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1920s parallels are frightening

∞ Posted at 12:45 pm

Like everyone in the world at the moment, the economy is very much at the top of my mind. I get to work in the morning and the first thing I do before reading my emails is load up Google Finance and check out the state of the NYSE and associated markets prior to close in the US. Its actually be very exciting for me to watch just how dramatic the whole thing has been. Its extremely frightening, but it gives me a little bit of a rush as well.

We’re living in times not seen in nearly 80 years. In fact, it was in 1929 that we last saw an economy perform much the way it is today. Whats most impressive is the differences in scale. In the week of October 6th to 10th, 2008, over US$2 trillion was wiped off the markets in the US. In 1929 just before the Great Depression, the entire GDP of the US was only just over US$800 billion. At the worst point of the Great Depression, GDP of the US had dropped to around US$600billion.

Imagine what we could see happen in our own time if the scales end up similar?

One explanation comes from the Austrian School of economics. Austrian theorists who wrote about the Depression include Hayek and Murray Rothbard, who wrote “America’s Great Depression” in 1963. In their view, the key cause of the Depression was the expansion of the money supply in the 1920s that led to an unsustainable credit-driven boom. In their view, the Federal Reserve, which was created in 1913, shoulders much of the blame. By the time the Fed belatedly tightened in 1928, it was far too late and, in the Austrian view, a depression was inevitable.

The artificial interference in the economy was a disaster prior to the Depression, and government efforts to prop up the economy after the crash of 1929 only made things worse. According to Rothbard, government intervention delayed the market’s adjustment and made the road to complete recovery more difficult.

Rothbard criticizes Milton Friedman’s assertion that the central bank failed to inflate the supply of money. Rothbard asserts that the Federal Reserve purchased $1.1 billion of government securities from February to July 1932 which raised its total holding to $1.8 billion. Total bank reserves only rose by $212 million, but Rothbard argues that this was because the American populace lost faith in the banking system and began hoarding more cash, a factor very much beyond the control of the Central Bank. The potential for a run on the banks caused local bankers to be more conservative in lending out their reserves, and, Rothbard argues, was the cause of the Federal Reserve’s inability to inflate.

[...]

Economic historians (especially Friedman and Schwartz) emphasize the importance of numerous bank failures. The failures were mostly in rural America. Structural weaknesses in the rural economy made local banks highly vulnerable. Farmers, already deeply in debt, saw farm prices plummet in the late 1920s and their implicit real interest rates on loans skyrocket; their land was already over-mortgaged (as a result of the 1919 bubble in land prices), and crop prices were too low to allow them to pay off what they owed. Small banks, especially those tied to the agricultural economy, were in constant crisis in the 1920s with their customers defaulting on loans because of the sudden rise in real interest rates; there was a steady stream of failures among these smaller banks throughout the decade.

The city banks also suffered from structural weaknesses that made them vulnerable to a shock. Some of the nation’s largest banks were failing to maintain adequate reserves and were investing heavily in the stock market or making risky loans. Loans to Germany and Latin America by New York City banks were especially risky. In other words, the banking system was not well prepared to absorb the shock of a major recession.

Economists have argued that a liquidity trap might have contributed to bank failures.

Economists and historians debate how much responsibility to assign the Wall Street Crash of 1929. The timing was right; the magnitude of the shock to expectations of future prosperity was high. Most analysts believe the market in 1928-29 was a “bubble” with prices far higher than justified by fundamentals. Economists agree that somehow it shared some blame, but how much no one has estimated. Milton Friedman concluded, “I don’t doubt for a moment that the collapse of the stock market in 1929 played a role in the initial recession”. The debate has three sides: one group says the crash caused the depression by drastically lowering expectations about the future and by removing large sums of investment capital; a second group says the economy was slipping since summer 1929 and the crash ratified it; the third group says that in either scenario the crash could not have caused more than a recession. There was a brief recovery in the market into April 1930, but prices then started falling steadily again from there, not reaching a final bottom until July 1932. This was the largest long-term U.S. market decline by any measure. To move from a recession in 1930 to a deep depression in 1931-32, entirely different factors had to be in play.

^{Causes of the Great Depression – Wikipedia}

There are a lot of differing hypotheses out there for the cause of the Great Depression of the 1930s and I am sure that all of them are right. I’ve been doing a lot of reading about not only the Great Depression but also the Weimar Republic and have come to the conclusion that the economy of the US (and most western countries) is in essentially the same situation the Weimar Republic was just before the Great Depression. The parallels are frightening.

In Germany, World War I was paid for with debt and a currency that had no value. Rather than raise bonds/taxes or use commodities, or even simply take on debt, the German war effort was paid for with money that didn’t actually exist. They printed their currency and Germany was thrown into a cycle of massive hyperinflation. After the war, we had the Treaty of Versailles and then the Weimar Republic was formed. In 1923 till 1929 there was a bit of a recovery in the Weimar Republic economy, but when the Great Depression hit in 1929/1930, their economy was so reliant on American loans and their international debt was so high that the depression essentially wiped their markets completely bare.

The Great Depression and the complete lack of value in the US economy put massive pressure on the Germans to repay the debt they had. Combined with the deficeit caused by the Treaty of Versailles, and the lack of countries willing to loan the Republic money for fear of a repeat of the War, the only way the Weimar Republic could pay these debts was to simply print more currency. The government was unable to establish Market loans with its own people as those same people were also scared that whatever loan they got would end up being used to pay off the reparations required by the Treaty of Versailles. This set the cycle of hyperinflation into overdrive.

It was the perfect situation that allowed the NSDAP to assume control. The people were broke and they saw that whatever money they did have was being sent off to other countries to pay back a debt they saw as crippling them.

What are the parallels we see today?

• We have a US-led war paid for entirely with debt. The war in Iraq is costing the US economy many millions of dollars a day but is perceived to be achieving nothing at all.
• We have a housing market that saw massive expansion and over inflation, then suddenly dropped off as people found they couldn’t pay back loans. This meant there was a huge number of houses that were simply empty. The banks owned them, but the people that used to live in them simply couldn’t afford to pay for them.
• We see thousands of building companies that were building houses and homes suddenly in a situation where those houses cost more to build than they can sell them for. We see many properties unfinished and going to waste because of this.
• Those companies building the properties are now in massive debt. The loans they took out to pay for the building projects are now more expensive than the return they will see on the completed projects.
• We see a banking system that took on massive debt and sold mortgages to people it knew were highly unlikely to be able to pay the loan back. It then sold this debt overseas to international banks who were none-the-wiser.
• We see the Federal Reserve attempting to restore confidence in the market by trying to inject huge amounts of money it doesn’t have. Worse yet, the amount of money its injecting is no where near the amount necessary. Personally, I believe the market needs to correct itself and the Federal Reserve should stay out of it entirely.
• All this money has to be paid for somehow. The US economy is already in debt beyond what it can realistically pay for. How’s it going to inject this new money into the economy when it doesn’t exist? Print it.
• We see a complete distrust in the financial sector by the average person on the street. This is compounded by the perception that the Government is bailing out those very people in the financial sector that caused this problem with the bad loans.

So what can be done to correct this problem? We need to look at the Weimar Republic and the Great Depression to learn these answers because that is the only period in history that can be comparable to what we are seeing today.

Firstly, people need to stop spending and start saving. But don’t keep your money in the shoebox somewhere. The money needs to be saved in the banking system where it will not only earn a small amount of interest, but it will also free up the banks to start issuing credit again. This is truly the most important part right now.

Secondly, take advantage of the fantastic deals you can get on stock at the moment and start reinvesting in companies that provide essential services. Everyone has a different idea as to what that means, so I won’t offer suggestions. But remember to perform your due diligence.

If you are not confident enough to invest in companies, buy interest bearing bonds. This is almost the same as you giving the Government a fixed term loan.

There is a pretty significant problem with these suggestions though. It takes a lot of courage to do that in the current situation. Especially when you could lose your job at any moment. But if enough people start to do this, then it will start the economy moving forward again.

With the markets as low as they’ve been in over 5 years, I really do see this as being a great opportunity for people to get in now while they can. Sure, you could wait and let things get worse and the markets drop far lower. But if you do that, you may find that you suddenly have no job and the money you do have now is needed just to buy food.