Affirming the Statement that “Those That Fail to Learn from Financial History are Doomed to Repeat It”

Subject: Economics
Type: Analytical Essay
Pages: 9
Word count: 2157
Topics: Finance, Tax, The Great Depression, Unemployment
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When financial analysts, government personnel and scholars fail to take account of the history, they are doomed to make the same mistakes in future. An analysis of the financial history offers an understanding of how to design the financial and economic system and regulate government policies and central bank policies. The historical evolution of the financial and monetary markets offers great insights into the major economic problems experienced in the past especially in the three major periods of economic distress experienced in the United States (US) such as the Great Depression, the Great Inflation and the Great Recession. Through the evaluation of history, this paper will analyse the causes of the Great Recession and align them to the failure of the financial analysts to learn from past financial history thus affirming the statement that “those who fail to learn from past financial history are doomed to repeat it”.

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An analysis of the Great Recession

The Great Recession that occurred between late 2007 and the third quarter of 2009 had damaging effects to the global financial sector. The employment rates dropped by 6.7%; output fell by 5.4% while consumption reduced by 2.1% (Christiano, 2017, p. 2). The financial crisis started as a housing bubble in the US and later evolved into the greatest recession of the 21st century. As it has been established in the past, an effect to the US financial market impacts the whole world. This turned to be true since, by mid-2008, the economies in the European Union and Asia had fallen into recession. By the start of 2009, the whole world was in a financial recession, an unexpected turn-around after the 2002-2007 financial boom (Katkov, 2012, p. 108).

The causes of the Great Recession

The financial crisis was largely related to the poor incentives in the US mortgage industry. Christiano (2017, p. 3) stated that the three factors related to this are a decline in housing prices at the summer of 2007, heavy investment of the financial system on house-related assets and mortgage-based securities and the shadow banking system that heavily invested on mortgage and which was vulnerable to bank-runs. The operations of the mortgage industry in the US had greatly changed over the years (Allen & Elena, 2009, p. 6).

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In the past, the banks would raise funds, screen borrowers and lend out money to only the people who passed the test. As such, there were fewer defaulters and in case this happened, the banks would shoulder the small losses (Jagannathan, Mudit & Ernst, 2013, p. 13). This strategy had however changed to the “originate and distribute model” where the originators, the banks and the brokers got commissions according to the number of mortgages they approved. With time, originators, brokers and banks started approving as many mortgages as they could and selling them off without caring much if the borrowers paid or defaulted (Laliberte, 2011, p. 19).

Another method that caused the crisis was securitisation where the distribution entities pooled various mortgages in different parts of the country together hence averting risks through diversification (Katkov, 2012, p. 108). Tranching would then be used to spread the risk differently among debtors. As time passed, all the tranches were sold off and the financial institutions involved in securitisation stopped following the right process. Eventually, financial institutions relaxed the process of checking for the welfare of the borrowers and all the mortgages under secularisation broke down (Love & Mark, 2011, p. 406).

Besides the real estate bubble in the US, other countries such as Spain, Ireland and other East Asian nations experienced the same. In the US, the real estate bubble was caused by the policies passed by the Federal Reserve Bank between 2003 and 2004 following the cutting off of the interests to about 1% in a bid to avoid recession after the technology bubble in 2000 and the 9/11 terrorist attack (Allen & Elena, 2009, p. 7). As such, more people were motivated to borrow money and buy houses whose prices were going up at a very high rate.

The bubble was caused by the high demand and an upward rise in prices. Spain and Ireland also experienced a bubble as the property prices increased continuously (Allen & Elena, 2009, p. 11). Other countries with loose monetary policies also facilitated the bubble due to the growth in credit. The Asian Crisis of 1997 also fostered the bubble since countries such as Thailand, South Korea and Indonesia experienced serious financial problems due to increased foreign borrowing. The increase in loose monetary policies, debts and the yen-carry trade were among the factors that facilitated the growth of the bubble (Laliberte, 2011, p. 45).

When the bubble burst due to the increased liabilities, the global economy went berserk. The bursting of the bubble was a culmination of the wrong decisions that people had made for several years due to the assumption that asset prices will continue having an upward trend (Grossman & Christopher, 2010, p. 319). During the years leading to the crisis, people could not save. Hence, they borrowed money for consumption. The crisis led to uncertainty about the stock and commodity prices since the prices were volatile. As such, people were discouraged from making long-term economic decisions due to the uncertainty in the future prices. This led to a slowdown of the global import and export trade resulting in the collapse of the world trade.

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Another factor that facilitated the bubble is the breakdown of the subprime mortgages (Allen & Elena, 2009, p. 12). Governments in the affected countries introduced various programs that would allow the financial institutions to swap their securities for treasuries. The consequences of the Great Recession include increased unemployment, reduced compensation, cut-backs in the public service, increased income inequalities and imbalances in the international trade among others.

Verick & Iyanatul (2010, p. 4) observed that the Great Recession came as a surprise to most of the policymakers, multilateral agencies, academics and investors despite all the pointers leading to a major financial crisis. In the aftermath, many economists were blamed for their blindness to the possibility of a catastrophic failure of the market economy. As a consequence, the severity of the financial downturn was underestimated for a large part of 2008. The financial crisis led to the closure or huge government bailouts of major Wall Street giants such as Lehman Brothers, Bear Stearns, Merrill Lynch, Fenniemae, AIG, Citigroup and Freddiemac among others. Besides, Goldman Sachs and Morgan Stanley were converted to bank holdings ending an era of investment banking in the US (Gupta, 2012, p. 16).

Grossman & Christopher (2010, p. 323) argued that the financial crisis quickly spread from the Wall Street companies to the Main Street. In the wake of the crisis, the writings pointing to an imminent bubble were on the wall and included the huge financial deficits among the developed nations, the introduction of lax monetary policies, reduced financial regulation and lack of risk mitigation. As policymakers and governments tried to avoid the mistakes that happened during other financial crises, they injected large amounts of credit into the credit markets, nationalised markets and reduced the interest rates. These steps helped avoid a catastrophic depression in most countries and the world at large. The recession later evolved into global jobs crisis as most of the people were forced out of employment (Gupta, 2012, p. 18).

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The relation of the Great Recession to other financial crises in the past

The Great Depression

After the end of the First World War in 1918, the Federal Reserve Bank began operating as the central bank in the US. In the 1920’s, the Federal Reserve Bank managed to regulate the financial and monetary systems in the US (Cargill, 2017, p. 220). The year 1929 marked the beginning of the Great Depression after the collapse of the stock market. The Great Depression and subsequent collapse of the financial system resulted from market failure hence the government was required to increase regulation and supervision to stabilise the economy. Besides, the government needed to use funds to offset the unstable private spending, use taxes to facilitate private spending and develop a monetary policy that will support private spending (Madhusudhanan, 2014, p. 36).

This led to the creation of the Keynes dominated public policy in the US which regulated the highly unstable private sector (Cargill, 2017, p. 222). The development of this policy resulted from the belief that the Great Depression had resulted from little government regulation and supervision, increased competition within the financial system, a close relationship between the banks and bond and equity markets and the lack of ability of the federal reserve bank to conduct monetary policy. Due to the lack of government regulation and supervision, financial institutions offered imprudent loans, operated with inadequate capital and took advantage of the debtors due to their position (Madhusudhanan, 2014, p. 37).

The Great Inflation

The Great Inflation started in 1965 due to a lax monetary policy resulting from the adoption of the Philips Curve economic model and the politicisation of the Federal Reserve Policy in the 1960’s and the 1970’s. This led to decreased employment and stagflation (a situation where the rate of unemployment and inflation increases considerably) (Cargill, 2017, p. 224). The economic model used also clashed with the government financial and monetary regulation. In this case, the government exercised increased regulation and administration of the domestic and international flow of funds to suppress the market forces.

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As such, the Great Inflation was characterised by economic distress due to inflation and financial distress due to the clash between lax monetary policy and a flawed financial system (Grossman & Christopher, 2010, p. 327). The introduction of the Bretton Woods fixed exchange rate system in 1944 led to unfair trading, the imposition of restrictions on imports, provision of subsidies to the exports and the adoption of the exchange control policies. The exchange rate system led to conflicts of interest between the US, Japan and Germany and was abolished in 1970 and replaced with a flexible exchange rate system in 1973. Financial distress within this period resulted from a clash of inflation with the increased interest rates on deposits, allowing only the commercial bank to issue checking deposits, limiting the powers of various depository institutions, subsidizing housing due to the placement of S & L’s as the specialized mortgage lenders and the separation of commercial and investment banking (Meltzer, 2005, p. 147).

These factors led to financial distress that lasted for two decades imposing heavy costs on the taxpayers. Beyond 1980, the economic system adopted an approach that emphasised the benefits of market forces and the suppression of using government intervention (Cargill, 2017, p. 225). The Great Inflation, subsequent collapse of the S & L industry and banking problems experienced resulted from flawed financial regulation, financial supervision and central bank policy. After 1980, the US government adopted a strategy that allowed the market forces to actively control the flow of funds, offer more funds to the economy and also support more involvement of the Federal Reserve in stabilising prices.

The need to learn from past financial history

The bursting of the bubble on housing prices and the following recession between 2007 and 2009 portrayed the market as inherently unstable and as one that requires great regulation and supervision (Meltzer, 2005, p. 149). After the Great Inflation in the 1980’s, the US had adopted the deregulation process where, while government supervision and regulation persisted, market forces were allowed to play a more active role in the allocation of credit. As such, the financial crisis resulting from the housing bubble was associated with deregulation. In the aftermath, the US government created the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Within the Act, the government is mandated with identifying firms that pose systemic risk to the economy and the financial system, seizing and closing institutions that pose a threat to the financial and economic well-being of the country and reducing the ability of the financial institutions to trade in financial instruments among other provisions (Cargill, 2017, p. 229).

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From the discussion, it is evident that “Those That Fail to Learn from Financial History are Doomed to Repeat It”. Some of the characteristics of financial crisis detailed include a crisis in the banking sector, currency, security market, lack of risk mitigation, reduced financial regulation and increased debt defaults among others. The lack of government regulation was heavily associated with the Great Depression while the Great Inflation was associated with strict government regulation. The recent Great Recession, on the other hand, was related to the deregulation of markets. Despite all the markers that pointed to a financial crisis in 2007, economists and scholars all over the world seemed quite unprepared for such an eventuality which is a case of failing to learn from past financial history hence repeating the same mistakes.

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  1. Allen, F. and Elena, C. (2009). An Overview of the Crisis: Causes, Consequences and Solutions. Presented at the Conference on Global Market Integration and Financial Crises at HKUST on July 12- 13, 2009. pp. 1- 45.
  2. Cargill, T. F. (2017). The Financial System, Financial Regulation and Central Bank Policy. New York: Cambridge University Press.
  3. Christiano, L. J. (2017). The Great Recession: A Macroeconomic Earthquake. Federal Reserve Bank of Minneapolis: Economic Policy Paper 17-01. pp. 1-8.
  4. Grossman, R. S. and Christopher, M. M. (2010). International Aspects of the Great Depression and the Crisis of 2007: Similarities, Differences and Lessons. Oxford Review of Economic Policy. 26(3): 318- 338.
  5. Gupta, T. (2012). Global Financial Crisis: Causes and Consequences. IOSR Journal of Business and Management (IOSRJBM). 1(3): 16- 24.
  6. Jagannathan, R, Mudit, K. and Ernst, S. (2013). Causes of the Great Recession of 2007-2009: The Financial Crisis Was the Symptom Not the Disease. Journal of Financial Intermediation. 22(1): 4- 29.
  7. Katkov, A. (2012). Great Recession of 2008-2009: Causes and Consequences. Journal of Applied Business and Economics. 13(3): 107- 122.
  8. Laliberte, P. (2011). Crisis: Causes, Prospects and Alternatives. International Journal of Labour Research. 3(1): 1- 155.
  9. Love, N. S. and Mark, M. (2011). The Great Recession: Causes, Consequences and Responses. New Political Science. 33(4): 401- 411.
  10. Madhusudhanan, S. (2014). The Great Depression Revisited. Journal of Business and Economic Policy. 1(1): 35- 38.
  11. Meltzer, A. H. (2005). Origins of the Great Inflation. Federal Reserve Bank of St. Louis Review. pp. 145- 176.
  12. Verick, S. and Iyanatul, I. (2010). The Great Recession of 2008-2009: Causes, Consequences and Policy Responses. IZA DP No. 4034. pp. 1- 61.
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