To understand the dynamics of the global crisis, it is useful to start with a historical perspective. Over the past 130 years, US income per capita (adjusted for inflation) has increased by an average of 1.85 per cent a year (see graph below). The solid line shows that from $3,300 in 1870, US per capita income has increased to more than $45,000 in 2007.

There are three important lessons from this. First, most of the time the increase in income proceeds in a smooth pattern; recessions are short and barely noticeable; expansions are smooth and relatively long. Second, there is one calamity that stands out in this graph – the Great Depression of 1929-33. There is nothing in US economic history that even vaguely resembles this trauma. Third, the graph shows that no matter what happens – mild recessions, depressions, rapid expansions (such as the second world war) – the US economy has always returned to the trend of 1.85 per cent growth in per capita income (the straight line).

The facts about the Great Depression are staggering. From growth rates of between 3 and 10 per cent in per capita terms, the US economy imploded: contracting 11 per cent in 1930, another 9.5 per cent the following year, and then shrinking a further 15 per cent in 1932. After surging during the 1920s, share prices on Wall Street plummeted, with the Dow Jones Industrial Average falling to a low of 41.22 points in 1932 from 381.17 points in September 1929.

To put that in context today, it would be equivalent to the Dow falling to 1,666 points from a peak of 14,164 (October 9 2007) within just two years. While the stock market fell some 90 per cent, the output of the US economy fell by one-third during the Great Depression, unemployment shot up to 25.2 per cent from 3.2 per cent, and one-third of the 24,000 banks in the US closed down. This is a partial, yet telling view of the magnitude of the Great Depression. It was so traumatic because the economy became trapped in a vicious circle, in which banks’ balance sheets worsened because of a deterioration in economic conditions and the economy declined because banks did not lend since their balance sheets deteriorated.

How does this compare with today’s crisis and what can be done to ensure that the global economy does not again fall into such a vicious circle?

Causes of the current crisis

By now there is widespread agreement on the proximate and fundamental causes of the current downturn. The immediate reason for the start of the crisis was the housing market bubble in the US, which began to deflate in 2006. Other factors – such as subprime lending, securitisation, leverage and opacity of financial instruments – magnified the problems resulting from the decline in housing prices. The deeper question is: why did this bubble with all its complications develop? What went wrong in the sophisticated signalling mechanisms that are supposed to warn any policymaker that deep imbalances are in the process of developing?

The rapid growth in China at the start of this decade combined with a high savings rate created a continuously increasing pool of liquidity. Some of these savings were used to purchase US Treasury bonds, which pushed yields on US debt to historical lows. The “savings glut” from China, other emerging economies and oil-producing countries generated low interest rates, which facilitated borrowing.

While in the long end of the yield curve there was a clear movement down, on the short end the US Federal Reserve also pushed the Fed funds rate down to 1 per cent. Today, many observers blame Alan Greenspan, then Fed chairman, for driving down the rate to 1 per cent but he did this because between 2002 and 2004 US inflation was getting dangerously close to the deflationary zone. At the time, policymakers and market participants were predicting that the US would enter a period of deflation and this would be the path to repeating either the Great Depression or at least the Japanese slowdown of the 1990s. Few central bankers would have reacted differently.

Probably the deepest cause for the crisis is the inconsistency in the way the financial sector is regulated. While commercial banks are regulated and supervised quite closely, investment banks and other financial institutions have very light regulation. Commercial banks had the incentive to originate mortgage loans and remove them from their balance sheets by securitising them and selling the new securities to funds, investment banks or other investors. Since mortgages were transferred off the balance sheet of commercial banks, the loan officers had almost no incentives to monitor the quality of borrowers. The fact that some entities are closely regulated but others are not is a big part of the problem.

The picture so far suggests that the massive increase in liquidity generated falling long-term interest rates, low inflation justified low short-term interest rates, and both of these developments led to higher demand for borrowing in developed markets. Banks were lending and reshuffling loans into securitised instruments.

The credit rating agencies also played their part by rating certain portions of these securities with the highest possible rating, implying very low probability of default. In other words, they prepared the market for the mispricing of these securities. Because these securities were complex, few investors could understand the underlying risks and, therefore, they relied on the credit rating agencies. Once the agencies certified them as safe investments, demand for these securities soared. With demand high, US banks had incentives to create more securities without paying too much attention to the risks associated with the borrowers to whom they lent. It was this detachment of the loan originator (a US bank) and the ultimate investor in this highly complicated security that led to the breakdown of the standard monitoring of the quality of borrowers.

The shock resulting from the collapse of the house price bubble was bad enough but what is worse is that it has been amplified by the collapse of the financial sector, which has pushed the economy into a Depression-style vicious circle. In this situation, financial institutions tend to reduce lending, which slows real economic activity and, as a result, the number of defaults on bank loans increases. These defaults feed back to the financial sector by straining banks’ balance sheets. Under these conditions, the financial sector further reduces lending and the economy fluctuates between real collapse and financial collapse.

Empirically, we do not know whether market forces will restore equilibrium without intervention. During the Great Depression, policymakers tried to see how deep a recession would go if left to the market. We do not know whether they ever reached bottom because the Depression was brought to an end by government intervention. Every deflationary financial crisis since has ended either with a massive monetary policy injection or fiscal expansion, or both.

What happens next?

Given the similarities between the current crisis and the Great Depression (in terms of shocks and amplification mechanisms), it is useful to keep the historical perspective and look at how the Great Depression ended. Franklin D. Roosevelt was inaugurated as the 32nd US president on March 4 1933. Immediately, he started working on four fronts to stop the deflationary spiral: limit the pervasive banking panic and reconstruct the financial sector; suspend the Gold Standard and allow the Fed to use monetary policy to increase liquidity aggressively; prepare a broad-based fiscal expansion; and change the regulatory environment. The US economy started to recover rapidly, with growth rates of 8 to 10 per cent during the next few years.

The current crisis may be resolved along similar lines. The first set of actions taken in October and November 2008 were designed to stabilise the financial sector. This step is essential because without banks lending, the economy goes down into a vicious downward spiral. The second line of dealing with the crisis involves monetary policy. It is difficult to overemphasise how aggressive and unorthodox US monetary policy has been in the last quarter of 2008.

The Fed started with a rather standard response to the crisis by lowering interest rates in 2007 and 2008. The collapse of Lehman Brothers in September of last year changed the game. The massive injections of capital in the US and in other advanced economies did not generate the necessary revitalisation of the lending process.

In an unprecedented move, on October 27 2008 the Fed opened its lending window to start lending directly to non-financial institutions in the commercial paper market. In a matter of two weeks, the facility – which buys commercial paper – ballooned from zero to more than $250bn. Without this lending, companies would not have received short-term funds to pay suppliers or workers, or would have received funds from commercial banks at a substantially higher cost. One can only speculate where the economy would have ended up without this lending directly from the central bank.

The commercial paper lending facility is only one of several lending facilities opened by the Fed in the past 12 months. The injection of liquidity by the Fed in the past few months has seen its balance sheet explode from $900bn to more than $2,200bn since September.

The third pillar relates to fiscal policy. By cutting taxes or increasing spending, the government can prop up demand in the economy and stop the vicious circle. There is little doubt that a well-designed fiscal package can shorten the recession dramatically and make it much shallower than it would be without a fiscal stimulus. How big should that stimulus be? The package must have three critical components: immediate implementation; an initial instalment of between $500bn and $1,000bn; and an expectations-setting component that states that there will be an additional stimulus package further down the road.

Finally, one can easily anticipate a wave of regulatory changes. Our perceptions about the financial system during the past 70 years were shaped to a large extent by the Great Depression. The process of disintermediation by commercial banks during the Depression was seen as a major amplifying force for the crisis. Regulation (for example, the 1933 Glass-Steagall Act, which prevented commercial banks from engaging in the investment business) focused most of the attention on regulating commercial banks, leaving investment banks much less regulated. With the repeal of the Glass-Steagall Act in 1999 and with the rapid advance of financial innovation, the investment banking sector has become closely intertwined with commercial banks and, therefore, regulators can no longer afford to leave investment banking activities with the degree of supervision that existed previously. The new regulatory framework will have to address the asymmetry between the importance of investment banks in liquidity provision and their status as less regulated entities.

A common misconception

There is a concern that the massive injections of liquidity by the Fed will create inflation and even hyperinflation in the US. This misconception is based on the assumption that the money created by the Fed will translate at some point into purchasing power that will put pressure on prices. Indeed, between September 10 2008 and November 5 2008, the monetary base in the US – the money supply fully controlled by the Fed – increased by almost 50 per cent. Under normal circumstances, this would create too much liquidity in the system that would translate eventually into lending and spending. This increase in spending would push up prices and inflation would soon materialise.

However, in the current environment this is not happening. The liquidity created by the Fed is stored in the vaults of commercial banks and there is almost no increase in broader measures of money. Banks are required to keep a certain amount of deposits as cash in their vaults (or as deposits in the central bank). It is in their interest to keep as little cash as possible because it is by lending money that they earn interest. In normal times, the US banking sector keeps about $2bn in so-called excess reserves – cash above and beyond what is required by law. In the four months following the collapse of Lehman, the excess reserves have ballooned from $2bn to almost $800bn. The commercial banking sector in the US is required by law to keep about $53bn dollars in reserves, but the actual number is $852bn.

If the Fed finds that the money they have injected into the economy starts to create inflationary pressures (that is, lending resumes), then they can slowly or quickly (it is their choice) mop up the excess liquidity. They can do this in several ways: by closing down some of the newly created lending facilities or by a straightforward increase in interest rates. Will it work? It did in Japan. During the country’s period of quantitative easing, the monetary base increased rapidly, with the base nearly doubling between 2002 and 2006. As quantitative easing came to an end, the bank promptly withdrew the excess money and thus avoided a rise in inflation.

Conclusion

For almost a decade, many economists warned that the global imbalances that developed in the late 1990s and early 2000s were unsustainable. Excessive consumption in the US and high savings rates in emerging markets created large US trade deficits financed by China and other emerging economies. In some ways, the global financial crisis is the resolution of these global imbalances. Consumption in the US will have to be reduced to more sustainable levels and the disappearance of the wealth effect from the high house prices will facilitate this adjustment.

As the graph of US income per capita shows, the US economy historically has always returned to a steady growth of 1.85 per cent. The big debate is whether we need a long and painful deviation like the Great Depression to get there.

Whether the adjustment will be smooth or abrupt and painful depends on the actions of policymakers. Any projection about a recession or recovery for 2009 or 2010 has to specify explicitly what kind of policy actions are anticipated in this period. With prompt and aggressive monetary and fiscal policy and a well-developed programme to restructure the financial sector, the recession might indeed end in 2009. There is only one way to create a calamity like the Great Depression: by ruining the financial sector and sitting on the sidelines waiting for self-correction mechanisms to kick in.

In 2000, before becoming Fed chairman, Ben Bernanke wrote one of the most informative accounts of the Japanese decline in the 1990s. His prescriptions involved aggressive and non-orthodox policy measures. Today he is implementing his own recommendations through the lending facilities introduced by the Fed. His article ended with: “Perhaps it’s time for some Rooseveltian resolve in Japan.” Today it is time for some Rooseveltian resolve in the US and across the world.

Ilian Mihov is professor of economics at Insead and Novartis chaired professor of management and environment.
ilian.mihov@insead.edu