How do Economic Crises End?

The Issue:

We are now in the acute economic phase of a crisis that is unprecedented in modern times — a health crisis from the coronavirus pandemic that has sparked a follow-on economic crisis. The virus represents both a supply shock (as people are forced not to work and supply chains are disrupted by the need for social distancing) and a demand shock (as incomes plunge, people are unable to go out, and economic uncertainty surges). Moreover, these shocks have put severe strains on the financial system. Against this backdrop, the economic outlook has darkened considerably since the pandemic burst into public view, and many macro forecasters now expect a deep and painful recession as economic activity is abruptly curtailed. While much remains unknown about the spread and severity of the coronavirus crisis, and even though there are clear differences from the current situation, we can look at two past economic crises — the Financial Crisis and the Great Depression — to draw lessons. History suggests that two ingredients are needed to stanch the acute phase of an economic crisis; a transparent resolution of the underlying cause of the crisis and a dramatic economic policy response that both mitigates the economic damage and causes a shift in business and consumer sentiment.

History suggests two ingredients are needed to stanch the acute phase of an economic crisis; a resolution of the underlying cause and a dramatic economic policy response that mitigates the economic damage and causes a shift in sentiment.

The Facts:

• The Great Depression began with a financial panic that was ignited by the stock market collapse in October 1929. That panic quickly led to a run on banks and many bank failures. Indeed, the number of banks operating in the United States at the end of 1933 was down by almost half from its total in 1929. In turn, the economy turned down sharply, with real GDP falling more than 25 percent between 1929 and 1933. 
• The economic policy response at the outset of the Great Depression was muted. Little fiscal stimulus was put in place, and the Federal Reserve allowed the money supply to contract precipitously. This ended when President Franklin Roosevelt took office in March 1933. One of his first acts was to declare a bank holiday that required all banks to close temporarily. During the holiday, Congress passed the Emergency Banking Act that, among other things, introduced deposit insurance. Those steps brought the banking crisis to an end. At about the same time, the economy turned up, with Industrial Production picking up in April (just one month after the bank holiday) and real GDP began rising starting in 1934 (only annual data for GDP available before 1947). The economy began to recover once the underlying problem of the banking crisis was addressed but, unfortunately, this did not occur until 1933. Delay proved very costly, and this experience informed subsequent policy responses, including the immediate response to the financial meltdown in September 2008.
• The Financial and Economic Crisis that emerged in 2007 and became acute in the autumn of 2008 had its origins in the vulnerabilities arising from housing finance and the financial engineering built on these assets. A primary trigger of the Financial Crisis related to subprime mortgages and the complex and opaque securities created to support the financing of those mortgages. As the bubble in house prices burst, the value of these securities came into question and by September of 2008 the solvency and liquidity of many financial institutions holding those securities came into question as well. The financial panic in the wake of the bankruptcy of Lehman Brothers in September 2008 served as a trigger for the most acute phase of the crisis as financial markets seized up in the midst of great uncertainty about the solvency of financial institutions due to the extensive and opaque web of connections among banks and lending institutions.
• In the wake of the Lehman collapse, the economy spiraled down. Real GDP fell at an annual rate of more than 8 percent in the fourth quarter of 2008. Private nonfarm employment plunged by more than 700,00 in both November and December of that year. The economy was in recession for a total of 6 quarters — the longest recession since the Second World War — and the unemployment rate remained above 6 percent until the fall of 2014. The collapse of Lehman Brothers and the resulting financial meltdown quickly spread across the world to other advanced economies. Governments acted in concert to address this. 
• There were two key aspects to the U.S. response: massive economic policy intervention and a dramatic demonstration that the underlying problem (fear of insolvency of big financial institutions) was under control. The economic policy intervention had many components. Congress passed the Troubled Asset Relief Program (known as TARP) in October of 2008, making $700 billion available to support financial institutions. The Federal Reserve dropped the federal funds rate — the short-term interest rate it controls — to near zero in an effort to make credit as cheap as possible, purchased massive amounts of U.S. Treasury and mortgage-backed securities to provide liquidity and put downward pressure on longer-term borrowing costs, and created numerous special programs that provided targeted credit to struggling segments of the financial markets. In February 2009, Congress approved a huge economic stimulus program that included about $800 billion of new spending and tax cuts.
• Bank Stress Tests in May 2009 bolstered confidence in the health of United States financial institutions. To reveal and publicize information about the health of major financial institutions, the Federal Reserve instituted the Supervisory Capital Assessment Program (more commonly known as Stress Tests) in 2009. These tests were designed to establish how banks would fare under adverse scenarios in which economic and financial condition worsened significantly. The results of the first Stress Test were released in May 2009, and they demonstrated that major financial institutions had sufficient capital to weather a bad storm. Unfortunately, similar efforts in Europe failed to offer the same results because the tests there were seen as less credible (no banks failed the stress tests in Europe).
• The economy began to recover in the wake of these efforts. With massive economic policy intervention and transparent evidence that the financial institutions were on sounder footing, the economy turned up and began a long and slow recovery, with real GDP growth turning positive in the third quarter of 2009. Consumer and business sentiment also began to recover, with the Michigan Survey of Consumer Sentiment turning up noticeably in the second half of 2009.
• There are important differences between the economic fallout from the coronavirus crisis and these earlier crises. Because the current crisis did not originate in financial markets but from a virus, the resolution of the underlying cause depends primarily on public health and medical responses. Moreover, taking steps to alleviate the health crisis, through social distancing, exacerbates the economic crisis. These differences make the response to the acute phase of the economic crisis more challenging. As has been widely noted, efforts to stimulate demand are not helpful in a time when many people are sheltering at home. That being said, government spending can still play a crucial role in confronting the economic fallout. Efforts to slow the pandemic are slashing incomes for many workers and revenues for many businesses. Providing substantial income support to these groups will serve as a financial lifeline to those facing especially dire consequences in the short run. This support will also help sustain businesses that would otherwise be viable but for the precipitous drop in revenue.