Could We Have Avoided the Crisis?
Unearthing the Global Financial Crisis, the Great Depression and
Minsky’s Hypothesis
Miguel Antonio B. Garcia
University of San Carlos
THE RISE OF THE GLOBAL FINANCIAL
CRISIS
Many economists did not see it coming. The
global financial crisis rocked the entire world.
Crashing stock markets, massive bank
foreclosures, and bankruptcies among
juggernaut financial institutions created was
reminiscent to the devastating global
downturn of the 1930s Great Depression.
Bursting from the housing bubble, the
takeover of Fannie Mae and Freddie Mac, and
the domino downfall of Merrill Lynch, Bear
Sterns, Lehman Brothers, and AIG, the Global
Financial Crisis shocked economists and many
began to question the existing economic
theories and models governing the global
economy.
The nature of the crisis is reminiscent
of Alan Greenspan’s warning of “irrational
exuberance” in the stock market.1 And with a
series of unfortunate events happening in the
world, Nobel Laureate Paul Krugman bemoans
the return of Depression Economics. This
would imply that the gravity of the Global
Financial Crisis requires extraordinary
economic policies used during the Great
Depression.
To summarize, problems in the sub-
prime mortgage sector became popular
explanation in ushering the Global Financial
Crisis.2 U.S. banks provided loans to high-risk
borrowers with poor credit histories. These
loans are bundled into Collateralized Debt
Obligations (CDOs) and sold to investors
worldwide. As housing prices fell and interest
rates increased, many borrowers found
themselves unable to pay their mortgages. As
1
Alan Greenspan (1996) Speech delivered during the
Annual Dinner and Francis Boyer Lecture of the
American Enterprise Institute for Public Policy
Research, Washington D.C.
2
Timeline: Credit crunch to Downturn (7 Aug. 2009).
The BBC News
http://news.bbc.co.uk/2/hi/7521250.stm#table Date
Retrieved: 17 October 2009.
a result, investors lost and refused to buy
more CDOs. Fearing the risk of having to deal
with bad loans from other banks, banks
refused to lend from each other.
The problem quickly spread to other
parts of the globe. Investment banks in the
United Kingdom, the Netherlands, Germany,
France, Belgium, China and Australia suffered
severe losses. As a consequence, many firms
canceled bonds worth billions. To control the
rise in interest rates and to stabilize money
markets, the Federal Reserve and the
European Union’s Central Bank provided
funds to banks. But despite this effort, banks
remained cautious in lending with other
banks. Low credit levels among banks,
companies and households would usher in
recessions, job losses, bankruptcies and
repossessions. The bankruptcies of Northern
Rock in the United Kingdom and Bear Stearns
in the United States forced their respective
governments to intervene and national them.
More government intervention came
with the US government passing a US$ 700
billion bailout to clean Wall Street’s bad debts
in return for shares in the banks. The US
government hopes to sell bad assets once the
housing market stabilized. Moreover,
governments worldwide followed suit in
saving their economies from total collapse.
The UK Government also launched its
own bailout of £400 billion for extra capital for
investment banks. Countries like Iceland and
France nationalized their banks while Spain,
Germany, Belgium, Greece, Denmark and the
Netherlands moved to provide deposit
guarantees. Russia provided extra
government funding to its banks while
Australia moved to cut its interest rates.
As news today perked up signs of
recovery, the Global financial crisis had left
falling stock markets, rising unemployment,
and unstable financial markets. Furthermore,
economists return to their drawing boards
and debate over theories, economic policies,
and institutional roles in national and global
Page 1 of 11
levels. But in deepening our understanding
why the Global Financial Crisis caused such
alarm to many people across borders, it is
important to understand how the global
recession mutated into such a monstrous size
by viewing its historical timeline.
CHASING THE GLOBAL FINANCIAL CRISIS3
Symptoms of the Crisis in 2007
Although the crisis drew its climax in 2008,
warning signs were already buzzing as early
as 2007. In fact, we could trace our steps
back in 2004 where U.S. interest rates rose
from 1 per cent to 5.35 per cent between
2004 and 2006. Consequentially, this slowed
the U.S. housing market. As interest rates
increased, homeowners, who at the start
could barely afford to pay their mortgages,
began to default. These defaults would later
create a ripple effect across the financial
system, and inevitably, across international
borders.
Early warning signs began as early as
February 2007 with the Hong Kong Shanghai
Banking Corporation (HSBC) announcing its
losses from US subprime mortgages. In April
2007, New Century Financial, a financial
institution specializing in subprime
mortgages, declared bankruptcy and laid-off
half of its workers. Crisis in the subprime
mortgage sector continued with Bear Sterns
declaring large lessons in two of its subprime
mortgage hedge funds. News rocked firms
like Merrill Lynch, JP Morgan Chase, Citigroup
and Goldman Sachs, which loaned the
company money.
By the second half of 2007, it was clear
that trouble was brewing in the financial
sector. In August 2007, investment bank BNP
Paribas told investors it could not take money
out of its funds because its assets were
valueless. The German Sachsen Landesbank
collapsed after investing in the subprime
market. The collapsed urged Central Banks in
the European Union, the United States,
Canada and Japan to intervene. More bad
news came in September 2007. German
lender IKB announced a US$ 1 billion loss
3
Compiled by Mauro F. Guillen, Director of the Lauder
Institute at the Wharton School of the University of
Pennsylvania,
http://lauder.wharton.upenn.edu/pdf/Chronology
%20Economic%20%20Financial%20Crisis.pdf. Date
Retrieved: 16 October 2009.
after investing in the subprime market.
Northern Rock in the United Kingdom sought
financial support from the Bank of England as
the credit crunch squeezed out its lending
ability. Soon, depositors withdrew £ 1 billion
from Northern Rock, the biggest bank run in
the UK for more than a century.
By October 2007, Swiss bank UBS
declared losses of US$ 3.4 billion from
subprime investments. Citigroup declared
subprime losses of US$ 3.1 billion. Later,
Citigroup declared losses of US$ 5.9 billion
and within six months, bowed down to a loss
of US$ 40 billion. By the end of the month,
Merrill Lynch’s CEO resigned after the
investment bank declared exposures to bad
debt amounting to US$ 7.9 billion.
A Series of Unfortunate Events in 2008
The opening of 2008 saw a downhill in the
global financial system. By January, global
stock markets suffered their biggest loss
since 11 September 2001. In February, the
British government nationalized Northern
Rock. March saw JP Morgan Chase buying
Bear Stearns as the bank continued towards
financial collapse. News in April on the
severity of the subprime markets swelled as
confidence in the UK housing market fell to its
lowest in 30 years. Persimmon, one of UK’s
house builders, announced cutbacks. In May,
the Swiss UBS launched a US$ 15.5 billion
rights issue to cover losses amounting to US$
37 billion.
By July, American Federal regulators
seized IndyMac Bank after succumbing to
tight credit pressures, falling housing prices,
and rising foreclosures. In addition, financial
authorities started assisting the US’s Freddie
Mac and Fannie Mae. These are America’s two
largest lending institutions guaranteeing US$
5 trillion worth of home loans. In August, the
UK’s Bradford and Bingley posted losses
worth £ 26.7 million in the first half of 2008
from rising mortgage arrears.
September and October 2008 saw the
most dramatic downturn in global financial
markets. In 10 September 2008, the US
government seized Fannie Mae and Freddie
Mac. The US government packaged the US$ 5
trillion of mortgages onto taxpayers. The
following day, Lehman brothers announced it
was actively looking to be sold after posting
US$ 4 billion in losses. The US government
was actively looking for potential buyers of
Page 2 of 11
the bank. On 13 September 2008, bankers
flooded the New York Federal Reserve to
discuss options on Lehman.
On 14 September 2008, the worsening
turn of events grew even sourer. Barclays
pulled out its bid to buy Lehman, Bank of
America eyed on buying Merrill Lynch at US$
29 per share, and the Federal Reserve
declined to provide financial support facility
for Lehman. With all the major declines,
Lehman Brothers posted for bankruptcy on 15
September 2008. Lehman’s bankruptcy
declaration was the largest in US financial
history at US$ 639 billion. This trickled into
the financial markets with all shares plunging
into a nosedive. The Dow Jones Industrial lost
504 points to close at 10,917.51. European
stock exchanges fell. The London FTSE 100
closed with a 210 point drop to close at
5,202.4. At the same time, the US
government agreed to bail out insurance
giant AIG with a US$ 20 billion lifeline.
The following days saw a plunge in
Asian markets. Japan’s Nikkei index closed
570 points down at 11,609. Back in Wall
Street, Goldman Sachs reported a 70 per cent
drop in profits. The London FTSE 100
continued to fall while the Dow Jones
experienced erratic changes but closing 141.5
points up. The US government agreed to
provide US$ 85 billion to AIG in return for 80
per cent equity stake in the company.
Russia suspended stock market trading
for two days. Barclays agreed to buy
Lehman’s North America banking divisions.
Morgan Stanley’s shares fell 30 per cent and
sought for a merger with Wachovia. The FTSE
closed below 5,000 since May 2005 and the
Dow Jones lost 449 points to close at 10,609.
In Asia, the Nikkei continued to drop closing
260 points lower at 11,489. But in 19
September 2008, the Nikkei closed higher by
431 points and the Russian stock markets
bounced back with the government
announcing to pledge 500 billion rubles. On
Wall Street, the Dow Jones Industrial closed
up by 368.75 points to 11,388.44 points. At
the same time, Bush Administration
announced its proposed Bailout Plan to
Congress. U.S. Treasury Secretary Henry
Paulson immediately started creating the
package.
Later in the week, Morgan Stanley and
Goldman Sachs downgraded their status from
investment banks to traditional commercial
banks. In Asia, Japan’s Nomura bought
Lehman Brother’s Asian operations and in
Britain. Ireland became the first state to
declare recession. General Electric saw its
profits slipping. Thereafter, Federal regulators
seized Washington Mutual, America’s largest
savings and loan company, and sold to JP
Morgan Chase. In Europe, authorities in the
Netherlands, Belgium and Luxembourg
agreed to provide € 11.2 billion.
As September closed, the British
government nationalized Bradford and
Bingley as it took over £ 50 billion in
mortgage and loans books. The news brought
the London FTSE to its worst ever trade in
days. In Iceland, the government took control
of one of the nation’s biggest banks. In
America, Citigroup planned to take Wachovia
for $ 2.1 billion in stock. However, Wall Street
saw its largest fall with the Dow plunging a
historic 777 points.
At the beginning of October 2008, the
US Senate approved the bailout package,
passing a US$ 700 billion relief bailout. In a
dramatic upset, Citigroup let go of Wachovia
as Wells Fargo took control. The FTSE saw its
largest one-day point fall. The British Treasury
announced a £ 500 billion bank rescue
package. The Federal Reserve, the Bank of
England and the European Central Bank all
cut half a point off their key interest rates in
the first unscheduled rate move since the
aftermath of 11 September 2001. The London
FTSE continued to suffer as it closed down
238.5 points at 4,366.7. The Dow dropped
189 points despite global interest rate cuts. In
a five-year low, the Dow closed to 8,579
points.
In Asia, recession fears deepened as
Japan’s Nikkei index falling almost 10 per
cent. Singapore officially slid into recession.
Back in London, the FTSE 100 plunged more
than 10% to 3,932.1 points, falling under the
4,000 mark in five years. In Wall Street, the
Dow crashed almost 700 points to 7,882 in
the first few minutes of trading. In 15 October
2008, the FTSE suffered its fifth biggest fall in
history, closing down 7.16 per cent.
Meanwhile, the Dow Jones dropped by 7.8 per
cent. American banks J.P. Morgan and Wells
Fargo reported falling profits while US retail
sales suffered their biggest fall in three years.
By the following day, the Dow Jones
Industrial Average made strong gains of 401
points. But in Asia, Japan’s Nikkei suffered its
Page 3 of 11
worst fall since 1987, and the FTSE 100 index
slumped to 3,861. In Switzerland, UBS
received a capital injection from the
government of more than $ 13 billion to cover
liabilities arising from the credit crunch.
By the end of October, American bank
Wachovia reported a deficit of US$ 24 billion,
its biggest quarterly loss since the onset of
the credit crunch. Government figures
confirmed that the U.K. economy shrank with
the biggest GDP drop since 1990. Stock
markets around the world plummeted.
Investors feared that governments,
central banks and finance ministers would not
be able to stop the deepening of a global
recession. The Dow Jones opened with a drop
of almost 5 percent drop in its points. The
Japanese Nikkei dropped 9.6 per cent while
Germany's DAX index plunged as much as
10.8 percent. France's CAC 40 slid 10 per
cent and Britain's FTSE 100 fell by 8.7 per
cent. Hong Kong stocks fell by 8.3 per cent.
Many other Asian markets stock prices also
plunged. Investors pulled out money from
emerging market economies in Eastern
Europe, Latin America and Asia on fears
vulnerable countries would default on their
debt.
The Crisis’ Black Shroud4
After tumultuous rollercoaster in the global
financial markets, the United States
announced in November 2008 the loss of
240,000 jobs in October 2008. Job losses
would continue in 2009 with unemployment
reaching 8.5 per cent in March. On the other
side of the Atlantic, the Eurozone slipped into
recession after EU figures showed the
economy shrinking by 0.2% in the third
quarter.
To aid nations from further financial
collapse, the International Monetary Fund
(IMF) approved a US$16.4 billion loan to
Ukraine to bolster its economy from the
financial turmoil. It also approved a U$ 2.1
billion loan for Iceland. The Bank of
England continued slashed interest rates from
4
Taken from the BBC News Online,
http://news.bbc.co.uk/2/hi/7521250.stm#table and
the Council on Foreign Relations,
http://www.cfr.org/publication/18709/. Date
Retrieved: 16 October 2009
4.5% to 3%, the lowest level since 1955.
Following suit, the European Central Bank
lowers Eurozone rates to 3.25% from 3.75%.
In Asia, China set out a two-year US$586
billion economic stimulus package to help
boost the economy by investing in
infrastructure and social projects, and cutting
corporate taxes.
The US government also announced
a US$ 20 billion rescue plan for Citigroup after
its shares plunged by more than 60% in a
week. On the other hand, the US Federal
Reserve announced injecting another US$
800 billion into the economy to stabilize the
financial system and encourage lending.
Alarmed by the spread of the crisis, world
leaders of the G20 met in Washington, DC in
14 November 2008 to call for reforms in the
global financial system.
By December, the National Bureau of
Economic Research announced the United
States was in recession. The committee
concluded that the US economy started
contracting in December 2007.
More bad news followed. Bank of
America announced up to 35,000 job losses
over three years following its takeover of
Merrill Lynch. President George W. Bush
announced the US government would use up
to US$ 17.4 billion of the US$ 700 billion
bailout package to help General Motors, Ford
and Chrysler. In the stock market, the London
FTSE 100 closed down 31.3 per cent lower
since the beginning of 2008, the biggest
annual fall in the 24 years since the index was
started. In Germany, the Dax in Frankfurt lost
40.4 per cent over the year while the French
CAC 40 dropped 42.7 per cent.
Obama’s Promise
With the opening of 2009, President Barack
Obama promised to address the global
financial crisis as his main priority. However,
political problems across the world were
brewing for the failure of many governments
to cope with the global financial crisis. In
Iceland, the Icelandic government coalition
collapsed. The governments of Belgium and
Latvia would soon follow crumbling.
In response to the problem, President
Obama signed the US$ 787 billion stimulus
Page 4 of 11
package into law. Furthermore, Obama
rushed to implement early counterattacks.
U.S. Treasury Secretary Timothy Geithner
unveiled details of a plan for "stress tests" at
big U.S. banks to determine the strength of
their balance sheets. The move came as part
of a financial stability plan. Other measures
included a public-private investment program,
and the Term Asset-Backed Securities
Lending Facility. And following the November
2008 meeting, leaders of the G20 met in
London on 2 April 2009 to pledge triple
funding for the International Monetary Fund.
Finally, Treasury Secretary Geithner
and White House economic adviser Lawrence
Summers introduced proposals to reform the
US financial regulatory system. The plan
called for additional oversight powers to the
Federal Reserve to better monitor systemic
risk. The plan also called for higher capital
and liquidity requirements for banks, new
reporting requirements for issuers of asset-
backed securities, and the creation of a
council of regulators aimed at coordinating
different existing regulators.
It is clear that from the historical
developments woven about the financial
crisis, origins run parallel to the set of events
of the Great Depression in 1929. Although
Krugman, as he introduced the idea of
Depression economics returning in the foray,
the damage of the Global Financial Crisis is
not as catastrophic as opposed to the Great
Depression, but the origins leading to its
inception are similar. In fact, the analysis of
the bursting of the subprime mortgage
bubble, the defaults in mortgage debts, the
collapse of financial institutions, the increase
in unemployment, and the abysmal fall of
many countries into recession follow the
same thread followed by the Great
Depression. We will discuss the economic
analysis in the succeeding section.
LESSONS FROM THE GREAT DEPRESSION
The 1929 Market Meltdown
To appreciate the gravity of the Global
Financial Crisis of 2008, it is important to turn
back the hands of time and place it in context
with the Great Depression of 1929.
Undoubtedly, the Great Depression remains
the most piercing memory in economic
history. Between August 1929 and the end of
1930, factories and mines suffered heavy
blows from sharp declines in sales. This led
them to cut 31 per cent of production.
Consequentially, laying-off their workers was
the most logical option. Within this period, the
unemployment rate tripled from 3.2 per cent
to 8.9 per cent (Frank and Bernanke, 2004: p.
427; Mankiw, 2007: pp. 317-318; Backhouse,
2002: p. 215). Financial markets were also
not spared. Frank and Bernanke (2004) and
Backhouse (2002) narrated how the Great
Crash in October 1929 led the stock market to
lose nearly a third of their value in three
weeks.
The viral spread of the Great
Depression extended its wrath beyond 1930.
Production slowdowns and rising
unemployment continued to 1931. Frank and
Bernanke (2004) continued that the United
States economy had a temporary period of
stability but the Depression nosedived during
mid-1931.
Backhouse (2002) narrated that US
industrial production to almost half from its
1929 production levels. Unemployment
continued to climb and it reached its peak in
1933 with 25.2 per cent of the American
workforce without work (Frank and Bernanke,
2004:428). However, unemployment eased
after that (Backhouse, 2002: 215). Mankiw
(2007) and Blanchard (2006) provided data
on the U.S. unemployment rate. The data
showed a continuing decrease in
unemployment levels and in 1937, the
unemployment rate decreased to 14.3 per
cent. But the years succeeding it showed that
unemployment remained at that level.
Frighteningly, the Great Depression
also brought about a global contagion to
other economies around the world.
Backhouse (2002) enumerated how countries
suffered from large declines in unemployment
levels. In 1933, Germany’s unemployment
was 26 per cent, the Netherlands had 27 per
cent, Norway had 33 per cent, and the United
Kingdom had 21 per cent. In Germany, the
Great Depression paralyzed economic activity
as hyperinflation hounded the value of the
German mark.
Additionally, many European countries
had large intergovernmental debts from the
First World War. They borrowed among
themselves and from the United States. They
thought that imposing huge reparations on
Germany’s defeated Weimar Republic would
recover their costs (Backhouse, 2001: p. 216).
Page 5 of 11
However, these measures only insinuated the
rise of an angry and vindictive Adolf Hitler
and his Nazi German Reich (Frank and
Bernanke, 2004: p. 428).
The Scare of Depression Economics
It was clear that the existing economic
theories governing the global market failed to
cushion economies from the Great
Depression. However, many economists, even
today, continue to wrestle their ideas and
theories about the cause of the Great
Depression. Frank and Bernanke (2004) listed
a list of theories economists have offered to
explain the phenomena. First, some
economists would point out the Great Crash
in Wall Street in October 1929 as the main
culprit. Second, some economists suggested
that free-market economies like the United
States and many capitalist nations were
naturally unstable. However, the consensus
among many economists today attributed the
Great Depression to poor economic
policymaking by both the United States and
the industrialized nations.
To them, there are several arguments
why the Great Crash of 1929 and the
instability of free markets are wanting of
validity. First, the October 1929 crash could
not have triggered the Great Depression
because similar succeeding stock crashes
similar to the 1929 event did not slow
economic activity significantly. In addition,
the Great Crash was confined only to the
United States while the Great Depression
enveloped throughout a lot of countries
around the world. Second, Frank and
Bernanke (2004) found the free market
argument implausible because of the
succeeding trends of growth and prosperity
throughout the industrialized world after the
Second World War.
Blanchard (2006) added to the stock
crash argument that a recession had already
started before 1929. However, he also noted
the importance the crash played in the Great
Depression saga. In contrast, the depression
could not have triggered the Depression
because no major economic news was known
before the crash. Blanchard blamed the burst
of the speculative bubbles: stockholders that
purchased at high prices anticipated for
higher future prices but they went frantic and
hurriedly sold their stocks. At this rate, prices
dropped enormously. In effect, the crash
decreased consumer wealth and increased
uncertainty.
Furthermore, Mankiw (2007) looked
into the cause of the Great Depression. He
looked at the issue based on the shifts of the
IS and LM curves. Some economists would
argue that the cause of the Depression was a
significant shift of the IS curve to the left.
Called as the spending hypothesis,
economists blamed the significant fall of
goods and services as the cause of the
Depression. Looking at the trend of various IS
components, Mankiw saw falling consumption
levels. On the other hand, some economists
would also consider the fall in investment
spending in the housing market. In the early
1920s, the housing market formed a bubble
and the demand for housing became
excessive. Additionally, he also mentioned
the decrease in immigration during the 1930s
(Mankiw, 2007: pp. 318-319).
Finally, Mankiw (2007) and Blanchard
(2006) mentioned several policy mistakes the
United States government during the Great
Depression. First, Mankiw narrated the
concern among US politicians in balancing the
budget. The US Congress passed the 1932
Revenue Act, which increased various taxes,
particularly targeting on lower and middle
income families. On the other hand,
Blanchard (2006) saw that a large decrease in
the nominal stock as one important culprit
that triggered the Depression. Data showed
that the nominal money stock decreased from
US$ 26.6 billion in 1929 to US$ 19.4 billion, a
27 per cent decrease in money stock. We will
discuss this further on the discussion of the
money hypothesis.
A Domino Effect: Banking Failures
during the Depression
Mankiw (2007) added that poor banking
regulation may have exacerbated the
recession. Specifically, he emphasized the
inadequacy of banks to support investment
spending. Hubbard (1994) explained that
during the United States suffered periodic
financial panics during the late nineteenth
and early twentieth centuries. Backhouse
(2002) supported this observation by noting
that the early twentieth century struggled
with much economic instability during the
inter-war period. The world experienced a
brief boom in 1920 but it soon suffered from a
very sharp depression in 1921 (Backhouse,
Page 6 of 11
2002: 214). The period met with falling prices
and rising unemployment levels.
Financial panics created violent
fluctuations in the financial markets. These
panics usually arise when bad news from a
firm or bank echoed an increase in interest
rates and a fall in stock prices. Frantic
depositors immediately withdrew available
lending funds. As a result, money supply
decreased. In sum, the decline in money
supply and its behavioral impacts on
borrowers swelled reductions in economic
activity (Hubbard, 1994: p. 704).
Furthermore, Hubbard (1994) also
mentioned Bernanke’s work how financial
panics and bank failures worsened the Great
Depression. Depositors converted large
quantities of bank deposits to currency or
risk-free securities. Fearing of losing its
lifeblood, banks, in turn, reduced its
willingness to lend among risky borrowers.
The domino effect would throb as interest
rate spreads for risk-free securities widened.
As a result, household, business and
agricultural spending declined sharply.
In terms of financial markets, Bernanke
and James (1991) reported that among the 24
countries in 1931, financial panics happened
in not only in the United States but also in
Austria, Germany, and many Eastern
European, South American, and Middle
Eastern countries. Among the other countries
hit by the banking crisis included France,
Belgium, Estonia, Hungary, Italy, Latvia,
Poland, and Romania. Countries classified as
having been spared from a banking crisis
included Australia, Canada, Czechoslovakia,
Denmark, Finland, Greece, Japan,
Netherlands, Norway, New Zealand, Spain,
Sweden and the United Kingdom.
Furthermore, Bernanke and James
(1991) pointed out countries with a banking
crisis experienced greater succeeding
declines in output and employment as
opposed to countries spared from the crisis.
Finally, they saw that industrial productivity
level disparity was greatest in 1932, a year
after the banking crisis. Countries with a
banking crisis declined at an average of 16
per cent while countries spared from the
crisis only declined at 2 per cent.
Arguments on the Money Hypothesis
Many economists considered money as the
root that paralyzed the global economy in the
1930s. They argued that the decline in money
supply led to a contraction of the LM curve.
Moreover, Milton Friedman and Anna
Schwartz blamed the actions of the Federal
Reserve (Mankiw, 2007: 320; Brue and Grant,
2007:500-501). To Friedman (1969), U.S.
monetary authorities followed deflationary
measures. Friedman saw in his empirical
findings that the quantity of money fell by
one-third. This is caused by the Federal
Reserve’s policies of forcing a sharp reduction
in money supply.
However, Mankiw (2007) and
Blanchard (2006) took a different route to
explain the role of monetary policy during the
Depression. Mankiw (2007) would argue that
the behavior of real money balances did not
fall from 1929 to 1931; monetary policy would
have been found as the prime suspect in
shifting the LM curve downwards if real
money balances fell. Although real money
balances started falling from 1931 to 1933,
arguing a shift in the money supply would be
tenuous. Second, using the LM curve in
triggering the Depression would imply a rise
in interest rates. However, Mankiw pointed
out that the data contradicted this argument
as interest rates fell from 1929 to 1933.
On the other hand, Blanchard (2006)
explained this in relation to banking failures.
Bank money forged a relationship between
the nominal money stock and the monetary
base. Specifically, the money stock depends
on the monetary based and the money
multiplier. In turn, the money multiplier is a
function of the reserves kept in proportion to
deposits and the money held by people as
currency. Going back to historical data, the
monetary base increased from US$ 7.1 billion
in 1929 to US$ 8.2 billion in 1933. This trend
showed that the money multiplier – not the
monetary base – led to the decrease in
money supply.
Blanchard (2006) would agree with
Hubbard’s (1994) observation that bank
failures may have insinuated the depression.
A large decline in output led to more inability
for borrowers to repay their loans to banks. In
turn, more banks became more insolvent and
some went bankrupt. From 1929 to 1933,
around 4,000 of the 20,000 operating banks
closed down. Hence, bank failures led to the
reduction in the money supply.
But Blanchard also noted that the
route bank failures decreased money supply
Page 7 of 11
was indirect. Depositors were frantic in
withdrawing their money from banks and
consequentially, increased the ratio of
currency to checkable deposits since
withdrawals converted checkable deposits
into currency. This pulled down the money
multiplier (Blanchard, 2006: pp. 478-479).
Hence, the real money stock (M1/P) was fairly
constant. The fall in the money supply was
complemented with a fall in the price level.
This would imply that the LM curve remained
relatively unchanged.
Prices and the Money Hypothesis
Reflecting on the arguments presented, we
see a potential opening that may explain the
cause of the Great Depression: falling prices.
From 1929 to 1933, the price level fell 25 per
cent (Mankiw, 2007: p. 321). Furthermore,
Mankiw (2007) explained that many
economists found the aggravating effects
deflation has brought, particularly in ushering
high levels of unemployment and very low
income. This brought a whole new angle into
the money hypothesis.
Previously, economists believed that a
decline in the price level would automatically
push the economy back toward full
employment levels. However, economists
found this self-correcting hypothesis
problematic. They argued using the debt-
deflation theory and the role of expected
inflation (Mankiw, 2007: p. 321). In the debt-
deflation theory, unanticipated changes in the
price level redistributed wealth between
debtors and creditors. Given that real money
balances are denoted as M/P, a fall in the
price level raised the amount of debt. This
enriched creditors and impoverished debtors.
Furthermore, it would be plausible to assume
that debtors had larger propensities than
creditors; hence, the net effect of debtors’
spending reductions as opposed to the
increases from creditors contracted the IS
curve and in effect, lowered national income.
To connect with impact of expected
inflation, Mankiw (2007) emphasized the
difference between nominal and real interest
rates. Investments depend on the real
interest rate while money demand depends
on the nominal interest rate. Expected
inflation came into play as we adjust the
nominal interest rate with expected inflation
to derive the real interest rate. This is
expressed as i – πe. With falling prices, real
interest rates would become higher than the
nominal interest rate. This would lead to
lower investment spending and in turn,
shifting the IS curve downward. As a result,
the real interest rate rose, the nominal
interest rate fell, and national income fell.
In less technical terms, firms expecting
a deflation would be reluctant in borrowing to
buy investment goods because repaying the
loan in the future would become more
expensive. Consequentially, planned
expenditure and, in turn, income fell (Mankiw,
2007: p. 323). In addition, Blanchard (2006)
provided data that showed that the rate of
deflation increased to 9.2 per cent in 1931
and 10.8 per cent in 1932.
The domino effect continued with
income reducing the money demand and the
nominal interest rate. However, nominal
interest fell less than expected deflation and
the real interest rate increased (Mankiw,
2007: p. 323). Blanchard (2006) reported that
the nominal interest rate fell from 5.3 per
cent in 1020 to 2.6 per cent in 1933. Real
interest rates rose to 12.3 per cent in 1931,
14.8 per cent in 1932 and 7.8 per cent in
1933. To support, Mankiw (2007) would point
out that economists implied the severity to be
caused by the Federal Reserve. The
destabilization originated from the logic that a
fall in the money supply would lead to a fall in
income.
HYMAN MINSKY’S REVENGE ON THE
GLOBAL FINANCIAL CRISIS
The perplexity among economists with the
birth of the Global Financial Crisis led many
economists to return to their drawing boards
and reflect upon its nature and cause.
Unearthing from the literature, economists
found that the Global Financial Crisis, like
many recessions in the past, followed a
consistent sporadic growth path. Such
observations were kept in the research of
Hyman Minsky, a member of the Post-
Keynesian School. Shostak (2007) would
reveal that Minsky had different views from
most mainstream economists. In his mind,
Minsky argued that even in the absence of
external shocks, the capitalistic economy had
an inherent tendency to develop instability.
Minsky would narrate that in times of
economic prosperity, firms in the economy’s
profitable areas are rewarded by raising their
Page 8 of 11
level of debt. This would mean that more
borrowing implies greater profits sown. In
turn, rising profits attract other businesses to
join and raise their level of debt. With a well-
performing economy and healthy balance
sheets among borrowers, lenders become
more eager to lend. Later, the pace of debt
accumulation rises much faster than
borrowers' ability to repay the debt. At this
stage, an economic bust is seen in the
horizon.
Furthermore, Shostak (2007) would
add that Minsky distinguished three kinds of
borrowers playing in financial markets. First,
hedge borrowers are those borrowers that
could meet all their debt payment from cash
flows. Second, speculative borrowers would
meet their interest payments but they
constantly roll over on their debt to repay the
original loan. Finally, Ponzi borrowers can
neither repay their interest nor the original
loan. Ponzi borrowers heavily rely on the
rising value of their assets to refinance their
debt. In his Financial Instability Hypothesis,
Minsky (1992) revealed that the longer the
period of economic prosperity, the more
fragile the capitalistic system became.
Particularly, he described the transition from
having a financial structure full of hedge
borrowers to a structure where Ponzi
borrowers dominated. Without doubt, this was
exactly the situation that happened in
subprime mortgage crisis.
Furthermore, Minsky (1992) would
correctly predict in his hypothesis that in
times of economic prosperity, banks and
other financial intermediaries would
sophisticate in assets acquisition and
liabilities marketing. In the pursuit for greater
profits, financial intermediaries repackaged
debt and lured investors to buy them. In
effect, financial players end up placing their
money in various little investments. Among
these include subprime-mortgage securities.
The sophisticated packaging and high rate of
return makes these subprime mortgage debts
attractive.
Minsky injected a bit of psychology into
his theory. Borrowers and lenders become
reckless in both borrowing and loaning due to
the increasing profit they accumulate over
time. But as the capitalist system begins to
thin, economic conditions would shift the
tides and borrowers realize that they are
unable to finance their debt. The domino
effect would roll and lenders would curtail
their supply of funds. In the Global Financial
Crisis, This accurately described the behavior
banks exhibited when many borrowers
defaulted. In turn, borrowing intermediaries
like Lehman Brothers and Bear Stearns
suffered heavily on this blow and bankruptcy
soon followed. This paralysis espouses the
rise of a financial crisis.
To summarize Minsky’s economic
system, Taylor and O’Connell (1985) modeled
Minsky’s financial theories. Looking closely to
Minsky’s thinking, the key assumption is that
wealth is determined by the value of firms’
assets in response to economic confidence.
The second assumption involved high
substitutability between firm liabilities and
public portfolio. They correctly forged today’s
recession with their model that falling
anticipated profits would lead wealth to
contract. In effect, the public would shift their
preferences from portfolio to money. This
shift of currency as opposed to securities
would increase interest rates, lower profits
and espouse debt-deflation. Here, the link
between the Global Financial Crisis and the
Great Depression are clear.
However, Shostak (2007) cautions us
that Minsky simply described the financial
crisis. Digging well into Minsky’s logic, it is
revealed that the problem of the financial
crisis is not credit per se, but the existence of
unbacked credit created by banks. Many
would argue that Minsky’s hypothesis would
only be limited to modern capitalist
economies, but the existing financial
framework of unbacked credit supports
Minsky’s logic. Even more careful
examination would reveal that the reckless
incentives among lenders and borrowers and
lenders are actually caused by the existence
of a Central Bank.
Central banks provide avenues for
unbacked credit. To be precise, a bank short
of a given amount can sell some of its assets
to the Central Bank for cash. Furthermore,
banks can also secure money by borrowing to
the Central Bank. The interesting revelation is
found in the Central Bank’s ability to make
money out from nowhere. Hence, unbacked
credit arises. Shostak (2007) would elucidate
our thinking that Minsky needed to add the
institutional existence of the Central Bank to
complete the logic inefficiencies happening in
the capitalist structure.
Page 9 of 11

CONCLUSIONS
Krugman (2009) reminded economists not to
be complacent about the state of economics
science, particularly that of macroeconomics.
After all, the purpose why we touched on the
Global Financial Crisis, the Great Depression
and Minsky’s Financial Instability Hypothesis
is to reflect and understand why seemingly
similar problems of bubbles, bursts and
recessions continue to haunt us over and over
again.
Economists must learn to accept that
the assumed idealistic Fairytale Utopia of a
rational, perfect, and self-correcting
competitive market is far from reach. In fact,
it is impossible to have such criteria framing
the real economic world today. The real world
exists where externalities frolic, market
imperfections are in vogue, irrationality is a
way of life, and complications are
commonplace.
In short, mainstream neoclassical
economists must keep themselves in touch
with the world. Instead of hanging around
inside their lecture rooms, solving abstract
mathematical arguments, and complicating
economics even further with a shroud of
models, economists must see the world at its
utmost. The reason why people remain
skeptical about economists is precisely
because they have not predicted well real
market situations. Without doubt, there is a
fundamental scientific crisis in economics.
The dismal science prides of its ability to
encroach other disciplines. Furthermore, it
boasts of its logic and mathematical proofs to
extract the essence of market interactions
and human behavior.
However, this same pride and
boastfulness are the very same human vices
that would bring down the collapse of the
discipline. In particular, its stubbornness to let
go the assumptions of rational choice and
market efficiency remain a hindrance from
further scientific improvement. Holding these
assumptions as axioms places the future of
the economics profession in peril. The rise of
new research in behavioral finance and
behavioral economics, and even Minsky’s
contention of financial instability in capitalist
economies, would reveal that the behavior
among borrowers, lenders and other financial
players should not be placed as a given.
Furthermore, the onset of a return of
‘another Great Depression’ made us return to
Keynesian economics. We found refuge at
how government intervention in market
interactions remains a key ingredient in
saving economies from total collapse.
Furthermore, revelations of the nature of
credit would also allow us to think twice of the
role of Central Banks. Hence, it was a correct
observation among heads of state that the
global order needs an ambitious reform in the
global financial system. In particular, it is
crucial that we find mechanisms to deal with
the problem of unbacked credit to keep
capitalist economies from collapsing.
It is clear that government intervention
remains the most effective solution in battling
recessions and depressions. Time has tested
and Keynesian economics should not be
laughed at. However, as to how the
intervention must be taken, that remains
another question. Since we have unraveled
the contradictory situation monetary policy
places itself in the role of stabilizing the
financial market, thorough assessment must
be placed on the regulation of Central Banks
in terms of its interaction with private banks.
In conclusion, much work is to be done
to bridge the great divide of economics. The
role in economics is not only to immediately
diagnose the viral growth, but also to stir
away markets and institutions from getting
into the trap of recessions and depressions. In
this case, economists must be market
physicians who promote the well-being of
every human being in the economy. But to do
that, they must do away with the idea that
mathematics supersedes reality. Reality and
the world context must govern the dictates of
mathematical reasoning that hounds
economic literature. There should not be
disconnections between our tools and the real
things happening around us.
As Krugman would correctly describe
it, the key to stopping or minimizing future
recessions and depressions is found in our
ability to go away from the ‘neat and wrong
solutions’ and really start handling the dirty
work.
REFERENCES CITED
Backhouse, Roger E. (2002) The Penguin
History of Economics. England:
Penguin Books.
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The Gold Standard, Deflation and
Financial Crisis in the Great
Depression: An International
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Financial Crises, R. Glenn Hubbard, ed.
Chicago: University of Chicago Press.
Blanchard, Olivier (2006) Macroeconomics, 6th
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Brue, Stanley L. and Randy R. Grant (2007)
The Evolution of Economic Thought, 7th
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Frank, Robert H. and Benjamin S. Bernanke
(2004) Principles of Economics, 2nd ed.
New York: McGraw-Hill/Irwin.
Friedman, Milton (1969) The Optimum
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Chicago: Aldine.
Hubbard, R. Glenn (1994) Money, the
Financial System and the Economy.
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Krugman, P. (2009) How Did Economists Get
It Wrong? The New York Times
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http://www.nytimes.com/2009/09/06/magazin
e/06Economic-t.html?
th=&emc=th&pagewanted=print. Date
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Paul Krugman (2008) Depression Economics
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Mankiw, N. Gregory (2007) Macroeconomics,
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Minsky, Hyman P. (1992) The Financial
Instability Hypothesis. Working Paper
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Shostak, Frank (2007) Does the Current
Financial Crisis Vindicate the
Economics of Hyman Minsky? Ludwig
von Mises Institute Website,
http://mises.org/story/2787. Date
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Taylor, Lance and Stephen A. O’Connell
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