y

US Financial Crisis: Is the Great

op
Depression II in the Making?
Case Study Reference No. ECC0025

This case was written by Akshaya Kumar Jena under the direction of Saradhi Kumar
Gonela, Icfai Business School Case Development Centre. It is intended to be used as the
tC
basis for class discussion rather than to illustrate either effective or ineffective handling of
a management situation. This case was compiled from published sources.

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 US Financial Crisis: Is the Great Depression II in the Making?

tio P Y
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n
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US Financial Crisis: Is the Great
Re ON

Depression II in the Making?

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t F CT
E

“The past is always a rebuke to the present.” 1

or
SP

– Robert Penn Warren, Pulitzer Prize-winning Author

No
IN

The US is in the thick of its most threatening financial crisis since the early 1930s, stirring terrible memories of
those traumatic years. The month of September 2008 has become chock-a-block with a series of convulsing events
involving blue-blooded Wall Street firms. The nationalisation of US’ biggest mortgage lenders Fannie Mae and Freddie
Mac, the fall of Lehman Brothers, the disappearance of Merrill Lynch into the Bank of America, the $85 billion federal
rescue package for the insurance giant American International Group (AIG), the fire sale of Washington Mutual to JP
Morgan and of Wachovia to Wells Fargo, the sudden conversion of Goldman Sachs and Morgan Stanley from glamorous
investment banks into government-regulated commercial banks, and the extraordinary emergency confabulation of
the current US President with the election year Presidential hopefuls have brought to mind shades of economic
breakdown of the magnitude not witnessed since the Great Depression of the 1930s.
An early feel of this impending financial turmoil was provided 6 months back in March 2008 when Bear Stearns
buckled, necessitating its takeover by JP Morgan Chase with the help of the Federal Reserve Board. The immediate
trigger was the default on subprime mortgages; although disagreement dwells on the underlying deeper causes
and also on the effects of the financial meltdown on the real economy. Some discount the possibility of a recession
– let alone a full-blown depression – from the crisis in the credit markets. The basis of their argument is the fact that
tio P Y

non-financial corporations are not much indebted. Many others including US policymakers, however, fear that the
Great Depression II may well neigh be in the corner, if timely rescue measures are not taken to inject confidence
into the collapsing credit markets. Depressions or major recessions doubtless spring from cutbacks in production
uc O
n

as the rate of profit declines due to deficient demand, triggered by credit crunch; but the first signs of them are often
od C

visible in the form of financial crises as in 1929, 1987 and 1998.

Re ON

What is Depression?
I
pr

Depression is broadly perceived to be a prolonged, deep phase of recession, which in turn is defined to be two or
t F CT

more consecutive quarters of negative growth in GDP, often accompanied with unemployment. Whether a recession
has reached the stage of depression is a matter of subjectivity. An oft-quoted wry remark captures the point so
effectively: A recession is when your neighbour loses his job, a depression is when you lose yours. Even the conventional
E
or

definition on recession looks ‘silly’,2 pointed out The Economist. It cited, as an example, that if an economy’s GDP
SP

grows by 2% in one quarter and then declines by 0.5% in each of the next two quarters, the economy is considered to
have fallen into recession; but if its GDP declines by 2% in one quarter, rises by 0.5% in the next, then falls by 2% in the
No
IN

third, the economy is deemed not to be in recession even though it is obviously weaker compared to the economy in
the first instance. There are at least four key gauges such as aggregate GDP, per capita GDP, unemployment rate and
1
“Is the US going to face a new nightmare?”, http://www.gulfweekly.com/article.asp?Sn=5927&Article=20441
2
“Redefining Recession”, http://www.economist.com/finance/displayStory.cfm?source=hptextfeature&story_id=12207987, September 11th 2008

2
 US Financial Crisis: Is the Great Depression II in the Making?

actual GDP relative to potential GDP to judge the severity of the economic downturn and on each criterion the ranking
order of the countries with respect to their economic pain may not be the same (Exhibit I).

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Exhibit I

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Four Gauges for Judging Severity of Economic Slowdown

n
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GDP GDP per person
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% increase since Q3 2007 % increase since Q3 2007
0 0.2 0.4 0.6 0.8 1.0 0 0.2 0.4 0.6 0.8 1.0
I
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US Japan
t F CT

Britain Britain
Euro area Euro area
E

Japan US
or
SP

Unemployment rate percentage-point GDP relative to potential output %

change since August 2007 shortfall since Q3 2007
No
IN

0.5 - 0 + 0.5 1.0 1.5 1.0 0.8 0.6 0.4 0.2 - 0

Euro area Japan
Britain nil Euro area
Japan US
US Britain

Source: “Redefining Recession”, http://www.economist.com/finance/displayStory.cfm?source=hptextfeature&story_id=12207987, September 11 th

2008

However, an economic downturn inflicting on the society an unemployment rate of not less than one-quarter of
the total labour force has generally been acknowledged as a case of depression. Before the Great Depression of
the 1929 – the benchmark of cataclysmic economic distress, any degree of economic decline was dubbed as a
depression. However, to differentiate the likes of the Great Depression from smaller economic declines, the term
recession was brought to usage to refer to the latter. The US economy has fortunately not experienced this newly
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defined depression since the one of 1929 that lasted for almost a decade. At the height of the Great Depression in
1933, the rate of unemployment reached the traumatic level of 25.2%, which to optimists is a long way off from the
current level of 6.1% (Exhibit II).
uc O
n

The alarmists, however, point to the stark proof of the rapidly deteriorating economic situation of the US with the
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unemployment rate bolting from 6.1% in September 2008 to a 14-year high of 6.5% in October 2008 (Exhibit III). Bill
Re ON

Gates believes that unemployment rate may exceed 9%. And any substantial swell in unemployment will exacerbate
it further in a vicious cycle.
I
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t F CT
E
or
SP
No
IN

3
 US Financial Crisis: Is the Great Depression II in the Making?

Exhibit II
Great Depression of the US: 1929–1940

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Unemployment rate

uc O
%

n
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28

24
Re ON

20

16
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12

8
E

1933
or

2008
4 25.2%
SP

6.1%
0
No

29 30 31 32 33 34 35 36 37 38 39 40
IN

19 19 19 19 19 19 19 19 19 19 19 19

Source: Schifferes Steve, “Lessons from the 1929 stock market crash”, http: //news.bbc.co.uk/1/hi/business/7656949.stm

Exhibit III
Bolting Unemployment Rate during September–October 2008

Seasonally adjusted
%
6.5

6.0
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5.5
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5.0
n
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4.5
O N D J F M A M J J A S O
Re ON

2007 2008
I
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Source: “Nation’s Unemployment Rate Jumps to a 14-Year High of 6.5 Percent”, http://www.msnbc.msn.com/id/27591780/, November 7 th 2008
t F CT

Why Depression Occurs?

E
or
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In the 1930s, when the axioms of classical economists that ‘supply creates its own demand’ and ‘full employment
is the norm in a non-interfered free market economy’ failed to match with the reality of the extant depression, in came
No

J M Keynes to explain why and how recessionary pressures get built up into a capitalist economy. He postulated that
IN

a free economy can function normally only if everything produced gets sold. This happens if people spend all their
income accruals from the production of goods on purchase of those goods or alternatively, if saving leakage from
spending stream is plugged by an equivalent measure of investment injection. If firms cannot sell all their goods

4
 US Financial Crisis: Is the Great Depression II in the Making?

because of an excess of saving over investment, they react by cutting production down and laying workers off. This, in
turn, causes further contractions in the market owing to deficient demand, leading eventually to a depression. Thus, an

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excess of saving necessitates an offsetting demand. The Keynesian prescription to neutralise excessive saving is
government’s intervention in the form of lowering of tax and interest rates to encourage private spending coupled with

uc O
an up-scaling of its own. Thus, grew the new age economic theory of government intervention with appropriate fiscal

n
tools for the smooth functioning of market forces. Following the current financial crisis in the US, the Keynesian theory

od C
will once again be put to test.
Re ON
How the US Financial Crisis of 2008 Takes Hold?
I
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The US financial crisis of 2008 has its root in another crisis – the tech bubble of the late 1990’s. When the tech
t F CT

bubble bust in 2000 and stock market went into a tailspin, plunging the US into recession the next year, the Federal
Reserve executed a sharp cut in interest rates to boost the sagging economy. The US has been trying to stave off an
incoming pop of a bubble or its painful aftermath by series of drastic cuts in the interest rate, which is at the root of the
E
or

bubble. This systematic succession of cuts in the cost of credit has led to an extended bubble, the implosion of which
SP

has got to be more severe. The Fed rate, for example, stood at 6% at the outset of the year 2001, after a succession
of 11 cuts, it has come down to a mere 1% in 2003.3 These lower interest rates made mortgages cheaper. Consequently,
No
IN

the demand for homes began to swell, sending prices up. As housing prices kept on rising, the risk on the mortgages
went down on the perception that default on the part of the borrowers leading to foreclosure would not put the lending
institutions to any loss in a scenario of ever soaring house prices. Added to it was the development of securitisation of
mortgages, which obviates the need for the banks to hold the loans on their balance sheet, which would have burdened
them with restricted ability to lend further. At the same time, the banks earn the fees for originating the mortgages.
They, therefore, became lax in sticking to procedures pertaining to credit worthiness of borrowers and started giving
No Income, No Job or Assets (NINJA) loans as Asset-Backed Securities were created in huge amounts (Exhibit IV).

Exhibit IV
Asset-Backed Securities of US (in $ trillion)

2.5

2.0
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1.5
uc O
n

1.0
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0.5
Re ON

0
I
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1995 ’97 ’99 2001 ’03 ’05 ’07 ’08* *upto end June
t F CT

Source: “A Short History of Modern Finance: Link by Link”, http://www.economist.com/displaystory.cfm?story_id=12415730, October 16 th 2008
E
or

Securitisation gave rise to Collateralised Debt Obligations (CDOs) and other sophisticated instruments backed by
SP

computer-aided financial mathematics, which slice the various debts and remix them into different packages of bonds
for resale as per investors’ appetite for risk. When homeowners make their monthly installments, these are passed
No
IN

through to ultimate investors as interest payments on their bonds. Investors were happy since CDOs yielded more
than government bonds while at the same time considered as safe as treasury bonds, thanks to the often high ratings

3
“Global Credit Crunch – Towards a Crisis of Globalisation”, http://www.fifthinternational.org/index.php?id=259,1303,0,0,1,0, Autumn 2007

5
 US Financial Crisis: Is the Great Depression II in the Making?

by the rating agencies. This business was supported by the authorities as a means of spreading risk, for they represented
claims on a diversified group of borrowers. Simultaneously, Credit Default Swaps (CDSs) were invented to insure, for

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a premium, against the risk of default on debt obligations. Thus, potentially high-risk subprime mortgages were insured,
turning them into most trusted income generators. The greed of earning a lot in the gamble of betting on default led to

uc O
explosive growth of CDS. From 2001 to 2007, the volume of CDS kept on expanding almost doubling each year

n
(Exhibit V). Gramm-Leach-Bliley Financial Services Modernisation Act of 1999, which put aside parts of the Glass-
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Steagall Act of 1933 that had provided sufficient regulatory firewalls amongst commercial banks, insurance companies,
securities firms and investment banks during the era of the Great Depression, has over the years helped in the
Re ON

evolution of these shady financial activities.

Exhibit V
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t F CT

Growth of Credit Default Swaps (in $ trillion)

E

70
or

Rising risk
SP

62.2
60 The credit default swap
No

market nearly doubled

IN

54.6
each year from 2001
50 through 2007.

40

34.4
30 Value of Credit
Default Swaps
Outstanding
20
17.1

10
8.4

0 0.9
2001 2008
2001 ’02 ’03 ’04 ’05 ’06 ’07 ’08* Q2
tio P Y

*end June
uc O
n

Compiled by the author from “A Short History of Modern Finance: Link by Link”, http://www.economist.com/displaystory.cfm?story_id=12415730,
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October 16 th 2008 and Varchaver Nicholas, “The $55 Trillion Question”, http://money.cnn.com/2008/09/30/magazines/fortune/
varchaver_derivatives_short.fortune/
Re ON

This huge CDS market has surpassed even the Gross Domestic Product (GDP) of all the countries of the world put
together (Exhibit VI). The reason for emergence of such a gigantic CDS market lies in the fact that one need not have
I
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to own a debt to buy a CDS on it. Any person can place a bet on other people’s debt. Therefore, while total corporate
t F CT

debts are $6.2 trillion, CDS contracts are a massive $54.6 trillion. And these financial derivatives have come to prove–
what Warren Buffett famously dubbed them back in 2003 – as ‘financial weapons of mass destruction.’4 Derivatives,
E

though developed to hedge risks on various investments, have themselves turned as the means of investment. The
or

acceptance of credit derivatives – and more so when they are more complex promising more returns – led to increasing
SP

parcelling up of loans in innovative ways and its insurance, reinsurance and sale through a web of transactions. This
financial engineering was both prompted by and justified astronomical salaries for the new age investment banking
No
IN

professionals, who, with their arcane mathematical wizardry, outsmarted the the laidback low-salaried regulators and
put the credit system off-guard. Though the CDSs are hailed as wonderful inventions since they increase liquidity by
4
“Buffet Warns on Investment ‘Time Bomb’”, http://news.bbc.co.uk/2/hi/business/2817995.stm, March 4th 2003

6
 US Financial Crisis: Is the Great Depression II in the Making?

generating quick and cheap bond portfolios, the scary part is that they are offloaded for realisation during economic
downturn when the default mounts and debt’s value starts melting, leading each other in a self-fulfilling vicious circle.

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Everyone in the lending chain presumed that the preceding link had checked out on the quality of the loan made,
although in reality nobody cared to do. The excessively high leverage in credit market by means of derivatives is at the

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root of all bubbles as diagnosed long back by Prof. J.K. Galbraith. For example, the land boom in Florida in the 1920’s

n
leading to the Great Crash of the 1930s was not simply because people actually purchased so much land, but “they

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bought options to buy the land, and traded those”.5
Re ON
Exhibit VI
CDS vs GDP (in $ trillion)
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54.6 54.3
E
or
SP
No
IN

Credit World
Default GDP
Swaps
Outstanding

Source: Compiled by the author from Varchaver Nicholas, “The $55 Trillion Question”, http://money.cnn.com/2008/09/30/magazines/fortune/
varchaver_derivatives_short.fortune/
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uc O
n

In the midst of the US housing bubble, propped up by these exotic debt instruments as well as teaser loans having
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initial low interest rates for a short period with soaring rates later on, the subprime borrowers eventually started
defaulting on loan repayments. This predicament hastened with successive hikes in the interest rate pursuant to a
Re ON

series of spikes in the US Fed fund rate which were alleged to be the follow up for the rises in the US Treasury bill rate
owing to massive sale of T bills to finance the US’s Iraq war and consequent fall in price of T bills. Since the resumption
of the war, Alan Greenspan, the then Fed Reserve Chairman, raised the US Fed fund rate on 14 occasions and his
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successor Ben Bernake on 3 occasions, carrying it from 1.25% in 2003 to 5.25% in 2006. 6 The defaults led to more
foreclosures and tighter lending standards. The former presented more houses for auction while the latter shrunk the
number of buyers. More supply and less demand started depressing home prices. Since the US home loans were non-
E
or

recourse ones, the borrowers were not personally liable for the loans and had every incentive to default when home
SP

prices nosedived. This pummelled home prices in a downward spiral, leading to the burst of housing bubble in the US.
Consequently, the inverse pyramidal debt market that was structured on the base of the housing mortgage crumbled,
No
IN

creating deep turmoil in integrated global financial sector and conjuring up heightened fears over an impending
depression not only in the US but also in the whole world economy.
5
Mitchell Donald, “Editorial Review: What Actually Happened in 1929?”, http://www.amazon.com/Great-Crash-1929-Kenneth-Galbraith/dp/0395859999, October 24th 2001
6
Ramachandran G., “Prime Cause of Sub-Prime Crisis”, http://www.thehindubusinessline.com/2008/05/14/stories/2008051450030800.htm, May 14th 2008

7
 US Financial Crisis: Is the Great Depression II in the Making?

That the decline in home prices would push the economy into depression could be read from Case-Shiller US
house price index which reveals that house prices were falling on average by 3.2% in 15 out of 20 major cities while a

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year back, these prices were rising by 7.5% nationally.7 This is the record year-on-year decline in the 20-year old
history of the index. The crisis of confidence has led to crisis in credit. The UBS economists visualise a 1% rise in the

uc O
cost of capital, with 10% fall in share and house prices, that would push US’ output growth down by 2.6% next year,

n
plunging the economy into recession, which, if persists, will exacerbate into depression.
od C
Would the Present Crisis Slip into Depression II?
Re ON

In their seminal book A Monetary History of the United States: 1867-1960, Milton Friedman and Anna Jacobson
Schwartz probed into the underlying cause of the Great Depression of the 1930s and found it to be the steep credit
I
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crunch due to an epidemic of bank failures. 608 banks failed in the first wave including the Bank of the United States,
t F CT

which accounted for about a third of the total deposits. This resulted in suspension of payments by the banks with
combined deposits of more than $80 million. The crest of the crisis witnessed bust of over 5,000 banks, drop of
E
or

industrial output by 45%, fall of crop prices by more than 50% and loss of livelihood for 15 million people.8 Thus, Wall
SP

Street joins to the Main Street through credit highway.

According to Friedman and Schwartz who closely examined the key years of the Great Depression between 1929
No
IN

and 1933, the Great Depression, contrary to popular belief, was not a direct outcome of the stock market crash of
October 1929. Nor was the latter a precondition for the former. Rather the burst of the speculative investment bubble,
which was blamed for the stock market crash of October 1929, might have itself been triggered by the hike in the
Federal Reserve’s lending rate to commercial banks in August 1929. “The true story is that monetary policy tried
overzealously to stop the rise in stock prices” acted mainly in slowing the economy.9
But anti-monetarists argue that the Great Depression was the outcome of a massive shift of income shares from
wages to profits. This shift resulted in huge surplus capital which could not get deployed in productive capacity in view of
less need for it on account of declining consumption. The inevitable end result was flow of funds into speculative channels,
especially stock markets. The stock market bubble of the late 1920s eventually burst because euphoria could not be
sustained for long and panic was the inevitability. The stocks having risen fourfold over the past 10 years, a bubble was
already in the making. October 1929 saw sharp falls in shares of Wall Street; in 2 days ending on Black Tuesday of
October 29th 1929, the Dow Jones industrial average shed 25%. And in July 1932, the record low was reached with the
Dow Jones knocking off 89% (Exhibit VII). As demand for securities listed on the stock exchange petered out, banks
found themselves clutching at billions of dollars in ‘distressed assets’. Then ensue did the credit freeze of the 1930s.
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Exhibit VII
Fall of Dow Jones
uc O
n

400
od C

350
Re ON

300
250
I

200
pr
t F CT

150
100
E
or

50
SP

0
1928 1929 1930 1931 1932 1933 1934
No
IN

Source: Schifferes Steve, “Lessons from the 1929 stock market crash”, http: //news.bbc.co.uk/1/hi/business/7656949.stm

7
“Global Credit Crunch – Towards a Crisis of Globalisation”, op.cit.
8
Palit Amitendu, “The Great Depression: Then and Now” The Financial Express, October 26th 2008, page 5
9
“Remarks by Governor Ben S. Bernanke: Asset-Price ‘Bubbles’ and Monetary Policy”, http://www.federalreserve.gov/BoardDocs/Speeches/2002/20021015/default.htm,October 15th 2002

8
 US Financial Crisis: Is the Great Depression II in the Making?

The Keynesians also argue in a similar vein. They pointed out that consumption tends to be less than output
produced and the shortfall in demand may not necessarily be taken up in matching amount in the form of private

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investment expenditure. Therefore, economic instability is a recurring feature in the capitalist, market-driven economy
and government intervention in right degree and direction is a desideratum. However, the post-Keynesians like British

uc O
economist R.F. Harrod and US economist E.D. Domar, added the rider that the Keynesian solution is a short-term one

n
looking only at the demand side. For, the investment expenditure, which adds to the demand side in the short run, also

od C
adds to the supply side through capacity augmentation in the long run. In order to keep the economy stable, the rate
of investment expenditure must be so manipulated as to keep on rising in the same ratio as rate of growth of output.
Re ON
A slight deviation off this ‘razor’s edge’ growth rate will throw the economy into instability.10 Economic balance is
compared to ecological balance. Too many tigers kill off the whole lot of deer and the latter’s extinction leads to the
I

ultimate starvation and death of the former as well; too many deer, on the other hand, also result in their own
pr
t F CT

disappearance owing to their overgrazing and collective starvation.

Arguments are also advanced that financial markets, the happenings of which seep into real markets, are inherently
E
or

unstable because of their attempt to do the impossible. While the ultimate lenders or savers want financial assets to be
SP

short, safe and simple, the ultimate borrowers or investors have projects, which are long, risky and complex. Financial
institutions try to give both sides what they want. In so doing, they have to undergo a tradeoff between efficiency and
No

stability. Therefore, efficient unregulated capitalist institutions add to productivity only at the cost of inherent instability.
IN

But whether a downturn would spin into depression depends on so many factors. As Prof. Charles P. Kindleberger
points out getting trapped into the fallacy of compositions may be one cause.11 Overinvestment in railroads business
in the US in 1840–1850 and its subsequent unprofitability is an instance. The railroad investments, which were initially
very profitable and attracted so many people to invest in railroads, became very unprofitable because the aggregate
effect was overinvestment. The action of each individual is rational, provided others are not behaving the same way.
There is a self-reinforcing mechanism, which allows for irrationality. A person buys an asset because others buy assets
of that sort and by so doing, the person makes their prices rise which validates the wisdom of the people who already
bought these assets. This, in turn may lead other people to buy and so on. As people overdo it in their irrational
exuberance and some insiders feel that the peak has been reached and quit the market, mania leads to sudden panic
at this Minsky moment12 , named after the US economist Hyman Minsky, and the crisis unfolds.
Marxists point out that today’s so-called financial crisis is merely a symptom of depression and the underlying
cause is, in fact, capitalism itself, for it entwines destructive conflict into its production and distribution of goods and
services. Capitalism has over the years promoted a general increase in the share of output going to capital as opposed
to labour, known in Marx’s phraseology as the increase in the rate of exploitation (Exhibit VIII).
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Exhibit VIII
Wage Share of National Income (%)
uc O
n
od C

EU 15
80
Japan
Re ON

75 US
70
I
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65
t F CT

60
55
E
or

50
SP

1970 1975 1980 1985 1990 1995 2000 2005

No

Source: Harman Chris, “From the Credit Crunch to the Spectre of Global Crisis”, http://www.isj.org.uk/index.php4?id=421, March 31 st 2008
IN

10
“The Harrod-Domar Growth Model”, http://www.sjsu.edu/faculty/watkins/growthmodels.htm
11
“A Review of ‘Manias, Panics and Crashes: A History of Financial Crises’”, http://www.geocities.com/hmelberg/papers/981006.htm
12
Cassidy John, “The Minsky Moment”, http://www.newyorker.com/talk/comment/2008/02/04/080204taco_talk_cassidy, February 4th 2008

9
 US Financial Crisis: Is the Great Depression II in the Making?

The lowly stagnant or declining share of the wages of workers in the total income accrued in the production process
is insufficient to enable them to purchase the growing output of their labour. Employers, unable to vend all that they

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produce, start to lay off their own employees, which would only aggravate the problem further. On the other hand, bubbles
crop up because profits do not find any avenues of productivity to get deployed and therefore gush, through the financial

uc O
system into higher risk and reward laden speculative ventures one after another. The results are periodic booms waiting

n
to be burst. It happened with the stock exchange and property booms of the late 1980s, the dotcom boom of the late
od C
1990s. And it is happening with the subprime mortgage boom of 2002–2007. The bubbles inevitably burst because
slowing pace of growth in the real economy reduces the value of the assets upon which the fictitious capitals – the claims
Re ON

on future wealth in the form of financial instruments and their complex derivatives – rest. Empirical data also provide
veracity to the above logic how skewed income distribution causes the bubble. The Great Depression of the early 1930s
I

and the dotcom bubble of the late 1990s were, for instance, the years of more skewed income distribution (Exhibit IX).
pr
t F CT

Exhibit IX
Skewed Income Distribution and the Bubble
E
or
SP

%
50
No

Income share of Top 10% of population

IN

45

40

35

30 Excluding capital gains

Including capital gains
25
1917
1922
1927
1932
1937
1942
1947
1952
1957
1962
1967
1972
1977
1982
1987
1992
1997
2002

Source: “Does Income Concentration Cause Bubbles?”, http://economistsview.typepad.com/economistsview/2008/10/does-wealth-con.html,

October 10th 2008
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Although Marx and Keynes, quintessentially, hit at the same button pertaining to the cause of the downturn in the
economy, the former acted as the grave digger of capitalism while the latter was the saviour of it. One wanted the
uc O

hopeless terminal patient to die; the other prescribed periodic doses of medicine with the faith that it would rejuvenate
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the patient.
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Some believe that one cannot predict whether depression would pan out, although one may explain how or why it
Re ON

has happened. A particular action may have different effects and it is then not possible to figure out the effect in
advance. A rise in interest rate, for instance, may either attract funds or repel them, depending upon the expectations
that a rise in interest rates generates. Rising interest rate may be anticipated to head for a decline as the next step. Or,
I
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it may be expected to continue the trend of rising even further. Only after the event, one can know which effect has
t F CT

come out stronger.

E

However, the steep decline in the US house prices and the indices of the US banks and agencies (Exhibit X) have
or

started to create business pessimism and panic that spook some into believing that the Depression II is round the
SP

corner. Relative to the S&P composite index, banks have lost almost half of their market value within a year. History
attests to the fact that a banking crisis invariably leads to an economic slump, the scale of which depends on the size
No
IN

of the banking crisis. And the year 2008 has witnessed the biggest systemic financial crunch up since the 1930s.

10
 US Financial Crisis: Is the Great Depression II in the Making?

Exhibit X
Steep Decline in the US House Prices and Bank Indices

tio P Y
US House Prices

uc O
US Banks and Agencies

n
S&P/Case-Shiller 10-city composite Indices and share prices relative to S&P 500

od C
Index Annual % change Commercial banks Fannie Mae
Nominal Real Nominal Real Investment banks Freddie Mac
Re ON
350 20 250

300 15
200
I
pr

10
250
t F CT

5 150
200
0
100
E

150
or

-5
SP

100 -10 50
50 -15
No

0
IN

0 -20 1998 2000 ’02 ’04 ’06 ’08

1988 ’90 ’95 2000 ’05 ’08

Source: Wolf Martin, “A Year of Living Dangerously”, http://www.ft.com/cms/s/0/2cc4291c-52a2-11dd-9ba7-000077b07658,dwp_uuid=d355f29c-

d238-11db-a7c0-000b5df10621.html

The broadest barometer of economic health, the GDP, which clocked 2.8% growth for the US in the second quarter
ended June 2008, has shrunk to 0.3% in the third quarter of July–September.13 This reverse swing of the US economy
underlines the enormity of the impact of the 2008 financial crisis of the US. Claims for joblessness by 400,000 persons
are reckoned to be the state of a struggling economy. Current claims for joblessness by 479,000 persons14 for the
week ending October buttresses the belief of many that a full-blown recession is a certainty and a Depression II is a
probability.
But many economic experts are confident that a much better understanding of macroeconomics down the years
since the Great Depression, coupled with the provision of social safety nets, will stave off any reemergence of a
depression. The government and the Federal Reserve are on the job of recovering the banking system so that the
latter can do its job of transferring the funds of the savers to business firms that provide employment and income and
tio P Y

keep the wheels of the economy moving. US Fed Chairman Ben Bernake (Bernake) has learnt from Milton Friedman
and Anna Schwartz’s magnum opus A Monetary History of the United States the importance of providing the economy
uc O
n

a stable monetary background, lack of which had led to the Great Depression. Referring to the Great Depression,
od C

Bernake acknowledged to the duo at the end of his speech, “You’re right, we did it. We’re very sorry. But thanks to you,
we won’t do it again.”15 If the current effort by the government at buying up mortgage-backed securities fails to boost
Re ON

asset prices and investment profits to create the ambience of confidence in banks and business firms, the government
can forestall bank failures by sufficient recapitalisation by way of investing public money in them.
I

Sceptics however counter that making available credit facilities does not mean the same thing as making use of
pr
t F CT

these, if deteriorating economic scenario shattering business confidence forbids it. Even if monetarists’ diagnosis of
the underlying cause of the economic depression is supposed to be correct, the prescription of reversing the cause is
not right. A horse can, for instance, be stopped from drinking by pulling it off from water; but no amount of effort in
E
or

pushing it towards water will make it drink if it is not thirsty. Credit line is just like a string that one cannot push on, as
SP

evident in the ‘Lost Decade of Japan’ during 1990s. Even though interest rates were practically non-existent in Japan,
domestic demand failed to pick up, forcing Japan to wallow in low or negative growth.
No
IN

13
Lewis Jon, “Consumer Spending Plunges”, http://wsbradio.com/localnews/local/2008/10/, October 30th 2008
14
Ibid.
15
“Remarks by Governor Ben S. Bernanke on Milton Friedman’s Ninetieth Birthday” http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021108/default.htm, November
8th, 2002

11
 US Financial Crisis: Is the Great Depression II in the Making?

Optimists believe that even if all the above-stated plans fail to fructify, the ultimate Keynesian strategy of massive
governmental expenditure on infrastructural building programmes is there to be adopted as a last resort to keep the

tio P Y
spectre of depression away. Nobel Laureate economist, Joseph E.Stiglitz is hopeful that a Depression II is unlikely
thanks to the new ‘instruments’ that can be deployed to fight off the occurrence of a depression.

uc O
Critics argue that though a lot of safeguards have been built into the system that were not existent earlier in the

n
od C
1930s, none of these, however, can deal with CDS and other complex derivatives which have blown up the subprime
muddle into the present state of crisis in confidence and financial turmoil. The high-earning innovating wizards at Wall
Re ON

Street have always proved too smart for their low-paid laidback regulators. Moreover, more regulation may not immunise
the economy against future crises, as experienced by more rule-bound economies like Japan and South Korea in
recent years. What is really required is not more regulation but better regulation. Moreover, as the followers of Austrian
I
pr

economist Ludwig von Mises assert contrary to mainstream Keynesian postulate, what the economy needs during the
t F CT

downturn is not more spending on consumption but more saving, so as to agree with the excessive investments of the
preceding boom. More and more spending to avoid the burst of bubble is simply postponing the day for a bigger
E
or

burst.While more saving is frowned upon by the Keynesians since this virtue of economising at individual or micro level
SP

results in vice at aggregate or macro level, Misesians see no such dichotomy since saving ultimately sustains investment.
According to the Misesians, the Keynesian approach is akin to continuous doping of a race horse with increasing
No

doses of steroid. Once the doses drop off, the race horse turns into the ordinary or even worse.
IN

Liberals put up the brave front that capitalism corrects itself in due course and there is no need to be panicking.
The auto corrections in the form of minor crises are indicative of the fact that major crises are going to be averted. The
downswing is an unpleasant yet necessary process by which the free market discards the errors of the boom to avert
the horror of a hard landing. The Great Depression of the 1930s was rather the offshoot of a ‘perfect storm’ of destructive
policies carried out almost at the same time. The record hike in tax in response to huge decline in tax proceeds caused
by the prevailing economic slowdown, the increase in tariffs by protectionist Smoot-Hawley Tariff Act that resulted in
retaliation leading to the reduction of demand for the US exports, the enactment of wage and price controls under the
National Recovery Administration that prevented market adjustments were some of the prime instances of these
policies, the consequences of which went opposite to what was intended. Moreover, after a crisis, appropriate lessons
are learnt and exactly the same mistakes are hardly repeated. For example, the lack of transparency in CDS transactions
has actually led to the plan for instituting clearing houses for CDS. The Great Depression of the 1930s is unlikely to
replicate itself in the current financial crisis of 2008, given the fact that present mortgages delinquencies of really
serious nature as percentage of loans stand at a little over 4% (Exhibit XI) while the figure in the 1930s was 40%.

Exhibit XI
tio P Y

Mortgages Delinquencies (in %)

uc O
n

7
od C

All Loans
6
Re ON

5
4
I
pr

3
t F CT

90+days Delinquent
2
E

1
or
SP

0
1980 ’85 ’90 ’95 2000 ’05 ’08
No
IN

Source: “America’s Bail-Out Plan: The Doctors’ Bill”, http://www.economist.com/opinion/displaystory.cfm?story_id=12305746, September 25 th

2008

12
 US Financial Crisis: Is the Great Depression II in the Making?

Besides, as argued by noted economic historian of Carnegie Mellon University’s Tepper School of Business, the
Great Depression had ‘waves of bank failures’ while the current financial crisis involves only ‘a few failures’16 . Then in

tio P Y
1933, above 4000 banks failed; now as of mid-November 2008 merely19 banks have met the same fate. Then the
downslide lasted for a grueling 43 months; the present downslide of 2008 is believed to be over by the next year, as a

uc O
survey of economists’ opinion by the Philadelphia Federal Reserve Bank reveals.17 More over, the US economy is a

n
gigantic economy with great ‘ability to reinvent itself’. Therefore, it will come out fast ‘in routine fashion’ from what is

od C
actually a localised problem – the US housing crisis covering mainly six communities such as Southern California,
Southern Nevada, Arizona, Southern Florida, Cleveland and Detroit. The slowdown in housing construction will definitely
Re ON
result in a modest economic downturn but not at all a Great Depression.18 Added to all these are the benefit of hindsight
and experience of shock-absorbing economic policies. Prof Krugman, however, points to the urgency of the analogy
I

between the Great Depression of the 1930s and the US financial crisis of 2008 in respect to the collapse of the
pr
t F CT

monetary policy. The Fed is getting as impotent now as it was then on account of “its inability to cut rates any more,
because they’re essentially zero” (Exhibit XII).
E
or

Exhibit XII
SP

Interest Rate of 3-Month Treasury Bill of US Federal Reserve System

No
IN

%
20

15

10

0
tio P Y

-5
uc O

1925 1940 1955 1970 1985 2000 2015

n
od C

Shaded areas indicate US recessions as determined by the NBER.

Re ON

Source: Krugman Paul, “Depression Analogies”, http://krugman.blogs.nytimes.com/2008/11/22/depression-analogies/, November 22 nd 2008

I
pr

Given the fact that about 90% of the world trade moves by sea, the Baltic Dry Freight Index that measures the
t F CT

shipping cost of dry bulk commodities is viewed by some as a proxy for general economic health and reflection of the
direction towards which the economy is heading. The drop in this index by a massive 80% in the year 2008 as of
E
or

September (Exhibit XIII) is a strong indicator of an unfolding recession with the depth to be turned into a depression.
SP

The index has, indeed, tumbled below the levels logged in 2004.
No
IN

16
Norton Rob, “The Thought Leader Interview: Allan Meltzer”, Strategy + Business, Issue 53, Winter 2008, pages 1–9
17
Gross Daniel, “Don’t Get Depressed, It’s Not 1929”, http://www.slate.com/id/2205186/?from=rss, November 22nd 2008
18
“The Thought Leader Interview: Allan Meltzer”, op.cit.

13
 US Financial Crisis: Is the Great Depression II in the Making?

Exhibit XIII
Y/Y Change in Baltic Dry Freight Index (2004–2008)

tio P Y
uc O
n
od C 15,000
Re ON
I
pr
t F CT

10,000
E
or
SP

5,000
No
IN

2004 May Sept. 2005 May Sept. 2006 May Sept. 2007 May Sept. 2008 May

Source: Shedlock Mike, “Baltic Dry Shipping Collapse Sign of Consumer Recession”, http://www.marketoracle.co.uk/Article6813.html, October 15th 2008

Even though both of the recessions arrow-marked (Exhibit XIV) were preceded by declines in the Baltic Dry Freight
Index, every decline in shipping rates is not a sign of approaching recession, not to speak of the spooky depression.

Exhibit XIV
Y/Y Change in Baltic Dry Freight Index (1985–2007)
tio P Y

300
250
uc O
n

200
od C

150
Re ON

100
I
pr

50
t F CT

0
E
or

-50
SP

Recessions
-100
1985 1989 1993 1997 2001 2005
No
IN

Source: “Baltic Dry Freight Index Indicates Recession Unlikely”, http://seekingalpha.com/article/31164-baltic-dry-freight-index-indicates-recession-

unlikely, March 30th 2008

14
 US Financial Crisis: Is the Great Depression II in the Making?

Some argue that the beginning of the 2008 recession should be dated to the first quarter of 2008 though official
affirmation puts the US growth at a positive territory of 0.6%. They reason that the final sale of products of the economy

tio P Y
is the true measure of the economic growth. The increase of inventory of unsold goods of 0.8% ought to be excluded
instead of being added since firms have to expunge that additional unintended inventory by means of cutback in

uc O
production and employment. Effectively, the first quarter growth is a negative 0.2%.19

n
od C
A glimpse at the quarterly analysis of the US GDP with its component breakdown for the second and the third
quarter of 2008 (Exhibit XV) gives an idea of a depression lurking in the corner.
Re ON

Exhibit XV
Quarterly Analysis of the US GDP
I
pr
t F CT

Q2 2008 Q3 2008
E
or

Personal Consumption Expenditures Gross Private Domestic Investment

SP

6 20
Quarterly Change (%)

4
Quarterly Change (%)
2 15
No

0 10
IN

-2 5
-4
-6 0
-8 -5
-10
-10
-12
-14 -15
-16 -20
Durable goods Nondurable Services Fixed Nonresidential Equipment Residential
goods investment structures and software

Net Exports/Imports Governmnet Consumption/Expenditure/Investment

20
8
Quarterly Change (%)

15 7
Quarterly Change (%)

10 6
5
5
4
0 3
-5 2
1
-10
0
tio P Y

Exports – Exports – Imports – Imports – National

Federal State and
Goods Services Goods Services defence Nondefence local
uc O
n

Source: “GDP: Negative 0.3%”, http://bigpicture.typepad.com/comments/economy/index.html, October 30th 2008

od C

Auto sales, which have large linkage effects – both forward and backward – in terms of job creation, have also
Re ON

gone for a skid into the negative territory in September 2008 compared to September 2007 (Exhibit XVI).
However, the National Bureau of Economic Research (NBER) Business Cycle Dating Committee is yet to declare
I
pr

the state of recession for the US economy because it has to consider net adverse impact of five indicators such as
t F CT

economic output, wholesale and retail sales, industrial production, personal income and jobs (Exhibit XVII) instead of
the straight mechanical definition of recession. The intensities of recessions are usually compared on the basis its
E

three Ds, namely Duration (No. of months), Depth (in terms of % change in real GDP & unemployment rate, maximum)
or

and Diffusion (% of industries with declining employment, maximum)20

SP
No
IN

19
Roubini Nouriel, “Q1 GDP: Aggregate Demand (Final Sales) in Negative Growth Territory”, http://www.rgemonitor.com/roubini-monitor/252541/q1_gdp_aggregate_
demand_final_sales_in_negative_growth_territory, April 30th 2008
20
Moore Geoffrey H., “Recessions”, http://www.econlib.org/library/Enc1/Recessions.html

15
 US Financial Crisis: Is the Great Depression II in the Making?

Exhibit XVI
Percentage Change in Auto Sales; September 2007–September 2008

tio P Y
uc O
n
Volvo
od C Porsche
Lexus (Toyota)
Re ON

Nissan
Ford
Chrysler
I
pr

Toyota
t F CT

Kia
BMW
Hyundai
E
or

Honda
SP

Mercedes
GM
No

Volkswagon
IN

Audi

% -60 -50 -40 -30 -20 -10 0

Source: “Auto Sales Tank”, http://bigpicture.typepad.com/comments/economy/index.html, October 1st 2008

Exhibit XVII
Five Indicators to Examine the State of Recession

Wholesale and Retail Sales Personal Income

Economic Output Manufacturing and trade industries Inflation-adjusted*
US gross domestic product, inflation- sales, inflation-adjusted
adjusted; quarterly data $1.00 trillion at monthly rate $8.6 trillion at annual rate
$12.0 trillion at annual rate
0.98 8.5
11.8 8.4
tio P Y

0.96
11.6 8.3
0.94
8.2
uc O

11.4
n

0.92 8.1
od C

11.2
2006 ’07 ’08 2006 ’07 ’08
11.0
Re ON

Industrial Production Jobs

2006 ’07 ’08
Index of output in factories, Total US nonfarm payrolls
utilities, mines
113
I
pr

140 million
t F CT

112 139
*Less transfers or income for which no services 111 138
E
or

are performed such as net insurance payments

and government social payments. 110 137
SP

Notes: Series adjusted for inflation are in chained 109 136

dollars; sales, income and GDP data are
No

108
IN

seasonally adjusted. 135

2006 ’07 ’08 2006 ’07 ’08

Source: Reddy Sudeep, “Economists Weigh Possibility of a Recession Amid Economic Growth”, http://online.wsj.com/article/
SB121720283536488455.html, July 28th 2008

16
 US Financial Crisis: Is the Great Depression II in the Making?

Critics, however, say that NBER’s non-declaration of the state of recession does not matter much since it takes at
least two quarters to know of its existence. What actually does matter is the perception whether one is in recession at

tio P Y
present or not. And the perception points to the making of another Great Depression.
History has a mystic capacity of repeating itself. The Great Depression of the 1930s and the present financial

uc O
convulsion have tell-tale common signs between them. Then it was easy money policy following the First World War,

n
od C
which led to over borrowing and high-risk speculation and asset-price bubbles. Now it is also easy money policy
following 9/11, which has led to sordid subprime saga, huge credit derivatives and house price bubbles. Then it was
Re ON
New York Bank; now it is Lehman Brothers, Merrill Lynch and Washington Mutual. Then it was an election year with
Franklin D. Roosevelt, a Democrat, taking over from a Republican; now it is an election year with Barack Obama, a
Democratic nominee and clear frontrunner (eventually, the November 4th 2008 election has favoured him as the
I
pr

President-elect).
t F CT

But to break the linearity, as an upside, while there was a policy vacuum of 5 months between the election of a new
President and his taking of office in 1933 that worsened the US banking crisis, the current Bush administration’s
E
or

gigantic bail out plan under Troubled Assets Relief Programme (TARP) to the tune of $700 billion is a quick one,
SP

endorsed as it is promptly by both the presidential candidates despite some misgivings. Then ill-conceived protectionist
measures of the US exacerbated the crisis; now in this globalised era all the countries hang together too tightly to allow
No
IN

any non-cooperation to bring them the collective doom of depression. Then the US spending, particularly military
spending was much smaller than what it is today and this sets up the bottom below which the US economy will not
slump. As a downside, while there was a trade off between unemployment and inflation then, as exemplified by the
Philips Curve, now there is the likelihood of the both keeping company in the form of double whammy stagflation. Then
the modes of information mining and transmitting were not as rapid and varied as it is now to scare people out with
hyperbolic headlines.
However, the moot question remains: Whether the policy framework will accentuate or alleviate the present US
financial crisis of 2008: or, whether policy activism serves any purpose at all. And there hangs on the torrid story of
Depression II to be or not to be.

tio P Y
uc O
n
od C
Re ON
I
pr
t F CT
E
or
SP
No
IN

17