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1929-1931 Financial Crisis and 2007-2010 Financial Crisis Comparison

Introduction

A financial crisis refers to a situation where there is a large loss of value by some financial institutions. Most financial crises are attributable to bank panics or sudden changes in the value of currency making it hard for it to serve its purpose. Many other situations may result in a financial crisis like crashes or crises in the stock markets, and financial bubbles busting among others. Despite the attempt by economists to come up with theories to explain how financial crises come about and how they can be mitigated, financial crises do occur today.

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According to Kelley (2010, p. 1), one of the earliest financial crises could be traced back to 1934 in England. This was referred to as the default of England. This was the period around which England was at war with France which lasted for about a hundred years. There have been other crises since the 17th century like the Netherlands crisis of 1637 and the bubble bursting of 1720 in Great Britain and France. These two cases occurred due to the countries’ assumption of national debts that lead to bubble bursting. They are regarded as the earliest form of the modern financial crisis because of their effects and causes. Many other financial crises have been experienced in the 18th, 19th, and 20th centuries. For example, the panic of 1972, the banking crisis in Australia in 1893, the New York stock exchange crash of 1901 among many others. The Wall Street crash of 1929 ushered in the greatest economic crisis in the 20th century which started in 1929 and continued the to early 1940s. This was referred to as the greatest depression. This was the most severe and longest economic crisis in the 20th Century. It started in the US towards the end of 1929 due to the crash experienced in the US stock market. It then spread to almost all countries in the world.

The objective of this paper is to study the financial crisis beyond 1929-1931.

Types of the financial crisis

According to Bonner & Wiggin (2006, p. 52), there are about four types of financial crises that have been discovered by economists depending on their causes. These include banking crisis, international financial crisis, speculative bubbles, and crashes, and wider economic crisis. A banking crisis is caused by a bank run where depositors withdraw their deposits suddenly from the banks causing banks to become bankrupt. This is because banks have lent out most of the deposits and can not be able to pay back the depositors if they suddenly demand their deposits. If this bank run becomes widespread, the situation is referred to as bank panic. This way banks cause a financial crisis.

Speculative bubbles and crashes occur when a financial asset like stock costs more than the present value of its future cash flows. When marketing participants buy the assets expecting to sell them at a higher price, if all then decide to sell the asset, the asset price crash is likely to occur. The price of the asset may significantly go down. A good example is the Wall Street crash of 1929 commonly referred to the as great crash of the United States. This affected all western countries as it caused an economic crash for ten years.

International financial crises occur because of sovereign default or currency crises. A currency crisis also called the balance of payment crisis occurs when a currency is suddenly devalued after a significant period of the fixed exchange rate. Sovereign default occurs when countries fail to clear their sovereign debt hence curtailing capital inflows and raising capital flight.

Possible causes of the financial crisis

Borrowing to finance investments (leverage) is one of the factors that may cause a financial crisis. When individuals or institutions borrow to finance investments, there is a high risk of bankruptcy involved or likely to occur. If the investment fails, the institution or the individuals are unable to pay their debts causing g the financial institution to go bankrupt. Statistics have it that leverage often precedes financial crisis. For instance, the 1929 Wall Street crash was preceded by people borrowing to invest in stocks. The share prices in the New York stock exchange had experienced growth for some time until on 29th October 1929 when the prices fell significantly and continued to fall for a full month. This day is since then referred to as black Tuesday. Investors lost their money and were unable to pay their debts. The financial institutions became bankrupt causing the financial crisis.

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The other cause of the financial crisis is an asset-liability mismatch. This happens when banks’ loans mismatch the deposits. Banks have current accounts where people can withdraw their money on demand and any time they want. The banks lend out the same money that can be withdrawn at any time. In the event the depositors panic and withdraw their money, the banks may become bankrupt (Bonner & Wiggin 2006, p.23). This is because they may not be able to recover their borrowed money at the same rate withdrawals are made. This results in bank run causing the banks to become bankrupt causing a financial crisis. Deposits are liabilities to banks while loans are assets. In case of a mismatch, there are high risks of the financial crisis occurring.

The third possible cause of the financial crisis is herd behavior and uncertainty associated with the investment. As many analysts have discovered, a financial crisis may happen as a result of illogical investment reasoning. This causes people to make noninformed investment decisions. The emergence of new financial opportunities may cause the investors to have illusionary investment expectations. For instance, the south sea bubble of 1720 was preceded by the emergence of investment in shares which was new and unknown to investors causing them to commit investment mistakes. The other example is the dot com bubble of 2001where people invested in the stock market of the new internet sector. Investments were quite promising but later caused a bubble burst. Herd behavior occurs when in the case of new financial innovations where the first investors make huge gains making more inventors expect the same. For instance, the first investors in the dot com companies made great gains making the succeeding investors buy hopes of such gains. This made the price of the assets higher than their true value. The prices later crashed without further gains assured causing a high rush of sales as investors expected prices to continue decreasing. This caused the prices to fall even further.

Regulatory failures are another possible cause of the financial crisis. These regulations are done by the governments in an attempt to reduce crisis through creating transparency in the financial institutions and to ensure that they are well equipped to honor their financial obligations. The failure of these regulations is believed to be likely to cause the financial crisis. For instance the financial crisis of 2008 is believed to have been caused by failure to regulate risks within the financial system.

The other cause of financial crisis is contagion whereby the crisis in one financial institution causes crises in other institutions. This can be referred to as spill over crisis. It can also occur when the crisis in one economy spills over to another. For instance, Thai crisis in 1997 cause crisis in South Korea through contagion.

Lastly, the other cause is in financial markets where there are strategic complementarities based on the investors generalisation. In the cases where one financial institution crashes, the investors expect that even the others will fall. They therefore withdraw from the financial institutions. For instance, where one bank collapses, the depositors in other banks expect that even the other banks will follow the same trend. This makes them to shun their banks making them to collapse too. This causes financial crisis.

Comparison of the current financial crises (beyond 1929-1931) and others

This section seeks to analyse and compare the financial crises of the period beyond 1929-1931 and those that occurred before.

Reasons for comparison

This comparison is aimed at achieving the following factors:

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One of the factors is to establish the causes and the impacts of the financial crises in order to assess common causes and impacts. The other factor is establish the measures that were used to contain the situation in the crisis 1929-1931 and before and see what can be borrowed in the recent crises. This comparison is also aimed at tracking the trend of occurrence of the financial crisis for purposes of forecasting. We shall also establish the mistakes that were made in the past that could have contributed to the current financial crisis. The other objective of this comparison is to establish the key players in both financial crises and find out the common players. The comparison is also aimed at ascertaining the most hit sectors in both cases in order to come up with measures to mitigate the same. The other reason is to establish the repetitive causes of financial crises.

To achieve the above objectives, we shall compare the financial crisis of 2007-2010 to cove the global economic crisis of 2008-2009 and the financial crisis of 1929-1931.

The financial crisis of 1929-1931(the great depression)

This was a world wide financial crisis or economic depression. It occurred during the decade next before the Second World War. It is believed that the great depression started in 1929 and prolonged through late 1930s marking the longest depression in the 20th century (Hall & Ferguson1998, p. 46). It started with the crash of the US stock market buy was later felt in the whole world as it spread in almost all countries. The stock markets were performing very well with price of shares increasing until on the 29th October 1929 when the prices fell drastically. That day was named the black Tuesday. It then spread rapidly in all countries in the world.

This period was characterised by several factors like low purchasing power of personal income. The real income for individuals went down as prices increased. People were unable to buy the commodities they same commodities they could afford before. The tax revenue to the government also reduced because almost all sector’s profitability declined. International trade was also hard hit. It dropped by half top two thirds due to low demand of commodities in the export market. The level of unemployment in the US also increased to 25% because companies could not afford to hire more employees. In other countries, the level of unemployment went up to about 33% with companies making losses. Cities that are dependent on heavy industries like construction were also affected heavily as construction was stopped in most nations. Farmers and rural area dwellers also suffered greatly (Kelley 2010, P.1). The prices of crops fell by about 60% making farmers to suffer loss. The most affected were the primary sectors. These include those dealing in cash crops and mining industry in the same category. Most of the countries were on their journey to recovery around 1930s but others felt the pinch until around 1945.

Causes

One on the causes of the great depression is the crash of the stock market in 1929 in the United States. This happened on what is referred to as black Tuesday when the stock market in US crashed causing the stock brokers to lose about $40 billion dollars in profit within two months (Hall & Ferguson 1998, p.34). This caused America to get in to great depression that late spread to almost every country in the world.

The other major cause is massive bank failures in America. Over 9000 banks failed in 1930s following the crash of the stock market. People had borrowed to invest in the stock market which later failed and were unable to repay the loan. This caused many people to lose their savings because the deposits were unsecured. The remaining banks could not give loans for fear of the same crash. This reduced the level of expenditure below the reasonable level.

Another factor was decline in purchasing at all levels. Due to economic unrest following the stock market crash, people reduced the number of items they bought causing a reduction in general production and workforce. People were retrenched and unemployment level rose to 25%. Firms suffered loss and many closed down.

American economic policy with Europe was the third cause. This began with creating smooth-Hawley Tariff in 1930 that imposed high tax on imports in the name of protecting the failing American local industries (Hall & Ferguson1998, p.34). This reduced international trade causing countries relying on exports to suffer big losses. This is how the crisis spread to almost all countries in the world.

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The other cause is draught conditions which contributed indirectly to the crisis. There was a great draught in Mississippi valley in around 1930s which made farmers to lose a lot of profit to an extent that they could not settle their bank debts. The tax revenue also decreased greatly since thee farmers could not pay taxes. This contributed to failure of banks.

The financial crisis of 2007-2010

This is the most recent global financial crisis. According to Scaliger (2009, p.1) this crisis was started by liquidity deficit experienced by the banking system in the United States that was caused by several factors. The stock markets around the world performed poorly, most of the financial institutions collapsed as a result of downturns experienced in the stock markets and the reaction of the government by bailing out the banks. This period is characterised by some key factors including the collapse of key businesses, government spending increased greatly, consumer wealth went down by a very big margin and general economic performance dropped. The key players in this crisis are financial institutions like commercial banks, pension funds, hedge funds, investment banks, insurance companies and mortgage companies. Other key players are the financial products like mortgage backed securities, mortgage loans, asset backed securities, credit default swaps and debt obligations with collaterals.

Causes of 2007-2010 financial crisis

This tend started with the decline of the interest rates in US in 2001. The mortgage loans also increased in 2002 causing the prices of houses to rise. The cost of borrowing was very low and the risk on loans was high. In around 2006, risks on loans increased as access was eased and no securities were asked by banks. The US governments had started two mortgage firms, Fannie Mae and Freddie Mac, to increase access on mortgages. They also required no securities.

In 2007, the trend changed. The interest rates went up, the price of homes fell because supply exceeded demand, but with no adjustment made on personal incomes. The credit market also contracted. As a result, people defaults on home loans increased because they were unable to finance them or sell their homes at throw away price due to depreciation Shiller J. 2008. The government mortgage lenders became bankrupt. The mortgage lender in UK called northern Rock could not raise financing and took emergency loan from the bank of England (Scaliger 2009, P. 1).

In 2008, around January, the in6terest rates were lowered in order to ease credit markets. The share price of the two government mortgage firms fell around July 2008. The firms needed to raise more capital but to no avail. The government took control of the two firms around September 2008 in order to mitigate their crisis from hitting the whole economy. The credit market contracted further. The financial institutions like Lehman became bankrupt and government bailed out AIG insurance the same month. In October, the government undertook to bail out the affected financial institutions. Due to continued credit crisis, financial institutions about 2.8 trillion US dollars and most of them collapsed causing the financial crisis.

Comparison

From the discussion above, we learn that, the key players in the two financial crises are almost the same. The financial institutions like the banks, insurance companies et cetera are the key players in the financial crises. The stock markets played big role in both crises.

Both were international phenomenon. We also learn that the US economy plays a big role in world economy. The two financial crises started in the United States and spread to the rest of the world. The decline in the international trade to as US tried to boost the collapsing local companies is one of the ways the crises spread to the rest of the world. The two financial crises were characterised by the same factors like slow economic growth, collapse of key businesses and increased government spending as the government try to bail out the collapsing countries among others. The most hit sector in the 1929-1931 financial crisis are the primary sectors while in 2007-2010 financial crisis, the financial institution are the most hit. The primary sectors are also hard hit in the current financial crisis.

Conclusion

The financial crises of a period beyond 1929-1931 are the modern form of financial crisis. The great depression of 1930s was one of the most severe forms of modern financial crises. The financial institutions are the most key players in the financial crisis. The control of the financial crisis should therefore be looked from these financial institutions. The effects of financial institutions are almost the same.

Reference list

Bonner W. & Wiggin, A., 2006, Empire of debt: the rise of an epic financial crisis. New Jersey: John Wiley and sons, Incl.

Hall E. & Ferguson J., 1998, the great depression: an international disaster of perverse Economic policies. Michigan: University of Michigan

Kelley M. 2010, About.com. American history: top 5 causes of the great depression. New York. The New York times company. Web.

Scaliger C. 2009, the new American magazine: Parallels with the great depression. Web.

Shiller J., 2008, Subprime solution: how today’s financial crisis happened and what to Do About it. New Jersey: Princeton university press

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