[In-Depth Look] Why We Worry About the Great Depression

Kyung-Yeop Jo, Director of Economic Research Office, Korea Economic Research Institute

Although it does not exactly coincide with past economic crises, there are many comparable similarities between the current and previous crises. Every crisis begins when a bubble, created by the government artificially stimulating the economy through monetary expansion and increased fiscal spending, bursts. To revive the economy depressed by the Spanish flu, the United States injected massive amounts of money starting in 1921. As the money supply increased, interest rates fell and stock prices soared, leading to widespread economic optimism. When the Federal Reserve Board (FRB) sensed the market was overheating and shifted to a tightening monetary policy, stock prices plummeted and unemployment surged.

The global financial crisis also arose due to government policies aimed at artificially stimulating the economy. In response to concerns that the dot-com bubble burst and the 9/11 attacks might trigger a severe economic crisis, the FRB implemented liquidity expansion policies. The excess liquidity in banks, combined with the Bill Clinton administration’s policy to promote affordable housing, led to the formation of a housing bubble. As interest rates rose, the number of borrowers defaulting on their debts increased. Not only commercial banks that lent to these borrowers but also mortgage-specialized financial companies, investment banks (IBs), institutional investors, and other financial firms that sold various derivatives backed by mortgages faced a chain liquidity crisis, resulting in a wave of bankruptcies.

The current crisis seems different from the past in that it started in the real economy. However, warnings had already been issued before the outbreak of the novel coronavirus disease (COVID-19) that the global economy was following the path of the Great Depression. Prolonged low interest rates following the global financial crisis led to a surge in investments in risky and illiquid assets. Investments in BBB-rated bonds, the lowest investment grade, tripled compared to 2008. Over the past five years, housing prices in major cities have surged by more than 50%. The bubbles that were bound to burst are now collapsing due to the COVID-19 crisis.

The crisis response method of trying to cure misfortune caused by money printing with more money printing is always the same. Governments that criticized banks for reckless lending scold them for being too cautious when a crisis hits. At a time when resources should be used most efficiently, unproductive public works are undertaken and public jobs like picking up trash are increased. Voices rise claiming that it is beneficial for the economy for citizens to consume everything they have and empty their pockets. If there is no money, they generously offer gift certificates. Absurd policies that believe mere spending, regardless of where it is spent, will bring prosperity dominate the scene.

The time it takes for a recession to end varies. The Great Depression lasted 12 years, whereas the global financial crisis ended in four years. The weaker the fundamental strength of the economy, the deeper and longer the depression lasts. After World War I, the global economy lacked the capacity to overcome the Great Depression because it failed to solve the challenge of converting wartime production facilities to peacetime use.

The fundamental strength of our economy is weaker than ever. The GDP gap, which indicates the difference between potential growth rate and real growth rate, turned negative in 2013 and the gap has been widening since. We are repeating the policy mistakes made by the U.S. government during the Great Depression. At that time, the U.S. government introduced minimum wage and limited maximum working hours to 40 hours per week under the pretext of improving workers’ purchasing power. It also regulated production facilities, operating hours, and output to prevent economic concentration, missing the opportunity to invest in emerging new industries such as aviation. Moreover, sharply raising corporate, income, and inheritance taxes, and increasing spending on unproductive areas such as public investment, public jobs, and welfare, contributed to the prolonged depression. These policies closely resemble those of the current government.

It must be kept in mind that government efforts to fight recession can actually prolong it. As Ludwig Edler von Mises said, “A recession is the healing process of a wounded market.” If we do not want to experience the Great Depression again, we must abandon anti-market policies at least once and allow the market time to heal.

Jo Kyung-yeop, Director of Economic Research, Korea Economic Research Institute