Question

Compare changes in the initial adjustments to the regulation of business and financial institutions during the Great Depression and the Covid19 recession.

Answer 1

The Great Depression was primarily due to a failure of monetary policy. Under the rules of the gold exchange standard that was being operated at that time, countries with net inflows such as the US or France should have allowed their money supplies to expand, fuelling increased spending, higher inflation, and a reversal of the capital inflows. This adjustment mechanism was short-circuited by sterilization - i.e. by open market operations by the Fed and the Bank of France which offset the impact of gold inflows.

Although the Fed cut the discount rate six times between October 1929 and the end of 1930 - from 6.0% to 2.5% and later to 1.5% in 1931 - the size of the Fed's balance sheet consistently declined for a whole year after the stock market crash. On the asset side, the Fed's holdings of gold increased steadily by about US$1 billion as funds from Europe poured in, but Fed credit - bills bought and discounted together with holdings of securities - declined by over US$1 billion, with the result that high-powered money or the monetary base also declined continuously.

Instead of facilitating or promoting positive monetary growth by conducting open market purchases, Fed officials looked at low-interest rates, and wrongly concluded that monetary conditions were easy. This was despite the on-going decline in the volume of deposits and the quantity of money. In October 1930 the first of three banking crises produced runs on banks.

Customers converted deposits to cash currency, which meant that the monetary base did start rising, but deposit withdrawals meant that banks were forced to reduce loans with the result that the money supply fell even further.Still, the Fed did not supply adequate reserves to the banks - although it could have easily done so by purchasing securities.By April 1933 the broad money supply had declined by a cumulative and catastrophic 35%.

In the years preceding the 2008-09 GFC (Global Financial Crisis) recession, US money and credit growth exceeded 10% per annum, which is an unsustainable growth rate for an economy such as the US. When the housing market peaked and residential mortgage loans deteriorated, commercial banks' were compelled to undertake a drastic "Spring clean", which caused money and credit to contract.
In the immediate aftermath of the GFC, large-scale stimulus programs were put in place consisting of monetary easing and fiscal support.

On the monetary side, in addition to cutting interest rates almost to zero, the Fed and the Bank of England both responded with Quantitative Easing from November 2008 in the case of the US and from March 2009 in the case of the UK. However, because, as mentioned, money and credit in the US & UK were already contracting, these QE programs did little more than offset the declines in broad money; they did not lead to rapid monetary growth. All four economies suffered anemic recoveries from 2009 onwards. One of the underlying reasons for the lack of adequate monetary stimulus in the wake of the 2008-09 crisis was that bank and household sector balance sheets, having been leveraged up in the years 2002-08, were severely impaired as a result of the crisis, requiring an extended period of balance sheet repair.

In the case of the banks, besides coping with the losses they faced, numerous new regulations were imposed such as the Dodd-Frank Act and Basel III which raised bank capital requirements substantially. Therefore in addition to facing an environment of weak loan demand due to household and non-bank financial sector deleveraging, the banks themselves had to raise capital, which inevitably drew funds from their customers' deposits and dampened their loan growth to a pace that was slower than it would otherwise have been. On the fiscal side, despite central government deficits in most advanced economies such as the US and UK of 10-12% of GDP in 2009-11, there was initially little success in achieving self-sustaining growth in the private sector other than in China.

The reason was that China was the only economy that had successfully engineered rapid money growth. The failure of fiscal stimulus in the advanced economies illustrated very clearly the widely forgotten lesson that without money growth, fiscal spending only transfers spending from the private sector to the public sector; it does not add to total spending. Only in China where broad money growth doubled from 15% to 30% p.a. in 2008- 2010 did fiscal spending appear to succeed. Appearances are deceiving; with the benefit of hindsight, we can see that it was the rapid money growth that fuelled the increase in Chinese spending in 2009-11. In the developed west, the lack of money growth necessarily implied that fiscal stimulus could not succeed.

Outside China, spending growth data - such as real and nominal GDP - therefore remained sub-par for most of the next decade. After a decade of banking reforms, commercial banks are much better capitalized and hold much higher levels of liquid assets now compared to 2008/09.

Therefore when the pandemic struck the developed economies in March 2020, instead of being unable to extend credit as they had been in 2008-09, these reforms allowed commercial banks to extend credit to the private non-financial sector in response to the sudden drawdown of credit lines by corporates.

As a bonus, US banks were also in a position to purchase US Treasury bills to partially fund the fiscal deficit. Three factors explain the surge in US broad money growth: the US$400 billion increase in lending by the banks to meet credit line drawdowns by companies, bank purchases of US$200 billion of Treasury bills, and Fed purchases of securities from non-banks, which would be reflected in additions to deposits of the sellers of those securities.

In combination, these developments have caused US broad money growth to rise above 20% year-on-year - in marked contrast to what happened in the GFC. US broad money growth in the aftermath of the GFC with money growth during the Covid-19 pandemic recession. In our view, the injection of substantial purchasing power into the US, UK, and Euro-area economies in 2020 will almost certainly ensure a vigorous recovery in 2020-21.