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When the Economy Contracts: History of Economic Crisis

We are now living through perhaps the worst economic crisis of history because of the effects of COVID 19. The unemployment rate has been increasing steadily for the past months, millions of people could not go to work because of lockdowns and governments accepted very comprehensive packages of economic measures throughout the world. COVID 19 economic crisis is very different when compared with the other crisis that the world has faced. In this article, we will examine the economic crisis that had global consequences in history.

Economists have different schools of thought which try to explain the reason why economic recessions occur. Although this looks like a very fundamental question of economics, we do not have a consensus yet. Surprisingly, every school of thought agrees upon the idea that recessions are caused by a fall in the demand for labor, but they use different mechanisms to explain this fall in demand. For example, the monetarist view shows the amount of money supply and monetary policy as the most important factors in recessions whereas real business cycle theory emphasizes the role of technology and price of raw materials such as oil. Each school of thought can be regarded as complementary to each other rather than being rivals. When we look at the crisis that the world has faced, we can easily see that every theory is valid in explaining a part of the crisis.

History of the economic crisis is generally accepted to start with the Great Depression of 1929. Although the world has faced many more other recessions after the Industrial Revolution, as the concept of calculating Gross Domestic Product (GDP) and measuring other economic indicators dates back only to the beginning of the 20th century, we do not have enough data to make well-developed comments upon these crises. We can only guess that their sphere of influence must have been very big due to the lack of financial regulations. Besides, governments did not have any sophisticated tools to intervene in the economy before 1929 since the prevalent belief was in accordance with Adam Smith's ideas of the minimal state, free market, and laissez-faire. Economists believed that government intervention would only decrease the efficiency, and the markets would come to a balance of full employment without any intervention with the mechanism that they call the “invisible hand”. They thought even if the economy faced a recession, the wages would adjust by decreasing in the long run, so the ones who lost jobs would be able to find jobs again as the employers would have the chance of employing more people with lower wages.

This belief in the "invisible hand" and the self-correcting mechanism of the markets were challenged with the Great Depression of 1929. The Great Depression was triggered by a Wall Street Crash in 1929. It was unexpected as most of the crisis are: Irving Fisher, one of the greatest economists of the 20th century, was writing two weeks before the Wall Street Crash that the economy was at its peak and they were expecting strong growth rates in the following years. In contrast, millions of people lost their jobs at record rates and thousands of firms went bankrupt. Firms and households were saving an important portion of their wealth in the form of stocks and bonds, thus when the value of them declined with the bursting economic bubble, their demand for goods and services declined. Less demand for goods and services meant less demand for labor, further decreasing the demand for goods as people were losing their income. Grapes of Wrath by John Steinbeck perfectly demonstrates how the life standard of the average person was affected. Thousands of banks throughout the world and in the US saw bank runs, all their customers were trying to get their money out from the banks in a state of panic, thinking that they would not be able to get it as the crisis worsened. As banks were lending out the money as long-term credits, they couldn't pay back the money that people had. This wave of bank runs resulted in a strong financial regulatory system in the US, discount windows for banks were created and reserve requirements for banks became very important-all crucial elements of today's financial system.

The Great Depression lasted for approximately 10 years and was worsened by the poor decisions of the US government. Due to the prevalent classical economic view of the era, the government thought the depression would go away without any intervention. However, in reality, as more people were losing jobs, demand was further declining, causing more people to lose their job. Besides, the money supply was being held lower than necessary, resulting in lower prices and less employment. Milton Friedman, who represents the monetarist view in economics, later showed that the monetary policy conducted worsened the Great Depression.

This environment gave way to the birth of the Keynesian view. John Maynard Keynes argued that the state of full employment was nothing more than a coincidence. He stated that waiting for the market to come to a balancing point was not logical since the crisis was getting worse as time passed. He thought even if the self-correcting mechanism of the markets were going to work, this was going to take a lot of time, as his famous words show: "In the long run we are all dead”.  Keynesianism states that government intervention in the markets is a very crucial thing during recessions to accelerate the overall demand for goods. Thus, it favors expanding government expenditures and lowering taxes to provide income to people (named as fiscal policy) and changing the interest rates (named as monetary policy) to promote investment and consumption. Keynesianism was very controversial when it was first created as a response to the Great Depression, however, it proved to be efficient in ending the Great Depression. Although it has faced many critiques throughout the 20th century, Keynesianism still forms the basis of the current government policies against the COVID 19 economic crisis, and many more recessions.  

When the growth rate finally managed to see its pre-depression levels, World War 2 started. This decade’s economy was generally defined by strong war effort: low household consumption and high government spending. Although there have been regional recessions, the fifties and sixties did not host an economic downturn at a global scale. Keynesian views increased the role of government in the economy, building inflationary pressures according to some.

Up until the 1970s, this has been a general view of the global economy. In 1973, the world faced a different type of economic downturn: The OPEC Oil Price Shock. In response to the US involvement in the fourth Arab-Israeli war, the OPEC countries decided to put an oil embargo on the United States and other Western countries. As most of the OPEC countries consist of Arab nations, this did not constitute a problem. This embargo caused oil shortages in many developed nations, causing skyrocketing prices of oil. As oil is a major element in production for a vast majority of goods (think of the transportation process), increasing oil prices increased the cost of production and caused less production. This era is also associated with stagflation (created by combining stagnation and inflation), which means the economic recession is followed by inflation. What is unique about the 1973 OPEC Oil Price Shock is that it is a supply-side crisis. In the Great Depression or the 2008 Crisis, the falling demand from consumers caused the crisis, however, in this one it is the shortage in the supply of goods that caused it. It took several years for the economy to come to its pre-recession levels.

Until 2008, the world has seen another major crisis. Its effects were not on a global scale, but it was feared that it would be so. The Asian Crisis of 1997 started in Thailand and quickly spread to the other “Tiger Economies” of the east, such as South Korea, Malaysia, Indonesia, and Singapore. These nations had the name of the Tiger Economy due to their strong growth rates throughout the second half of the 20th century. This optimism and growth caused a great deal of credit and debt accumulation in these countries. When the government of Thailand declared it was running out of foreign currency reserves, and it was not going to be able to protect the value of its currency, this bubble of optimism burst. Millions of dollars of foreign investment gone away from the region in this state of panic. People were afraid that other countries of Asia would soon see bankruptcies as well. To prevent the crisis from reaching out to a global scale, the IMF stepped in by creating bailout packages for the Asian countries.

As we entered the 21st century, the Keynesian views were being left out. People were thinking that the classical view had won their long dispute with Keynes. 2008 financial crisis showed us that this was far from the truth. In an environment of optimism, the credit loans were being extended to low-income families as well in the first half of the 2000s. Interest rates were following at a record low, further encouraging credits. As obtaining a mortgage was becoming easier, the housing prices were going up with increasing demand. A lot of people went into mortgages for buying a house. Banks were also creating credit packages by combining low and high-risk loans, artificially increasing the credit ranking of high-risk loans. This economic bubble of high housing prices eventually burst in 2008, as the rate of unpaid debt was increasing faster than it was expected. Banks could not get their money back from people they loaned money to, so they seized the houses that people got into debt for. As the prices of the housing industry were falling, even the houses that the banks confiscated proved not to be enough for the financial health of the banks. This eventually led to the bankruptcy of Lehman Brothers, a venture capitalist organization. The bankruptcy of this massive financial institution meant millions of people worldwide would not be able to get their money back, increasing the number of firms and households that went bankrupt. Decreasing demand for goods was further worsening the crisis. The US government accepted economic relief packages that increased government expenditures and decreased the tax rate. Interest rates saw the rate of zero to promote expenditure. Later research showed that this economic relief package prevented a fall of 2 to 2.5 percent fall in US GDP. It was seen that the economic crisis was not a part of history like it was thought, and Keynes was still necessary.   

The last and perhaps the worst crisis that we saw is the COVID 19 crisis of 2020. We do not have enough data about it yet since we are currently living through it. It is believed that the COVID 19 crisis is only comparable to the Great Depression in its scale. Its nature and effects will be long disputed in the following years in the academic cycles. Time will tell us how this incident will conclude.

From this history, we can see that although economic growth is persistent in the long run, it faces waves of going up and down. Science of economics does not yet have a definite answer regarding the nature of these waves of the business cycle, but the recessions that we faced throughout history gives us clues.

by Didem ÖZÇAKIR

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