, p. 140).
Several points substantiate the notion that the real estate boom of the 1920s
contributed to the Great Depression. First, as declining real estate prices precipitate
mortgage refinancing and repayment problems, mortgage defaults impair the
balance sheets of financial intermediaries, stifling credit supply. Declining house
prices also impede lending due to less qualitative and less valuable collateral
(Bernanke 1983). This is of particular importance as bubbles preceding downturns
are fuelled by eroding lending standards. In the face of rising uncertainty and
financial problems, financial intermediaries suddenly reverse lending practices and
again resort to restrictive credit extension, amounting to a negative credit shock.
Finally, declining house prices lead to reduced consumer spending and other outlays
27
owing to the "wealth effect". Several studies suggest a positive relationship between
housing wealth and consumption (Case, Quigley and Shiller 2005; Klyuev and Mills
2006; Greenspan and Kennedy 2005, 2008; Case and Quigley 2008; Zhou and Carroll
2012).
Early research was jointly concerned with the 1920s real estate boom and the Great
Depression, or at least held that the business cycle depression of 1929-1933 was
exacerbated by declining real estate prices. Subsequent research, however, has
tended to treat the 1920s boom and the Great Depression as two distinct and separate
phenomena. Continuously rising aggregate output and declining unemployment
after the housing peak in 1925 confirmed this approach, at first glance. Despite the
fact that the fall in house prices predated the onset of the Great Depression by several
years, a connection between the end of the housing boom and the Great Depression
may well be possible, especially since real estate values during the recent boom cycle
peaked in early 2006, while the crisis only started about two years later. Recent
research corroborates the notion that the real estate boom in the Roaring Twenties
and the Great Depression should not be analysed separately, but instead ought to be
seen as mutually reinforcing aspects of the crisis. In this context, Brocker and Hanes
(2013) show that, in the 1920s, cities which experienced the most pronounced
housing
construction booms and largest
increases
in
house
values and
homeownership rates suffered the worst downturns in housing prices and
homeownership rates and experienced the highest mortgage foreclosure rates in the
early 1930s. This data demonstrates that the effects of the 1920s' housing boom were
still prevalent in 1929 when the Great Depression started, which indicates that "in the
post-1929 downturn of the Great Depression, house prices fell more and there were
more foreclosures because the 1920s boom had taken place" (p. 4-5).
We do not suggest that the credit-boom view replace other explanations of the Great
Depression – such as the gold standard, monetary policy and those explanations
briefly touched upon in this article. Instead, we subscribe to Eichengreen and
28
Mitchener's (2003) opinion that "[t]he Depression was a complex and multifaceted
event. The perspective provided by the credit-boom view is a useful supplement to
these more conventional interpretations."
A pattern similar to that of the 1920s emerges with respect to the time preceding the
recent crisis. In the five-year period leading to the housing peak in 2006, real house
prices increased by approximately 31% in real terms (Figure 6). As was the case with
the boom in the 1920s, mortgage debt had increased by 6.57% p.a. in the ten-year
period preceding 1997-2007. In the decade leading to the crisis (1997-2007), the rate of
mortgage debt growth almost doubled, to 11.46%. In contrast to the 1920s, however,
the only aspect of the recent housing boom which is subject to a noteworthy degree
of controversy is the question whether or not mortgage lenders acted fraudulently.
That house prices had risen too far, too rapidly is a matter of no serious debate.
House prices almost doubled from the mid-1990s to the mid-2000s. As was the case
in the 1920s boom, an influential driver of home price increases was the gradual
erosion of lending standards to successively less creditworthy borrowers (Mian and
Sufi 2009; Keys, Mukherjee, Seru and Vig 2010; Demyanyk and Van Hemert 2011;
Purnanandam 2011). Unconventional terms, such as interest-only and low or no-doc,
increased significantly in the period 2001-2005 from 0% to 37.80% and 28.5% to
50.70%, respectively (Freddie Mac, as quoted by the Joint Economic Committee 2008,
p. 21). Another influential driver of housing starts was the Federal Reserve's
deviation from the Taylor rule, which artificially increased housing starts in the years
before 2007 (Taylor 2009b).
As Case and Quigley (2008) persuasively argue, reversals of housing market booms
exhibit inherent destructive properties due to a combination of mutually reinforcing
mechanisms: the wealth effect, the income effect and the financial market effect. The
end of housing booms feeds into the general economy via three distinct channels.
First, as household asset values increase due to rising house prices, households
spend more by extracting equity from their assets, or save less. Unfortunately, the
29
converse is also true when asset values decline. In an environment of falling house
prices, people will increase their savings rate and thus consumer spending will fall.
Second, as increasing house prices during the boom propel the economy, total
income will rise. When the trend reverses, sales of existing homes will decline,
reducing fees earned by brokers, building inspectors, appraisers and mortgage
lenders. At the same time, exchange-induced expenditures associated with
purchasing a new home will also decline. Even more important, the end of real estate
bubbles will materially impair the construction industry, as demand for new homes
falls. For example, new housing units peaked at 937,000 in 1925 and fell by 90% to
93,000 in 1933. The fall in new housing starts was less pronounced in the 2000s, but
house construction starts nevertheless declined by 73% from its peak in 2005 at
2,068,300 to 554,000 in 2009 (Figure 7). Third, as home prices fall and the number of
foreclosures rises, financial markets are adversely affected, as was the case both in
1929-1933 and 2007-2009.
Figure 7: New Residential Housing Units Started, 1921-1931 and 2001-2011 (in thousands)
1000
2500
900
800
2000
700
600
1500
500
400
1000
300
200
500
100
0
0
1921-1931 (left scale)
2001-2011 (right scale)
Data: Economic Report of the President (2013), table B-55 and B-56 and Carter et al. (2006), table Dc510
30
It is interesting to note that both the recent housing boom and the real estate boom in
the 1920s were based in no small part on the ready availability of money due to
financial innovation, i.e., both relied heavily on new financial products. As described
in Snowden (2010) and Goetzmanm and Newman (2010), early forms of
securitisation involved bundling commercial and residential mortgage loans and
creating pass-through securities. Similarly, the role securitisation played in the recent
crisis is hard to overestimate. Thus, the parallels between the crises are conspicuous
in that, in both cases, financial innovation had increased demand by broadening the
base of prospective buyers. In the 1920s, individual investors played an increasingly
important role in financing the real estate construction boom (Snowden 2010, p. 11),
while the possibility to create triple-A-rated securities from pools of less qualitative
assets provided new classes of investors – such as pension funds, which were not
allowed to hold fixed income assets not rated AAA and had thus been excluded from
the mortgage market – access to the real estate market.
As Goetzmanm and Newman (2010) observe: "By nearly every measure, real estate
securities were as toxic in the 1930s as they are now." The fact that securitised assets
almost utterly ceased to be traded after 1929 (Goetzmann 2010) and after 200712
(Beltran, Cordell and Thomas 2013) is another parallel between the two crises,
emphasising the toxic nature of financial innovation in combination with "irrational
exuberance" in financial markets.
Summarising, the rapid increase in building activity, house price appreciation and
accumulation of mortgage debt during the 1920s and the 1990/2000s look eerily
similar. During the time preceding both crises, real estate markets experienced
pronounced booms as housing prices strongly and steadily increased. Additionally,
both episodes were accompanied by rapidly growing mortgage debt levels. Figure 8
shows that the aggregate loan-to-value ratio more than tripled from 10.20% in 1920 to
In fact, the Federal Reserve now constitutes the main demand factor for MBSs. As of yearend 2013, the Federal Reserve held 25% of all Agency mortgage-backed securities (Elamin
and Bednar 2014).
12
31
its peak at 34.10% in 1932. The debt-to-value increase in the early 2000s was less
pronounced, albeit from an already high level. The ratio of mortgage debt
outstanding to real estate value had steadily increased since bottoming out at about
20% at the end of the Second World War. By 2005, the level had reached 40%, from
where it rose markedly to more than 60% by 2009. Then and now, the credit quality
of mortgages decreased, as people grew increasingly risk-seeking and anticipated
continuously rising home prices. Morton (1956, pp. 101-102) shows that nonamortising and high loan-to-value loans were important determinants for the
probability of foreclosure in the 1930s. Likewise, subprime loans, characterised by
high loan-to-value ratios and risky financing conditions, were the main reason for the
high foreclosure and delinquency rates in the early 2000s. As house prices failed to
rise after 1926 and 2006, respectively, many borrowers ran into troubles paying back
or refinancing their loans. As a direct consequence, the rate of delinquencies and
foreclosures rose to unprecedentedly high levels during 1929-1933, as well as during
2007-2009.
Figure 8: Household Mortgage Debt to Real Estate Wealth, 1896-2013
70,00%
60,00%
50,00%
40,00%
30,00%
20,00%
10,00%
0,00%
Grebler, Blank & Winnick series
Flow of Funds data
Data for 1896 to 1952 (non-farm) is taken from Grebler, Blank Winnick (1956), Table L6 and data for 1945 to
2013 (including farms) is taken from the Flow of Funds, B.100 Balance Sheet of Households and Nonprofit
Organisations, Line 4 and 33.
32
2.3.
Inequality
The role of inequality in the financial crisis of 2007-2009 has been briefly mentioned
in many earlier accounts on the crisis (see, for example, Morris 2008, p. 139-147; Rajan
2010; Stiglitz 2012) and was recently put into the spotlight by Piketty's bestselling
book "Capital in the 21st Century". On the other hand, inequality as a contributing
factor to the Great Depression has not found mention in any influential treatises on
the subject (Wisman 2014). Economic inequality, as measured by the distribution of
income and wealth, steadily widened prior to both crises. Figure 9 displays inequality,
as measured by the share of total income, including capital gains, going to the top
10% of the population in the United States from 1917-2007. As can be seen, high
levels of inequality were characterising features of the time preceding 1929 as well as
2007.
Figure 9: Top 10% Income Share in the US Including Capital Gains, 1917-2007
55,00%
50,00%
45,00%
40,00%
35,00%
30,00%
25,00%
Data: Tony Atkinson and Thomas Piketty – The World Top Incomes Database
While the time-series data clearly purports major trends of inequality over the past
100 years, the available data on income, particularly for the early 1900s, may not be
entirely accurate due to measurement inconsistencies, and is therefore difficult to
interpret. As a result, there certainly are disparities in comparability, and we do not
33
know for sure whether the situations before 1929 and 2007 were exactly as the data
suggests. While inequality during the early 1900s has received relatively little
attention,13 there exists a general consensus, based on a variety of reliable datasets,
that income and wealth polarisation has been a prevalent phenomenon since the
early 1980s. The phenomenon, it seems, has been particularly pronounced in the
United States (Morelli, Smeeding and Thompson 2014) where the subprime crisis
originated.
However, under-consumption as a likely result of rising inequality is not easily
reconcilable with either the Roaring Twenties or the early 2000s. In response to the
apparent contradiction between rising inequality and continuously strong
consumption spending, Kumhof and Rancière (2010) developed a model based on
inequality leading to bubbles, which explains the Great Depression as well as the
recent crisis. Both crises were preceded by a sharp increase in income and wealth
inequality as well as a substantial rise in debt-to-income ratios amongst lower- and
middle-income households. According to the model, the key factor which allowed
income and wealth inequality to proliferate was investors using a share of their
increased income to purchase financial assets backed by loans to workers. Increased
credit intermediation allowed workers to compensate real declining incomes, the
consequence of which was that consumption inequality increased less than income
inequality. However, the continuous rise of workers’ debt-to-income ratios generated
financial fragility, which eventually culminated in a financial crisis. 14 Similarly, Smith
and Gjerstad (2009) hypothesise "that a financial crisis that originates in consumer
debt, especially consumer debt concentrated at the low end of the wealth and income
distribution, can be transmitted quickly and forcefully into the financial system. It
13
A noteworthy exception is Wisman (2009, 2014).
It should be noted that this explanation closely resembles the Austrian School business
cycle theory, according to which stability creates instability, as economic booms lead to
unsustainable credit expansions.
14
34
appears that we're witnessing the second great consumer debt crash, the end of a
massive consumption binge."
As can be seen from Figure 9, the top decile's share of total income increased from
approximately 39% to just below 50% during the course of the 1920s. During the
same decade, consumer debt as a fraction of income increased from 4.7% to 9.3%
(Olney 1999, p. 321). By 1930, instalment credit had grown dramatically in
importance, financing 65-75% of automobiles, 80-90% of furniture, 75% of washing
machines, 65% of vacuum cleaners, 18-25% of jewellery, 75% of radio sets and 80% of
phonographs (Calder 1999, p. 19, as quoted by Wisman 2014, p. 384). The rising
importance of credit-financed consumption during that time prompts Olney (1999, p.
320) to observe: "The 1920s mark the crucial turning point in the history of consumer
credit."
A similar pattern is observable with regard to the early 2000s. The top decile's share
of total income increased from approximately 35% in 1980 to almost 50% by 2007.
"Yet this long term downward trend in the relative size of the middle class has
ironically been paralleled by a consumption boom," as Holt and Greenwood (2012, p.
364) observe. Besides adding a second worker or job, many households maintained
or increased their spending capacity by decreasing the savings rate from
approximately 10% in the early 1980s to less than 4% in the late 1990s. By 2005-2006,
the savings rate had turned negative for the first time since the Depression years
1932-1933 (Wisman 2009). In addition, deregulation in combination with the financial
safety net, as well as monetary policy, contributed to rapidly increasing levels of debt
to finance consumption. Household debt rose from 41% of GDP in 1960 to 45% in
1973 and 100% in 2007 (Holt and Greenwood 2012, p. 364). As home equity
extractions allowed current consumption levels to be maintained even in the face of
stagnating or declining real incomes, average household debt increased from 99.19%
in 1999 to 136.40% of gross disposable income at the eve of the crisis in 2007 (OECD
2013).
35
Indeed, the available data suggests that in the early 2000s, mortgages were often
used as a means of upholding current spending in the face of declining real income
levels. Before the housing market peaked in 2006, soaring house prices allowed
homeowners to borrow against high house values to boost spending capacity. Cashout refinancing enabled homeowners to draw on home equity and extract wealth by
refinancing mortgages on homes whose value had risen in value. According to
Greenspan and Kennedy (2005), such re-financings and home-equity withdrawals
amounted to 9% of disposable income – around $840bn per annum at the peak. In the
2002-2005 period, home-equity withdrawals increased consumption by about 3%,
equivalent to an annual amount of $300bn.
3. The Crisis Response
The key difference between 1929-1933 and 2007-2009 relates to the diverging crisis
response taken by the government and its agencies. Doan (1997, p. 33) divides the
Depression into two distinctive periods: During the first period from 1929 to 1932,
deflation was allowed to develop unimpededly and the government took a passive
stance to the crisis. The period from 1933 to 1941 witnessed a heightened government
commitment to reviving the economy and providing assistance to the population and
financial markets. At the outset of the Great Depression, the government's attitude
was aptly summarised by then-Secretary of the Treasury Mellon who, according to
Hoover (1952, p. 30), demanded: "Liquidate labor, liquidate stocks, liquidate the
farmers, liquidate real estate. It will purge the rottenness out of the system."
According to Anderson (1949, p. 222-223), leading Federal Reserve officials in
December 1929 shared Mellon's view, proposing to "let the money market 'sweat it
out' and reach monetary ease by the wholesome process of liquidation." In 1930,
when the first banking panic set in, the government's disposition began to change,
and in the course of the next years, several programmes were started which were
aimed at combatting the slump. In 1932, for example, President Hoover signed the
Reconstruction Finance Corporation Act, which conferred authority to the newly
36
established Reconstruction Finance Corporation (RFC) to lend to banks, trusts and
railroads in order to extend financial aid to agriculture, commerce and industry. In
the following years, Congress expanded the RFC's lending authority and broadened
the Corporation's mandate to include direct purchases of capital stock of banks,
insurance companies and other financial institutions (Treasury 1959, p. 1-2). As
described in Wheelock (2008), a number of measures were undertaken on federal,
state and local levels towards the end of the Great Depression and in subsequent
years to provide crisis relief for the population. For example, 33 states enacted
legislation which to some degree provided relief for delinquent mortgages, including
28 states which passed laws imposing moratoria on home foreclosures (Poteat 1938).
On the federal level, the government established a temporary programme by
enacting the National Industrial Recovery Act of 1933 to provide low-cost housing.
The programme was replaced in 1937 by the Housing Act, which provided federal
subsidies for housing projects undertaken by local governments (Doan 1997, p. 39-42,
as quoted by Wheelock 2008, p. 140). In addition to these immediate relief measures
aimed at providing affordable housing for mortgage debtors, the federal government
took steps to alleviate distress on the mortgage markets by establishing several
agencies to provide liquidity for lenders and to reform these markets.15
The authorities' response to the recent crisis differed in two important points from
that during the Great Depression. First, the actions taken were immediate, swift and,
by historical standards, unorthodox. Second, in sharp contrast to the Great
Depression, policy measures were primarily aimed at supporting the ailing banking
sector. During and after the recent crisis, government actions were mainly comprised
of monetary as well as fiscal measures in connection with bailing out large banks and
other major financial institutions.16 In early 2008, Congress enacted the Troubled
15
For a detailed list of agencies created and a discussion thereupon, see Wheelock (2008).
Congress did, in fact, take measures aimed at ameliorating homeowners' hardship in the
recent crisis, for example by enacting the Helping Families Save Their Homes Act of 2009.
These measures don’t belie the fact that the financial sector claimed a disproportionate share
16
37
Asset Relief Program (TARP) which authoried the government to purchase $700bn of
toxic assets from the financial industry. The funds were subsequently used to directly
inject capital into troubled institutions. Under the Capital Purchase Program (CCP),
created in October 2008, a total of $194bn was infused into financial institutions, 64%
of which went to eight large banks – Bank of America, Citigroup, JPMorgan Chase,
Morgan Stanley, Goldman Sachs, PNC Financial Services, U.S. Bancorp, and Wells
Fargo. In addition, under the Systemically Significant Failing Institutions Program
(SSFI Program), American Insurance Group (AIG) obtained funds, and under the
Target Investment Program (TIP), Citigroup received a second infusion of TARP
funds. At the same time, the Fed reduced the federal funds rate to near zero. In
addition to that, the Federal Reserve committed $7.77tr by March 2009 to rescuing
the financial system (Ivry, Keoun and Kuntz 2011). Moreover, the US government
and the Federal Reserve established themselves as dealmakers in "shot-gun
marriages", during which the government and the Fed played an important role as
guarantors of toxic asset pools in order to facilitate mergers (e.c. Bank of
America/Merrill Lynch, JPMorgan Chase/Bear Stearns).
More importantly, though, is the fact that the Federal Reserve deviated dramatically
from the lender-of-last-resort principles, as laid out by Walter Bagehot, during the
crisis of 2007-2009, "honor[ing] the classical doctrine more in breach than in
observance," as former Federal Reserve economist Humphrey (2010, p. 353) notes.
During the Great Depression, the Federal Reserve failed to act according to the
Bagehot doctrine as well, by neglecting to lend to solvent but illiquid banks, and in
1936-1937 by deliberately reducing solvent banks' liquid reserves (Humphrey 2010,
p. 354). "Since then," however, as Selgin, Lastrapes and White 2010 (p. 27) note, "it
[the Federal Reserve] has tended to err in the opposite direction, by extending credit
to insolvent institutions." During the recent crisis, Humphrey argues, "the Fed has
of government efforts during the crisis. A summary of the Act is available on the US Senate
Committee on Banking, Housing, and Urban Affairs website at:
http://www.banking.senate.gov/public/_files/050609_HelpingFamiliesSummary.pdf.
38
deviated from the classical model in so many ways as to make a mockery of the
notion that it is an LLR." During 2008 and 2009, the Federal Reserve repeatedly
violated the full set of Bagehot's recommendations. First, instead of charging penalty
rates for emergency loans, the Federal Reserve opened its discount window at belowmarket rates, which gave financial institutions a hidden subsidy (Ivry, Keoun and
Kuntz 2011). Second, the Federal Reserve departed from the classical model when it
violated Bagehot’s doctrine to lend only on sound security and, instead, accepted
hard-to-value collateral of dubious quality. The Fed deviated a third time from the
classical doctrine when it lent to insolvent financial institutions solely on grounds of
these institutions being identified as too-big-to-fail, thus ignoring the traditional
counsel never to accommodate unsound borrowers. In contrast to the Great
Depression, relief measures for distressed mortgage debtors were largely absent.
Something which has been widely overlooked with respect to the recent crisis is the
possibility that it was a painful, yet necessary adjustment mechanism to prior
maldevelopments. For example, high financial inequality, as it had existed in the
1920s, declined sharply after 1933 and remained at historical lows for several
decades. Moreover, the large number of bank failures hit those states hardest where
deposit insurance enacted on the state level had led to overbanking by encouraging
and enabling an economically non-viable number of banks. All in all, the self-healing
mechanisms of crises were allowed to play out rather unimpededly during the Great
Depression. It was only in 1932/33 that significant government interventions
occurred, aimed at reviving the economy by providing assistance to homeowners
and strengthening the scale and scope of mortgage markets. It should, however, also
be pointed out, that policymakers in the 1930s failed to acknowledge – or accurately
account for – the fact that unit banking had contributed materially to the banking
crisis of 1929-1933. Instead of reforming the banking system, various measures were
undertaken to allow unit banking to proliferate over the subsequent decades.
39
In sharp contrast to the Great Depression, the aggressive and unconventional
response to the recent crisis prevented any possible adjustments necessary to prior
dislocations. This stood in stark contrast to some market commentators'
recommendations. Emmons (2008) of the Federal Reserve Bank of St. Louis argued
that markets should have sorted themselves out in order to maximise long-run
economic growth. Instead of intervening in the workings of the markets, Emmons,
based on Stiglitz (1988, ch. 4), urged for the so-called compensation principle.
According to Stiglitz, the compensation principle can be seen as a "policymaking
corollary to the economic rule of laissez-faire in markets", "[so] that a portion of the
economic gains achieved by allowing markets to work unimpeded can and should be
used to compensate the losers – individuals who are harmed by the adjustment
process itself." Not only did the crisis response of 2007-2009 prevent an adjustment
process, it increased several of the problems which constituted driving factors
leading to the crisis in the first place.
First, the government's, and particularly the Federal Reserve's, actions amounted to a
bailout of a dominant share of the United States' and the world's largest and most
complex financial institutions. The crisis response thus aggravated the TBTF problem
by confirming and strengthening market participants' bailout expectations, a fact
which even the Federal Reserve (2012, p. 595) now recognises:
As a result of the imprudent risk taking of major financial companies and the severe
consequences to the financial system and the economy associated with the disorderly
failure of these interconnected companies, the U.S. government (and many foreign
governments in their home countries) intervened on an unprecedented scale to reduce
the impact of, or prevent, the failure of these companies and the attendant
consequences for the broader financial system. Market participants before the crisis
had assumed some probability that major financial companies would receive
government assistance if they became troubled. But the actions taken by the
government in response to the crisis, although necessary, have solidified that market
view.
40
Ueda and Weder di Mauro (2012) provide statistical evidence that the structural
government subsidy for systemically important banks increased substantially from
year-end 2007 to year-end 2009, as the extraordinary measures undertaken globally
both by governments and central banks in response to the crisis forcefully confirmed
market participants' bailout expectations. The authors estimate that the credit rating
bonus amounted to 1.8-3.4 at year end-2007, implying an average funding cost
advantage of 60bps. At the end of 2009, the credit rating bonus had increased to 2.54.2, widening the funding cost advantage of big banks to 80bps. Besides
strengthening TBTF expectations and increasing TBTF institutions' structural
subsidies, the years 2007-2009 saw a marked increase in the largest banks' market
share. As described above, countless government interventions prevented an orderly
exit of insolvent banks, which would have affected primarily large banks. In addition
to that, the government often promoted takeovers of troubled banks by less troubled
institutions. As a consequence to these actions, too-big-to-fail banks during the Great
Financial Crisis grew even larger.
Second, post-crisis policies aimed at sheltering banks' fragile balance sheets as well as
at inducing banks to lend by ultra-low interest rates boosted stock and bond markets,
amounting to an upward distribution of wealth.
41
Figure 10: Real 3-Month Treasury Bill Rate, Annualised, 2000-2014
4,00%
3,00%
2,00%
1,00%
0,00%
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
-1,00%
-2,00%
-3,00%
-4,00%
-5,00%
Data: Federal Reserve Economic Data (FRED)
The Federal Reserve's highly accommodative monetary policy has transferred wealth
from low-income to high-income individuals. According to Coibion, Gorodnichenko,
Kueng and Silvia (2012) several channels transmit such low- to high-income
household wealth transfer. The income composition channel rests on the reasonable
assumption that the composition of household incomes is heterogeneous. Incomes
will thus react differently to exogenous shocks. For instance, if expansionary
monetary policy, as pursued by the major central banks since the financial crisis,
causes profits to rise more than wages, households with ownership claims of firms
will benefit disproportionately, as households with a high share of ownership claims
of total income tend to be high-net worth households (Coibion, Gorodnichenko,
Kueng and Silvia 2012). Accommodative monetary policies hence compound income
inequality. Similar mechanics underlie the portfolio channel hypothesis, which is
concerned with households' wealth instead of income composition. Given that lowincome households tend to hold a relatively larger share of wealth in currency than
households at the other end of the wealth spectrum (Erosa and Ventura 2002;
42
Albanesi 2007), inflationary monetary policies will cause a wealth transfer from lowtowards high-income households, again increasing inequality.
Concluding, ultra-accommodative interest rate policies pursued by the Federal
Reserve and other central banks since the 2007/2009 crisis have boosted stock and
bond markets globally. To the extent that the amount of stock and bond holdings
increases with individuals' wealth, the main beneficiaries of low interest rates have
been high-income households. Saez (2013) looks at income development since the
end of the crisis in 2009 and finds that the average real income per family grew by
about 6.0%. The gains, however, were unevenly distributed. While the top 1% of
incomes grew by 31.4%, the bottom 99% increased only marginally, by 0.4%, from
2009 to 2012. While the share of the top 10% of total income (including capital gains)
fell sharply during the crisis, it has since recovered and now stands above 50% – a
level not seen since 1917 when data began to be available (Figure 11). In addition,
unconventional central bank policies led to a de facto recapitalisation of financial
intermediaries via monetary policy (Chodorow-Reich 2014), benefitting the financial
elite at the expense of lower-income households.
Figure 11: Top 10% Income Share in the U.S., Including Capital Gains, 1917-2012
51,00%
50,00%
49,00%
48,00%
47,00%
46,00%
45,00%
44,00%
43,00%
Data: Tony Atkinson and Thomas Piketty – The World Top Incomes Database
43
4. Conclusion
This paper presented empirical observations on the salient parallels and differences
pertaining to the two defining crises of the last 100 years: the Great Depression of
1929-1933 and the Great Financial Crisis of 2007-2009. The information presented is
tentative and suggestive, yet it is not statistically tested, instead requiring good
judgment on the part of the readers.
Concluding, the following stylised facts on the key parallels and differences between
the two crises can be summarised as follows:

Both booms and ensuing crises were firmly grounded in asset price bubbles in
the real estate sector. When house prices contracted and borrowers started to
default, the problem was transmitted to a vulnerable banking sector. The
cause of that vulnerability was different during the two episodes; the results,
however, were similarly devastating.

Until 1929 – and beyond –, the legal framework had fostered a banking system
based on small, undiversified unit banks, which was known to be susceptible
to shocks.

Before 2007, large, complex financial institutions deemed too-big-to-fail were
allowed to set capital almost unimpededly by regulators. Equipped with
implicit and explicit government guarantees, which had eliminated market
discipline from those institutions, they took inordinate risks, while at the same
time operating on dangerously low capital ratios and relying on highly
volatile funding sources.

Despite the different manifestations, then and now the approach to financial
sector design was fundamentally determined by the prevailing ideology. In
the 1920s, lawmakers attempted to preserve the United States' unique unit
banking system owing to a deeply rooted distrust towards large financial
institutions. In the past several decades, the belief in market efficiency
44
triggered
significant
deregulatory
measures
which
granted
financial
institutions increasingly more and broader asset powers, in spite of a
continuously generous – and expanding – safety net.

The results, then and now, were inherently similar. While it is evident that the
recent crisis did not experience the large number of bank failures and panics
which characterised the Great Depression, the potential danger was real and
tangible. In FCIC (2011, p. 354) hearings Bernanke corroborated the notion that
the dangers of repeating 1929-1933 were substantial, noting that "out of maybe
the 13 […] most important financial institutions in the United States, 12 were
at risk of failure within a period of a week or two."

The only factor which prevented a repeat of 1929-1933 in terms of bank
failures was the backing of the government and central banks as stabilisers,
despite negligence or ignorance of what a lender-of-last-resort function is
supposed to be and an appalling mis-interpretation of how capitalist systems
work.17

The Federal Reserve’s attempt to mitigate the immediate adverse effects of the
housing crash on the financial system has led to a series of interventions in the
economy which can be described as quantitative and qualitative easing (QQE)
and an expansion of the historically narrowly defined role of the Federal
Reserve as lender-of-last-resort. During the financial crisis, the Federal
Reserve expanded access for insolvent banks to its discount window, and for
that purpose accepted risky securities which formerly would not have been
eligible.

The Federal Reserve also opened credit facilities to non-banks for the first time
since the 1930s (AIG, Fannie Mae, Freddie Mac), all of which were unable to
We acknowledge that acting differently during the crisis would have been economically
difficult and politically challenging. This highlights the importance of providing a
functioning regulatory framework before crises erupt, preventing the onset of conditions
which leave little opportunity to take actions promising short-term relief without adverse
long-term effects.
17
45
secure funding in the market place due to their presumable insolvency. As an
auxiliary measure, the Fed reduced the federal funds rate to near zero and
then intervened in the allocation of credit in an unprecedented fashion by
expanding the Federal Reserve’s balance sheet through the purchase of longterm assets such as mortgage-backed securities (MBS), thereby reducing mid
and long-term interest rates.

However, these extraordinary measures have proven to be of limited effect
and can be described as negligible at best. Growth on both sides of the
Atlantic has remained sluggish in the aftermath of the crisis. On the contrary,
the evidence is mounting that bailing out large financial institutions has
aggravated the too-big-to-fail problem. In addition, ultra-low interest rates
have fostered policymakers’ complacency, while at the same time driving
market participants into successively riskier asset classes. Much more
importantly, the Federal Reserve has been politicised, compromising its
independence and undermining its ability to efficiently conduct monetary
policy (Goodfriend 2009; Hubbard, Scott and Thornton 2009; Bordo 2010).

The key difference between the two episodes thus relates to the central
authorities' responses to the crises. While the 1929-1933 crisis was allowed to
play out in a rather unimpeded manner, the U.S. government took aggressive
measures to bolster the financial sector during the recent crisis. Various
programmes recapitalised banks and other financial intermediaries. The latter
approach has been applauded by many economists and observers. "The good
news, of course, is that the policy response is very different," Eichengreen and
O'Rourke (2009) remark, "the question now is whether that policy response
will work." Indeed, the crisis and the government's inability to meaningfully
reform the financial sector has rendered the Federal Reserve a de facto
government agency, as the independence of central banks globally is now
strongly undermined.
46
Given the points raised in this paper, caution is certainly warranted. Whether or not
the policy response to the 2007/2009 Great Financial Crisis was effective will only be
clear in the long run. The authors of this paper tend to believe that it was not
sufficiently efficacious. Instead, the policies enacted seem to have fostered
complacency and prevented necessary reforms.
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