I&WM Julaug09 Topress.Indd

FEATURE

Compare/Contrast The Great Depression and Current Financial Markets

By Nick Paterakos, CIMA®

he fi nancial panics of October Th is current contraction will How will the reduction of this debt 2008 and March 2009 have be labeled defi nitively only after it play out? It could take place all at once T subsided and world markets has passed. But for now, comparing but more likely it will take place over an have rebounded. Some of the global historical events and data may help us extended period of increased savings. economy’s fundamentals have contin- understand what is happening in the In any case, savings will rise to meet ued to deteriorate while some leading interim and provide timely advice and debt. Th e nation has gone from negative indicators are turning up. Th ough the reassurance for our clients. savings to a 5-percent savings rate in short-term picture has brightened, the a matter of months, and this response possibility of a worldwide depression Debt Collapse and Economic Shock likely will continue. lingers. Does our future hold additional Many recessions are the result of inven- Th e downturn also may make and severe, long-lasting, life-changing tory correction or some other economic consumers less amenable to taking on fi nancial conditions? dislocation. Th e Great Depression and future debt. Harry Dent, Jr., in his latest To examine that question, I’ve looked the current decline, however, were set book, Th e Great Depression Ahead, to the 1930s and other recognized off by a sudden collapse in asset prices believes this shakeout or depression depressions for clues. In this paper I against a backdrop of high debt levels. largely will revolve around restructuring consider data as well as intangibles that Indeed, this is perhaps the strongest simi- the debt of the banking system, compa- may help in a comparative analysis of the larity between our current situation and nies, and the U.S. government.3 Great Depression and current events. the Great Depression. In both the Great Indeed, maybe the U.S. consumer is A depression is a contraction in Depression and today’s decline, sudden fi nancially unable to take on additional economic activity of 20–25 percent loss of wealth reversed a long period of debt to sustain spending levels. If this is that lasts several years. Th e Great rapidly increasing prosperity and trig- the case, the question of whether banks Depression was the most severe in gered a cycle of asset destruction. are willing to lend becomes moot. our nation’s history. It started after the Th e shock that began the Great Regardless, with asset prices down, a market crash in late 1929 and lasted Depression was the stock market crash, lack of collateral and income should until 1938. In depressions of the 1870s which resulted from overborrowing; mean a period of slower, lower growth. and 1890s, gross domestic product during the 1920s leverage rates of up to (GDP) returned to its original level 90 percent debt were not uncommon.1 Impacts on World Trade in fi ve years; recovery from the Great Th e recent dramatic leveraging of Noteworthy declines in world trade as Depression took almost 10 years. housing was similar to the leveraging of economies shrink are a trademark of But economic depressions are so stocks in the late 1920s. Th e latest asset depressions, and some of today’s picture rare that data describing their pre-con- boom, especially in real estate, was con- seems to mimic the Great Depression. ditions are scarce. Today’s economy and spicuous because it didn’t result from World trade is collapsing, wealth is overall accumulated wealth—individual greater incomes or demand; it resulted evaporating, the banking system is and national—are dramatically diff erent from credit-induced excess liquidity. broken, defl ation is a growing threat as from the 1930s, possibly muting the We’re now experiencing the deleverag- companies close plants and cut pay and validity of comparing the situation we’re ing of the infl ation in housing prices prices, and leaders worldwide are strug- living i n to the Great Depression. that grew over 20 years or more. gling to halt the decline. Th is comparison, however, still has Figure 1 shows that today’s debt Furthermore, the International value, even if it only illuminates the level as a percentage of income is above Monetary Fund reports that for the fi rst similarities and the diff erences between that of the 1930s.2 Debt as a percent- time since World War II the United States now and then. So what follows is a com- age of GDP reached almost three times and other industrial nations are suff er- parison, categorized by the characteris- disposable income at the onset of the ing simultaneous economic decline.4 tics and impacts of, as well as responses Great Depression, and surpassed that in Th e credit crunch has curbed fi nancing to, depressions. the past few years. for exporters and importers and led to a

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FIGURE 1: TOTAL U.S. DEBT AS A PERCENTAGE OF GDP low interest rates are leading to forecasts of slow growth for 2010. Jan Hatzius, ANNUAL 360% 20088 Q2 = 356.756 chief U.S. economist at Goldman Sachs 340% Group Inc. in New York, predicted a GDP decline of 7 percent in the ﬁ rst 320% three months of 2009;9 the number 300% 19339 = 2299.89. 20033 = 306.22 came in closer to a 6-percent decline.10 280% During the Great Depression, 260% GDP declined 8.6 percent in 1930, 6.4 240% percent in 1931, and 13 percent in 1932. 220% Th ese numbers bode well for the cur- 200% Averageve age = 194.94 rent decline, given the extent of wealth destruction that has taken place of late. 180% Wealth destruction, however, is a major 160% determinant of decreased spending. 140% But it’s unlikely that the economy will 120% continue to decline at the rate of the 4th 1916 1924 1932 1940 1948 1956 1964 1972 1980 1988 1996 2004 quarter 2008 and 1st quarter 2009. Such

Sources: Bureau of Economic Analysis Federal Reserve, Census Bureau: Historical Statistics of the United States a period of stability reduces the chance Colonial Times to 1970. Through Quarter 2 2008. (Figure 1 is from Michael Hodges, “American Total Debt,” a that we will be reprising the GDP chapter of The Grandfather Economic Report, available at http://mwhodges.home.att.net.) declines of the Great Depression. tumble in world trade. Trading volume to 89 percent below its 1929 high before Curtailed Lending plunged at an annual rate of 22 percent in beginning to recover in mid-1932. Th e pullback in lending as banks hoard- the fourth quarter from the third in 2008, Relatively speaking, overall economic ed capital was crippling in the Great according to the CPB Netherlands Bureau and balance-sheet losses for the recent Depression, and it has been disabling for Economic Policy Analysis.5 decline have been signifi cant and in the in the latest downturn. Indeed, the Th e peak-to-trough decline from ball park of the initial Great Depression contraction in bank lending is making it 1929 to 1932 was 35 percent as coun- declines. Combined with collapsing hard for Federal Reserve Chairman Ben tries slapped giant tariff s on imports. house prices, the free fall in the stock Bernanke and his fellow policy makers Today’s global trading partners are market will destroy $23 trillion worth to get much traction with their eff orts to acutely aware of the nearly two-thirds of U.S. wealth, according to Lawrence stop the economic decline. Th is type of drop in global trade after Smoot- Lindsey, a former senior White House breakdown happens only two or three Hawley tariff s were imposed in 1930.6 offi cial who now heads his own consult- times a century, and weaknesses in the Hopefully the General Agreement on ing company in Arlington, VA.7 economy and the fi nancial industry feed Tariff s and Trade won’t make the same on each other and can lead to a “down- mistakes by erecting new trade barri- Decline in the Gross ward vortex,” said Treasury Secretary ers, because the result might be a free Domestic Product Lawrence Summers. Summers also has fall in trade as was experienced in the Declines in the GDP are one of the voiced concern about a return of defl a- Great Depression. defi ning characteristics of recessions tion, which wreaked havoc during the and depressions. Great Depression. As wages fell back Market Declines In March 2009, Harvard economist then, workers had a harder time paying Market declines are another depression Robert Barro said he believed that the debts, thus aggravating banking woes.11 characteristic. Like the Great Depres- near term holds roughly a 30-percent Levels of U.S. public debt now are at sion, the current economic decline is chance of a 10-percent decline in GDP levels seen in the United States in the global. Domestically and internation- and consumption—his defi nition of 1930s and in Japan in the 1990s. Th e ally, all markets have crashed from their a depression.8 In fact, the economy collapsed lending market is forecasting highs. Since peaking in October 2007, contracted at a 6.2-percent annual rate rising defaults through 2009. Th e global the Dow Jones Industrial Average (DJIA) in the last quarter of 2008—the worst default rate on speculative-grade debt has fallen more than 50 percent. Over a point to date in the recent decline. will peak at 16.4 percent in November, similar time period—1929 to 1931—the GDP forecasts for 2009 fall mostly in worse than in the Great Depression, DJIA average fell 55 percent. It dropped the low-single-digit range. Stimulus and according to Moody’s Investors Service.12

July/August 2009 37

Unemployment tion has been taken and extraordinary but was not immediately recognized During the Great Depression, unem- eff orts have been made to stabilize the as severe, so the government did not ployment peaked at an estimated 25 fi nancial industry. But the initial inef- mobilize quickly. However, since the percent and wages (for those who still fectiveness of these eff orts may signal October 2008 market downdraft, the had jobs) fell 42 percent. Today people that this most recent decline is diff erent government has responded in dramatic are losing jobs at an alarming rate of from normal cycles and represents fashion with programs that aid nearly almost half a million per month. something more severe. every area of fi nance and banking with But determinants of potential lay- Th e Great Depression actually substantial quantities of capital. off s are GDP and corporate earnings, was aggravated by the federal govern- In our current decline, large banks and both are fl attening at this time. ment’s poor monetary policy. Instead of went under sooner in the cycle and the Th ough we are at 25-year highs for pumping money into the economy and Federal Reserve responded quickly by unemployment, it seems as if the free increasing the money supply, the Fed increasing deposit insurance as soon fall on corporate balance sheets and allowed the money supply to fall by 30 as banks began to fail. Bernanke also in business has leveled, making huge percent between the end of 1929 and cut the benchmark short-term bank future layoff s unlikely. 1933. Government offi cials now, espe- lending rates to almost zero. According cially in the United States, are moving to the Federal Reserve, money-supply Impacts on Leading Industries more rapidly to deal with the crisis and growth accelerated.14 In addition, mas- While we discuss the prospects for an avoid a similar mistake. sive stimulus packages have eff ectively economic depression, some industries Here’s what happened back then: reduced tension in the credit markets could already be there. Housing has led After the 1929 crash, the Federal from October 2008 levels. Th ough the way, and with little sign of an up- Reserve became accommodative. Th e stressed, the movement in the credit turn. While the credit crisis has moder- Fed made funds available to banks so markets is in the right direction. ated with better access to capital, hous- they could continue securities lending. ing prices are not necessarily increasing. Interest rates moved down quickly, and Deflation Residential investment is down 37 the discount rate (the rate at which the A long decline in asset prices has been percent in the past four years. But that Fed lends to commercial banks) fell a major characteristic of each U.S. compares favorably with the 80-percent from 6 percent in October 1929 to 2.5 depression, and the 1930s’ defl ation, drop in spending on home building that percent in June 1930. In fact, federal asset destruction, and eff ect on lifestyle occurred from 1929 to 1932. policy, protectionist blunders, and bank was the worst decline in U.S. history. Th e auto industry is in similar bankruptcies or panics weren’t of con- Th e current contraction has resulted straits. U.S. motor vehicle output cern as markets continued to tumble in asset prices well below their peaks slumped 75 percent from 1929 to in the fall of 1930. Th e money supply and has signifi cantly reduced purchas- 1932.13 Th e rate of auto sales dropped by declined only slightly in the next year. ing power. Th e government clearly almost half after the October 2008 col- Th e fi rst large bank failure took aims to stimulate growth, however, and lapse in equity markets. General Motors place in New York in December 1930. the result more likely may be infl ation and Chrysler needed government loans More and larger bank failures ensued. rather than defl ation. Th e thought pro- to temporarily stay afl oat, and they By 1933, 11,000 of the 25,000 banks cess is that we believe drastic measures ended up in bankruptcy anyway. in the United States had failed. Th e to infl ate asset prices will arrest the Th e fi nancial services industry also consequence was sharp decreases in defl ationary cycle. Warren Buff et, chief has suff ered in the recent decline. Since the nation’s money supply and a huge executive offi cer of Berkshire Ha- mid-2007, institutions worldwide have psychological impact on consumers thaway, said he believes that stimulus racked up $1.2 trillion in credit losses that kept them from spending. And it eff orts may lead to higher infl ation than and write-downs. Announced fi nancial- wasn’t until four years into the Great the infl ation of the 1970s.15 industry job cuts have topped 280,000 Depression—1934—that bank deposits in the United States alone. fi nally became guaranteed. Taxes and Saving By the time programs were leg- As the Great Depression progressed, Government Response islated to lift the nation out of the tax increases literally drained spend- Government initiatives abound in these Great Depression, they were generally ing. In 1929 the top tax rate was 24 situations until the economic decline ineff ective. Individual behavior had percent. By 1932, it was 63 percent, and reaches a bottom, and Washington’s been changed because of defl ation and it reached 79 percent in 1936. response to the current economic high savings. Th e current economic Today it is unlikely that Washington decline reveals its severity. Decisive ac- decline started a couple years ago would enact a tax change that would

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FIGURE 2: HOW FAR HAVE WE FALLEN?

hinder economic growth. One would rose to 5 percent in January, the highest bility of defl ation. Th e massive liquidity expect that tax brackets would not in almost 14 years. will have consequences. We know from increase. However, we must be aware economic theory that infl ation results that increased taxes from states and Trajectory from an increase in the money supply other sources, all together, might have Current economic statistics versus as production declines or remains the same impact. Additional tobacco, 1929–30 are remarkably similar. It is unchanged. Is a defl ationary depression gas, and usage taxes will add up. State clear we have passed the defi nition of worse than an infl ationary depression? budget shortfalls may mean higher taxes. the average recession. Are we heading Or does the stimulus create a new set of However, it is unlikely the overall rate toward depression? How does the rate of infl ationary problems? will approach tax levels of the 1930s. descent compare to other depressions? Th e economy’s continuing cur- Th e stimulus and the resulting Conclusion rent deterioration, however, likely will increase in the money supply may Th e economy will recover, but it may have enduring impacts. U.S. house- change the trajectory of this market not have the legs of a normal recovery holds already are rebuilding savings in cycle. Growth in the money supply and because of the need to raise taxes. Th e response to the crisis. Th e savings rate defi cit spending may reduce the possi- other diffi cult-to-measure eff ect is the

July/August 2009 39

cost of money in the future. Currently Services in Chicago, IL. He earned 6 See Protectionism in the Interwar Period, trillions of dollars are scared to invest in a BS in accounting and finance and U. S. Bureau of Public Aff airs: Offi ce of anything but Treasuries. Th is fl ight to an MBA in finance from DePaul the Historian, Timeline of U.S. Diplomatic safety surely is helping the government University. Contact him at History 1921–1936, available at http://www. fund bailout packages. Th e demand for [email protected] state.gov/r/pa/ho/time/id/17606.htm. money will be great for some time to 7 Rich Miller, 2009, Depression Dynamic come, but the desire to cheaply lend to Endnotes Ensues as Markets Revisit 1930s, the government may end. Th e velocity 1 Kirby R. Cundiff , January 2007, Monetary- Bloomberg.com (March 9), available at of money could increase, infl ation may Policy Disasters of the Twentieth Century, http://www.bloomberg.com/apps/news rise, or confi dence that the government Th e Freeman Online, available at http://www. ?pid=20601109&refer=home&sid=aNlx. can repay may change. thefreemanonline.org/featured/monetary- TpHF5W4. Our economy could experience a policy-disasters-of-the-twentieth-century. 8 Robert J. Barro, 2009, What Are the Odds of prolonged period of adjustment, which 2 Figure 1 is from Michael Hodges, “American a Depression? Wall Street Journal (March 4): is more common during periods with Total Debt,” a chapter of Th e Grandfather A15. high levels of debt, satiated needs, and Economic Report, available at http:// 9 Miller, ibid. impaired balance-sheet losses from mwhodges.home.att.net. 10 TradeRoots.org, ibid. traumatized markets. Th e defi cits 3 Harry S. Dent, Jr., 2008. Th e Great 11 Miller, ibid. and the adjustment period may signal Depression Ahead, New York: Free Press, a 12 John Glover, 2009, Global Default Rate Will that the recent U.S. spending path division of Simon and Schuster, Inc.: 323. Peak at 16.4% by November (Update2), was unsustainable. To regain balance 4 World Economic Outlook Update: Global Bloomberg.com (February 10), available at we may need to become more com- Economic Slump Challenges Policies, http://www.bloomberg.com/apps/news?pid petitive to grow our export economy. If January 28, 2009, International Monetary =20601110&sid=aO0V8Z2T86bU. consumers throttle back, balance sheets Fund, available at http://www.imf.org/ 13 According to statistics in Joyce Shaw will improve. Will the global economy external/pubs/ft/weo/2009/update/01/. Peterson, 1987, American Automobile grow to allow us to pay down debt? 5 TradeRoots.org, Comparisons to Depression Workers 1900–1933, Albany: State Th e duration of this downturn will be are becoming louder, clearer, Mar 15, University of New York Press. answered by how quickly we can attain 2009—Omaha World Herald, U.S. Chamber 14 Reference monthly data on the Federal a sustainable balance. of Commerce, available at http://www. Reserve’s Web site, available at available traderoots.org/newsArticle.jsf?documentId= at www.federalreserve.gov/releases/H6/ Nick Paterakos, CIMA®, is a senior 2c9e4f69200391d10120082094220778. Current. vice president for UBS Financial 15 Miller, ibid.

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