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Is the Economic Crisis in the US another Great Depression?
 

Is the Economic Crisis in the US another Great Depression?

TestFunda ,  26-Nov-08

The Stakeholders

Subprime borrowers, Investment Banks, privately-owned investment funds, corporations, pension funds, mutual funds, banks and individual investors, and many others

Background

·         The falling property rates compelled a lot of people who had taken loans at high interest rates to default on the repayment.

·         Banks had already repackaged the loans as CDOs and sold them to investors across the globe.

·         When the borrowers defaulted on the loans, the CDOs became worthless and the investors lost their money. Banks also had no money to lend. This compounded the problem further.

·         This is known as the Subprime Mortgage crisis. The bursting of the housing bubble plunged the US into an economic crisis that had far-reaching effects across the globe.

·         The government decided to step in to bailout the economy and got the Congress to approve a $700 billion Emergency Economic Stabilization Act of 2008.

Key points

·         The current economic situation does bear disturbing similarities to the Great Depression of the 30s.

·         The depression was perhaps the worst phase in the history of the US. By the end of the depression nearly a quarter of the population of the US was unemployed. The Dow index had fallen by a massive 89%.

·         The current economic situation is also very bad but not yet a depression. But it could be heading towards one.

·         For the moment, it is not even a recession. To qualify as a recession, the gross domestic product must shrink for at least two consecutive quarters.

Similarities

·         At the beginning of the Great Depression, there were big declines in the stock market. As a consequence, there was a reduction in people's wealth and a general decrease in spending. The Dow index fell 47% in a couple of months.

·         In October 2008, the Dow index again fell 42%, a margin that was uncannily similar to its initial fall in 1929. Things could be far more serious this time around because a lot more people have invested in stocks.

·         In 1929, the banking system collapsed because of bad loans given to people who made risky investments in stocks.

·         In 2008, the banking system again collapsed on bad loans. This time around the loans were made to homeowners who defaulted on repayment and to investors in mortgage-backed securities.

·         The depression worsened when banks stopped lending to avoid further losses. This slowed the economy even further. About five years after the depression began more than 5,000 banks had collapsed.

·         Even today, banks have cut down on lending to avoid losses. This has nearly brought the credit markets to their knees.

Differences

·         In the 30s, the Fed’s reaction to the economic crisis was to increase interest rates. This drained liquidity from the markets and slowed down the economy further.

·         The government contributed to the crisis by raising taxes to balance the budget. It also raised the fees charged on imported goods. Reacting to this move by the US, other countries followed suit. This badly affected exports and crippled US industries.

·         In 2008, the government played a more active role in preventing a meltdown. The Federal Reserve played an active role in shoring up the economy as “the lender of last resort”.

·         The Fed has also cut interest rates many times since the first signs of the crisis began showing up. It has also arranged for financial institutions to barter troubled assets for Treasury securities.

·         The 1929 depression was triggered off by the bursting of the stock bubble. The current economic situation is the fallout of the over-evaluation of commodities, stocks, mortgages and real estate.

·         The prevalent economic situations were also different. In 1930, the US was a country that was driven by manufacturing and agriculture. Today, it is a consumer and service economy. The recovery of the economy this time around will depend on how soon consumers start to spend again.

More Links

·         The Great Depression

·         Bailout Plan Is Only One Step on a Long Road

Group Discussion Topics

1.       Should financial institutions accept Government safeguards?

For:

·         The government comes to the aid of banks and other financial institutions in times of crises. These institutions must, therefore, subject themselves to some sort of government control.

 

·         Safeguards will ensure that there are no irregularities and will bring transparency to transactions.

 

·         It will help the government be prepared for any sort of economic turmoil.

 

·         Creation of government-insured bonds for mortgage financing will provide the market with the government’s support, when needed.

 

·         Unbridled expansion will come back to hurt the people when the economic bubble of a particular era bursts.

 

·         Extending the idea of safeguards from just financial entities to all kinds of corporations will help in curbing the damage to the environment due to illegal activities by these corporations.

 

·         Interest rates are kept in check with safeguards.

Against:

·         The American system is based on almost total freedom to businesses and financial institutions. Changing this would change the face of America.

 

·         Bureaucracy in any way slows down the process of economic growth because of the answerability involved.

 

·         Corporations and financial institutions have learnt their lesson and all they need is government support until they can stand on their own feet.

 

·         Situations such as the present crisis allow societies to evolve. Government control won’t allow for the kind of mistakes that help society think of new development strategies.

 

·         We risk stagnation by subjecting the free market to government safeguards.

 

·         Government safeguards curb the competition in the banking sector.

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