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COMPARISON AND ANALYSIS OF THE EVOLUTION 1

Comparison and Analysis of the Evolution of Economic

Thought During the Great Depression and Great Recession

Johnny Wright

Southern New Hampshire University


Abstract

This paper compares and analyzes the key differences between the Great Depression and

Great Recession, including the major players, role of economic thought, and economic policies

that prolonged the duration of both disasters. It is organized into three main categories: the

economic thought process that was evidenced from the major players and reactions during each

event, the role of the models used to make decisions on economic policy and their limitations,

and how business decisions were impacted due to the perceived nature of the situations. As well,

in studying the responses of other countries during these devastating times, an area for future

study is included that looks into how policy can be maximized to achieve its results and leave

little need for additional intervention. Due to the scale of both situations and a seemingly

ambiguous response due to the presence of externalities, a solution is needed that minimizes the

costs of those externalities and maximizes the benefit of the intervention.


Comparison and Analysis of the Evolution of Economic

Thought During the Great Depression and Great Recession

The 20th century and the beginning part of the 21st century are times that have truly

changed the United States of America, both physically and mentally, in many different sectors.

These changes can influence long-term and short-term outcomes, ultimately making them

socially costly or beneficial in retrospect. Determining what benefits are needed is crucial in

situations where the central authority must do more than simply enforce: they must lead. One of

the major ways it has to lead concerns the well-being of its citizens during times of distress and

the use of economic policy. The Great Depression and Great Recession are distressing times that

challenged the central authority's central way of leading by its Keynesian policies. Using this

thinking, both the government and Federal Reserve took actions to invoke economic activity. In

terms of physics, both entities tried to impact a slowing object by exerting enough force on it. In

order to understand the economic state of the country that resulted from both eras, it is necessary

to study the role of the major inputs of both disasters and examine the cost/benefit analysis of

each against the other. This paper examines key economic indicators during both times, as well

as the fallout from both events, using appropriate qualitative and quantitative analysis.

Event Time lines and Characteristics

The Great Depression

The Great Depression (1929-39) was a period marked as one of the largest economic

downturns, not only for the United States of America, but for the entire world economy. It is

often characterized by the large amounts of layoffs, migration, and morale decline. During that

time, real output in America fell almost 30%. The severity of the situation the macroeconomic


role and perspective of federal government in its role of maximizing employment: policies

changed from facilitation to provision with the assistance perspective changed to that of

dependence. A few of the events that cause this change are the following:

1. The stock market crash of 1929. This event signaled the loss of aggregate household

wealth in American and globally. The loss of wealth indicates downward pressure on

output since those people no longer have any way to contribute economic activity like

they use to.

2. The migration westward in search of opportunity. Following the stock market crash, there

was a period of migration west. The state population grew about 25% during the years of

the depression (Spector, 2012).

3. Two new world leaders: Franklin Roosevelt and Adolf Hitler. Roosevelt's presidency is

marked by the popularity and passage of New Deal Programs, aimed at strengthening

employment through reducing production to raise price levels (Smiley, 2008), achieved

by government expenditures. Similarly, the same year, Hitler used government

expenditures for public work creations, essentially using debt to foster employment of its

citizens and increase production (Weber, 2011).

4. The decrease in GDP in America and abandonment of the gold standard left Latin

American countries on the verge of default on their debts. Those countries were heavily

dependent on its exports; once the Depression hit these regions, they be became more

attractable for their land and labor, turning many of those economies into manufacturing

economies (Martinez, 2009).

5. The Employment Act of 1946. After the Depression and World War II, the government in


America had the responsibility of preventing the situation like the depression. The

Employment Act of 1946 allowed the government to take an active role in maximizing

employment of resources and production, reinforcing its central role of market

stabilization (Santoni, 1986).

The Great Recession. Much like its counterpart in the twentieth century, the Great

Recession was also a time marked with a severe decline in economic activity. The focal point of

this situation occurred in 2007 with the subprime mortgage crisis. While this economic decline

did not last long, it had lasting effects on labor laws that are still being felt. It also resurfaced the

debate of the federal government's role as well as included a question on living entitlements

(right to work, wages, etc..). Interestingly, it highlighted a strong desire for citizen dependence

on the government as many of the resulting reactions were social in nature. Some of the events

that further shape the evolution of labor laws are the following:

1. During the years of the recession, aggregate real GDP dropped about 6% and the

unemployment rate increased 4.7%. This could be due to the increase amount of citizens

going through bankruptcy following the mortgage crisis and claiming unemployment in

the statistics.

2. Commencement of Quantitative Easing in 2008. The tail end of the Recession saw the

emergence of quantitative easing actions of the Federal Reserve (purchasing of mortgage-

backed securities to increase supply of money in circulation). The logic is that if banks no

longer have toxic assets on its books, it can free up more funds to lend to small

businesses and foster investment, which helps employment.

3. Similar stimulus packages in the United States and China in 2009. In 2009, the American


Recovery and Reinvestment Act was established. Its purpose was to stimulate economic

activity by issuing a transfer payment to firms who meet qualifications denoted by the

government for the aid. The focus was aimed at saving approximately 3 million jobs

(Grunwald, 2010). In China, the stimulus package was aimed toward infrastructure to

facilitate GDP growth. The result was a smaller decrease in its export decline the

following year, measured against other developed nations (Plafker, 2009).

4. Growing resentment of low income citizens of income inequality in 2012. This normative

thought, spurned from Joseph Stigliz's The Price of Inequality, gave rise to questions on

fairness of wages in the labor market and states that the top 1% of citizens share the

majority of the wealth in the United States of America, while the rest share only a

fraction of the wealth (Mankiw, 2013).

5. Growing minimum wage problem, with largest increase occurring for a particular labor

market in 2014. In response to the growing income inequality and difficulty for a job that

provides a living wage, many people in the city of Seattle pressured its city council to

increase the minimum wage to $15 hourly over a period of seven years.

Government Reaction and Business decision making

Because of the downward pressure on gross domestic product during both disasters,

corporations list profits, resulting in rising unemployment. The unemployment that spurned

caused problems for the citizens of the country as they were unable to participate in the

economy, resulting in labor regulations to prevent the problem. By using social programs to

guarantee jobs for the citizens, employment became equalized among all of those who did not

have it. This has the same effect of making a private good into a public good. By equalizing the


right of employment among citizens, the rivalry has been eliminated; because the government is

taking it upon themselves to solve the issue, the explicit cost to citizens has been eliminated, thus

transforming employment into a public good. The only thing governments could do was respond

to the Great Depression and Great Recession by increasing government expenditures and enact

countercyclical fiscal policies, ones that work to counteract negative trends in the economy.

The primary difference between the reactions are what both problems represented. The

Great Depression, characterized by the inability to get a job due to their unavailability or

negotiate a livable wage, was handled in America by transforming the notion of production into a

right and a good, thus socializing business to fit requirements and establishing precedent for the

government to be the provider for its citizen's financial troubles. This is evidenced by some of

the programs the New Deal, specifically the Agricultural Adjustment Act of 1933, that set forth

to curtail production by providing subsidies to not plant (Smiley, 2008). In addition to social

programs, the government established the right of the citizens to negotiate better terms of

employment. In 1935, Congress passed the Wagner Act, which allowed individuals to collective

bargain for higher, livable wages through unionization (Zheng, 2011). By allowing individuals to

form a macro demand wage market, business were forced to operate at a desired level of wage

that exceeded their allocated wage costs and reduction in profits because of the rising costs.

In comparison, the Great Recession focused on the income level of the citizens. Because

of normative fairness debates, such as income inequality and minimum wage, the government

responded by using debt to assist firms expand into areas that are deemed as vital (science,

technology, mathematics, etc...) along with job creation. This can be evidenced by the American

Recovery and Reinvestment Act and what it set out to accomplish. It gave businesses the


incentive to invest in capital for expansion to new areas with the backing of the government. The

result is the long time it took to recover the jobs lost and sluggish recovery in the process.

Economic models and thinking

As previously stated, the Great Depression and Recession challenged the way central

authorities aid its citizens during times of economic hardship. Though both hardships have

similar upstarts, the fall out and duration of both were vastly different. One key difference is the

reaction of the Fed in both situations. Due to the quantity theory of money, which states that an

increase in the money supply leads to an increase in price level, the Fed had to be careful in what

actions it took as any action can cause unintended effects, also known as moral hazard. Moral

hazard will be discussed later, but it helps to understand the thought process during both times.

In the basic equation form, the quantity theory of money relates the product of the money supply

and velocity of transactions to the product of the price level and number of transactions that

occur: in other words, M*V = P*T (“Quantity Theory of Money Definition,” 2007). This theory

is the basis of economic thinking in both instances and changed in use.

Economic thinking during the Great Depression

The fallout from the event highlighted the need for collecting information on certain

economic indicators, such as interest rates, market activity, and aggregate employment. Because

the depression had the most noticeable effect on employment, this area was the most heavily

focused on. As seen in the time line, many of the programs created during the New Deal era were

aimed at fostering employment, albeit though production curtailing using debt. The idea is that

rising employment increases the demand for money and market activity, increasing the amount

and velocity of transactions. Appendix A shows that personal income had decreased by 29% in


the early years of the depression. The need for policy can be evidenced when looking at the

individual inputs to market activity. Perhaps the most staggering is 57% decline in private capital

investment (see Appendix B). While the government made its actions, the Fed invoked

contractionary monetary policies to reduce the amount of money in supply to be used, invoking

an appearance of a stable velocity of money. Because the conditions in the stock market during

the Depression left no room for value investing, a gold outflow from the country was evidenced.

The situation was described that because of the liquidity issues and gold outflow crisis that banks

faced during this era, expansionary policies would be counterproductive (“Monetary policy in

the great depression: What the fed did,” 1992). The limitation to this view is that the

employment issue would dealt with. Contractionary monetary policies, according to the IS-LM

model, suggest that a reduction in supply would lead to an increase in price, also known as rising

interest rates. Therefore, anyone were interested in production capital during this time would be

subject to higher interest rates for loans, causing capital investment to aid in the decline of

unemployment.

Economic thinking during the Great Recession. In comparison with the Great

Depression, the Great Recession had a similar profile: stock market crash, increasing

unemployment, and decreasing market activity. In the 2008 Recession, the velocity of

transactions decreased 12% from 2008 Q1 to 2009 Q2 (Federal Reserve Bank of St. Louis,

2015). The same time range displayed 2% drop in personal income as well as a 28% decline in

private capital investment (see Appendices C and D). Abiding by the same quantity theory of

money that guides policy, this would indicate a problem of unemployment as the demand for

dollars decreased among the aggregate economy. Unlike its 1930's counterpart, the 2013


Economic Report of the President report cited that the decreasing flow of labor force

participation put downward pressure on real GDP, evidenced by the 3% decrease in real GDP. In

dollar form, that is over $400 billion. Also, while the Depression focused on the right to a job

and changed aggregate thought among the citizens to dependency from the government, the

Recession gave rise to income inequality and living wage debates. This aspect justified

expansionary fiscal and monetary policies, since bank liquidity was not as severe of an issue

during this hardship in the aggregate. The Fed was forced to intervene in those specific instances

where it would pose a major problem.

As a result of the nature of the situation, the government used debt to stimulate private

consumption and private capital investment through its stimulus program. The goal was to

increase the demand for dollars and stimulate production. As mentioned above, the stimulus

program was focused on the technology sector in order to make the country more competitive

abroad. The report foretasted that productivity would increase 2.8% annually from 2013 on.

While this may seems like a decent number, it does present evidence that unemployment will put

a drag the full recovery of the economy and continuance of the structural stagnation state that the

United States of America has been in. In retrospect, this number was accurate, even since the end

of the Recession. On average, GDP has been increasing 2.14%, or almost $300 billion since

2010.

The Federal Reserve had a more serious problem to attend to. Similar to the stock market

crash of 1929, the 2008 Recession was caused by bank investment in highly volatile assets, with

the most notable offenders being Bear Stearns, Lehman Brothers, and American International

Group. Those assets, which were mortgage-based assets, largely increased they incurred and


drove their stock prices down. Due to the unprecedented nature of the situation, the Fed was

forced to intervene in some way, with respect to the moral hazard problem they face. In the case

of Bear Stearns, the Fed allowed J.P. Morgan to lend $29 billion to purchase those toxic assets

from the firm, with the promise that if the assets appreciate in value to offset the cost of

operating Bear Stearns, the Fed could see a gain. This deal also made the Fed liable for any

losses the assets incurred should J.P. Morgan no longer be able to cover them. Due to the

situation of the proposed bank runs from Bear Stearns because of the losses it incurred, the Fed

had to prevent a massive depression that bank insolvency would cause; however, in doing so, the

Fed took responsibility for the risk that Bear Stearns had imposed on itself: should those assets

lose value greater than what J.P. Morgan could cover, the central bank itself would stand to lose

money and have a spillover effect on the country as a whole.

A similar threat was posed by American International Group (AIG) that same year. The

company, who has a share in many different goods and service industries such as insurance and

construction, had invested a similar set of assets to Bear Stearns. In this case, the market

exposure alone made the solution to the situation difficult to find. As opposed to allowing

another bank to purchase the assets from this firm, the Fed itself loaned the money to AIG for

them to repay once the firm was able to do so. The consequence for AIG is this: because of the

deal made with the Fed and the measures the Fed took to insure against great loss, the $85 billion

is loaned to them would be enough to take control of the whole firm should AIG fail to repay,

implying that the Fed would also be responsible for AIG as well as Bear Stearns.

Monetary Policy, Fiscal Policy, the Principle-Agent Problem, and Moral Hazard

Both the Great Depression and Recession highlighted difficulty of intervention during


times of hardship. Evidence of economic activity is critical to the country's ongoing survival,

which give the government and the Fed the incentive to correct any issues. The problem arises

when any actions made are not perceived to be in the best interest of the citizens, illustrated by

the moral hazard and principle-agent problems.

The Moral Hazard Problem and Policy

In the 2008 Recession, the velocity of transactions decreased 12% from 2008 Q1 to 2009

Q2 (Federal Reserve Bank of St. Louis, 2015). Faced with this problem, the Fed had to try to

take an action that would reduce the overall effects of moral hazard on the economy. As seen in

the explanation of the IS-LM model, moral hazard is defined by the Fed as a the by-product of

intervention; in other words, it is the externality their actions produce on the citizens of a country

as a whole, due to their third party status in the implementation of the proposed policy. This

explains why the Fed is reluctant to intervene in crisis: their actions could cause bigger long term

problems. Its job is to add an additional layer of insurance against instability and, in doing so,

produce instability.

One such reason for the moral hazard problem when it comes to wages and productivity

is the unfairness associated with wages across different positions and lack of pertinent

responsibility. Since prevailing thought indicates that high standard of living is a right everyone

should have and, thus, a normative public good, a higher wage for someone else or lack of

additional opportunities for the employee will cause them to perform lower than agreed on,

making the moral hazard problem evident. In the case of the suppliers of labor (employees), they

have incentive to not maximize their production but still receive the full benefit of maximizing

their production via a full paycheck. This proves to the employee that the marginal costs


associated with full employment of their resources outweighs the marginal benefit of fully

employing their resources. It cause the long term productivity, with respect to this employee, to

fall overall.

When choosing which situations to intervene in, the Fed does so with the micro moral

hazard problem in mind. The goal of their actions is to foster financial, price, and economic

stability. This is usually best done by having strict guidelines about its actions. Through study of

the information market, the Fed limits the information it give out in terms of what it actually

means. They do this to assist the markets in letting themselves work out; in a sense, it is more

beneficial for the invisible hand principle to correct the problem before directly getting involved.

This is also done to not set any precedents to what actions they take. Without this, situations such

as Bear Stearns or AIG could lead to an incestuous dependence on the Federal Reserve for these

problems.

Once the Fed decides to intervene, it has to carefully select who they will assist and the

terms of the assistance. This is one reason why the third bank in crisis during this time, Lehman

Brothers, was not aided by the Federal Reserve. Assuming that the situation disrupts the goals of

stability the it is charged to do, the Federal Reserve then seeks out ways to have the private

sector solve the problem naturally. If that cannot work, the Fed then sees if the firm has enough

collateral to cover a loan; if it does, the Fed will intervene while working to reduce moral hazard.

If the firm does not have enough in collateral for a loan, such as the case with Lehman Brothers,

the Fed will let the market run its natural course with that firm under the understanding that there

is no moral hazard. This process resembles a larger demonstration of the cost/benefit analysis: in

the case of AIG and Bear Stearns, the benefit to saving those firms (the externalities failure


would have produced) outweighed the initial short-run costs of monetary policy. In the case of

Lehman Brothers, the costs exceeded the benefits where intervention would not have been

effective.

The Principle-Agent Problem and Policy. In addition to the moral hazards that can arise from

intervention, the principle-agent problem also works to constrain what actions the Fed and

government can make to achieve their goals. This problem occurs when a secondary party in a

contract has more incentive to align its interest with the primary party, though it may not be in

the best interest of the secondary party. In the labor market, this can be seen by the existence of

minimum wage and its controversial nature. Both events gave birth to the notion of a high

standard of living being normative public good. The introduction of unions into the economy

specifically serve to ensure that this occurs, through pushing for wage control laws. These laws,

when passed, increases the minimum amount that an employee is payed; however, due to

employee wages being counted in the cost of doing business, marginal operating costs rise

without the productivity to match the change. In addition to reduction in productivity, with the

increased price of purchasing labor, firms will demand fewer workers and contribute to the

inevitable unemployment rate increase.

The principal-agent problem in the aggregate economy exists when firms must be willing

to accept the price of labor increase, but see a decrease in performance. In order to solve this

problem, the agent must induce the principal to act optimally. This typically the reason firms

employ performance-based incentives (Spaulding, 2014); since these employees inherently have

no incentive to maximize themselves due to the added benefit being non existent, firms sacrifice

more in short-term costs to motivate their labor to increase long-term productivity.


Executive Pay Changes and the Principle-Agent Problem: Microsoft Example. The

topic of executive pay and fairness is one that sparks thoughts and ideas guided by many positive

and normative economic institutions of thought. In addition to this topic, the issue of the

principal-agent problem has been shown to be one that can not only decrease the value of their

purchased labor inherently, but also be solved using proper performance measurements. In the

case of Microsoft (NASDAQ:MSFT), a large technology company that manufactures raw and

finished goods for computers and electronics, the issue was one decided on by shareholders.

Investment Weekly News published an article in October 2009 on Microsoft's executive pay

structure was approved to be decided by its shareholders (“Microsoft Board Authorizes 'Say-on-

Pay; Advisory Vote on Executive Compensation, 2009). This decision was more than likely made

because of the interest of the agents; in this case, the agents (shareholders) had the incentive to

raise executive wages due the burden of corporate responsibility being on those executives and

the self-interest of the shareholders to maximize company value. In other words, allowing the

impartial shareholders to determine wages induces the executives to ensure the performance of

the firm overall. On the firm's side, it allows for those who invest into the company (which raises

company revenue) to determine the direction of the firm while still maintaining control of the

firm. Due to the rising unemployment during this time, firms have the incentive to maintain its

productivity or suffer declining profits. This is one reason why corporate structures would

logically change during such an event: unemployment implies declining productivity, which

leads to long-term problems that only firm leaders are responsible for. Their job is to foster

growth for their firm and worsening economic conditions can cause questions on whether or not

executives deserve the top pay they receive when the rest of the citizens continue to struggle.


Conclusion and Future Study

This paper analyzed the evolution of economic thinking in the cases of Great Depression and

Great Recession and compared the actions of the central authorities (the government and the

Federal Reserve) in each situation. Both periods of economic decline spawned from similar stock

market and other conditions. An analysis such as this is crucial for the next generation of

business leaders, politicians, and educators in that it provides an understanding to the role of

thinking in all levels of the economy that contributed to the problems that arose. In addition to

the understanding the economic thought and its evolution over time, an analysis like this can be

used to understand the economic condition of the country going forward.

The fallout from each era, seen by the sharp declines in personal income, private capital

investment, and GDP, yielded different results and changed the way American viewed the role of

the government. It forced the long-standing economic institution of capitalism to evolve by

changing the aggregate view of work and production. By modifying the definition of a public

good so that job stability and living wages are standard and has no implicit costs, governments

responded to the Great Depression and Great Recession by increasing government expenditures,

which caused citizens to become more dependent on what the government does. The problem

with this dependency is that government did not fully for non-financial externalities, such as

aggregate thought and perception of the usefulness of its actions; in other words, the government

did not account for the real issues that each era brought with it. The Great Depression,

characterized by the inability to get a job due to their relative unavailability and unlivable wage

that came with most available job, was handled in America by transforming the notion of

production into a right and a good and socializing business to fit requirements, thus setting


precedent for the government to be the provider for its citizen's financial troubles. In

comparison, the Great Recession focused on the income level of the citizens. Because of

normative fairness debates, the government responded by using debt to assist firms expand into

areas that would bring along with it high-wage job creation. Conversely, in both situations,

countries such as Germany and China used their debt to focused on simplifying production

internally and resulted in faster and stronger recovery in both nations compared to the United

States of America.

In addition to the role of the government, the role of the Federal Reserve was also

evident. The Fed acted differently in each situation. In the Great Depression, the Fed used a

contractionary monetary policy to limit the number of bank runs that occurred from the stock

market conditions. In contrast, the stock market conditions during the Recession caused the Fed

to invoke expansionary monetary policies, such as quantitative easing, to bring the economy to a

state a full employment in the realm of the aggregate money supply. The way the Federal

Reserve accomplished this task was through the purchasing of mortgage-backed securities. By

using the main proponent of the disaster, the Fed artificially stabilized the economy; however, in

keeping in mind its moral hazard problem, that left interest rates low on government bonds and

quelled any chance of gaining additional value from them.

This paper also discussed the labor market and how wages are determined. Through a

working definition of the labor market supplier (employees) and those who demand labor

(firms), a view of the problems that exist with the relationship between the two parties was

explored. Two problems can arise from the wage debate: moral hazard and principal-agent. The

moral hazard problem occurs post-contract when one party acts sub-optimally or has information


that could have changed the terms of the original contract. It creates a free rider problem. The

principal-agent problem exists when secondary parties are forced to align their interest with the

primary party (principal), though the alignment of those interests may not be to the benefit of the

secondary party. The evidence of this is seen in the discussion of executive pay. Using the recent

wage determination change of Microsoft's executives, it can be seen that introducing a

productivity-inducing action can solve both the moral hazard and principal-agent problems.

One thing to consider for future study is the effect of monetary and fiscal policy on

private capital investment. One of the problems with failings of economic policies is that it does

not foster production directly. In the consumption function for GDP, a fiscal stimulus or a

quantitative ease would result in an increase in consumption due to transfer payments. In a

similar fashion to China and Germany's recession responses, monetary or fiscal policy could be

engineered to foster production on a citizen level. This would again challenge the economic

institution of capitalism in that the government is giving something that is not earned, but it is

helping stimulate production on a microeconomic level. It still presents the same challenge as the

implementation of the countercyclical policy. As seen from countercyclical policies in the past

(the 2003 Economic Stimulus being most notable), the intended long-term effects of such actions

do take a long-term to fully be evident.

One striking reason for the focus on private capital investment is that since both the

Depression and Recession had similar starts, they also had similar events leading up to it. The

Great Depression saw the economic prosperity of the Roaring 20's while the Great Recession

enjoyed the economic prosperity of the 1990's. In the 1990's, private capital investment increased

6.88% yearly. Using this model as a base, economic policy can be used to reproduce the effects


of such times, if planned early enough.


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Santa Barbara, CA: ABC-CLIO. Retrieved from http://ezproxy.snhu.edu/login?qurl=http

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Appendix APersonal Income change during the Great Depression (1929 – 1935, annualized)

Appendix B


GDP and Private Capital Investment during the Great Depression (1929-1935, annualized)


Appendix CPersonal income during the Great Recession (2008-2009, quarterly)


Appendix DGDP and private capital investment during the Great Recession (2008-2009, quarterly)

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