THE BEAR'S LAIR Creating a great depression
By Martin Hutchinson
Financial downturns are unpleasant, but they do not need to turn into the Great
Depression, which historians now agree was the product primarily of a number of
egregious policy mistakes. For almost 80 years, we have thus felt safe from a
recurrence of the "Great Depression" phenomenon, primarily on the basis of "we
have learned from those mistakes - nobody would today be so stupid."
Sadly, recent events suggest that this optimism may have been misplaced and
that politicians, never the most economically intelligent of mankind, may be
working towards the considerable feat of constructing a Great Depression - Mark
II.
The bull market before 1929 was sold for a generation as unprecedented in size,
representing an apogee of speculation that
had never been seen before and would never be seen again. We now know that to
be rubbish. Radio Corporation of America, the Google or Microsoft of the
period, never sold for more than 28 times earnings, a generous valuation to be
sure but nothing compared with the stratospheric prices reached by the more
fashionable dot-coms in 1999-2000.
The stock market capitalization to US gross domestic product ratio peaked in
1929 at 75%, above the long-term average of 58%, equal to the 1966 peak, but
less than half of the 185% it reached in 1999 and still substantially less than
the 105% of GDP at the end of 2007. Then there was housing, which in the 1920s
enjoyed no great boom outside Florida (partly because mortgage finance was then
very conservative) and so did not represent a giant overhang of overpriced
assets ready to crush the economy when markets turned.
While the asset bubble awaiting deflation in 1929 was smaller than those of
2000 or 2007 (or that in Japan in 1990) the global economy of 1929 had other
weaknesses. The world payments balance had not recovered fully from World War
I, so continental Europe was dependent on loans from the New York money market,
as was much of Latin America. US and most European tariffs were much higher
than currently, while the British Empire was running an entirely self-defeating
unilateral free trade policy, with a currency that was linked to gold and
considerably overvalued - thus Britain had largely failed to share in the US
boom of the 1920s.
Thus the imbalances in 1929 and 2007 were different, but fairly close to
equivalent. In both cases, the world economy had shown robust growth over the
preceding few years but had weaknesses which were likely to cause trouble in
the long run. In the circumstances of 1929, it is now generally agreed that the
following ingredients came together to worsen an inevitable downturn and turn
it into the Great Depression:
1. A crash in asset prices, wiping out much wealth that had been thought
secure.
2. A revival in protectionism early in the downturn, destabilizing the world
payments equilibrium and causing world trade to decline.
3. A series of serious banking crashes - the Bank of the United States failure
of December 1930, followed by the Austrian Creditanstalt crash of May 1931,
leading to a collapse in the US and global money supply which was not corrected
by the Fed.
4. A determined diversion of resources from the private sector to the public
sector, initially in 1931-32 by president Herbert Hoover�s
Reconstruction Finance Corporation and then by the New Deal.
5. A panicky incentive-killing tax increase pushing up top marginal income tax
rates sharply from 25% to 63%. 6. A partial abandonment of basic principles of
capitalism through the first New Deal, disrupting relations between buyers and
sellers.
7. A government-directed destruction of capital raising mechanisms, motivated
by hatred of Wall Street and rendering risky debt and equity issues almost
impossible for the next decade.
As the political picture of the 2008 electoral transition comes into clearer
focus, personality parallels with the 1929-39 period appear. The current
presidential candidates eerily mirror the presidents who presided over the
Great Depression.
John McCain is Herbert Hoover, full of populist denunciations of Wall Street
that clearly come from the heart, but devoid of effective solutions to the
economic problems the US faces. We can imagine McCain in the White House, after
a year or so during which the economy proves recalcitrant, adding to the
national pessimism by scowling angrily for the cameras at a fate that has left
him confronted by a problem he cannot solve - or possibly borrowing some
leftist solution like Hoover's 1932 tax increase that makes matters much worse.
As in 1931-32, the electorate would soon be counting the days until 2012, when
another choice could be made.
As for Barack Obama, he is nothing more nor less than Franklin Roosevelt, empty
rhetoric and all. "We have nothing to fear but fear itself!" rivals "Yes, we
can!" in its mindless uplift and lack of specificity. Like Roosevelt, Obama
would be full of clever ideas to solve the nation's economic problems; like
Roosevelt's, his ideas would mostly be half-baked leftist panaceas that did
more harm than good, prolonging the downturn and leading the nation a
substantial distance further towards the nightmare of the leviathan state. His
rhetoric is so good, however that the electorate would not notice his economic
failures and would happily re-elect him as they did Roosevelt in 1936.
Given the grim political prospect ahead of us, we can now examine the checklist
for Great Depression causation, and see how many we can check off for today's
leaders:
Asset price crash: Check! We�ve already had the crash in asset
prices, twice, in 2000-02 with stocks and now with housing. As the stock market
crash of 1987 demonstrated, asset price crashes don't necessarily lead to Great
Depressions, but they do thoroughly shake the financial system and reveal
hidden weaknesses. This time around, there have been plenty to reveal.
Protectionism: Yes, but less severe. Protectionism is definitely
reviving, but to nothing like the level of the Smoot-Hawley tariff. Obama's
threat to renegotiate the Northa America Free Trade Agreement, combined with a
substantial recession, could produce a substantial leap in protectionism. We
can however have at least moderate confidence that Obama has no intention of
actually doing anything so foolish as to reopen trade agreements in the middle
of an economic downturn.
Bank failures: Check! We need an actual bank or two to go under however,
not just these investment banking houses of cards, and we need an international
bankruptcy along the lines of Creditanstalt. My money would be on one of the
thoroughly opaque Chinese behemoths. The Fed and other central banks will
doubtless try to avoid a collapse of the money supply following a bankruptcy;
they may simply produce hyperinflation, a problem we didn't have in the 1930s.
Expansion of the public sector: Check! Treasury Secretary Hank
Paulson�s US$700 billion housing bailout fund certainly qualifies here.
Commentators have noted the similarity to Hoover's Reconstruction Finance
Corporation, without noting that the RFC was a colossal economic failure. It
diverted resources to politically selected companies, increasing the level of
federal debt raising and thereby crowding truly private sector entities out of
the capital market. The diversion of resources from the private to the public
sector was itself deflationary, weakening the system�s productivity
growth potential and deepening the downturn.
Treasury Secretary Henry Paulson appears to be operating on the basis that
federal resources are essentially infinite. A $700 billion bailout and the $1
trillion deficits to which it will lead will "destruction test" this bizarre
theory. Obama's spending plans, which presumably won't be abandoned altogether,
will also be a problem here, Indeed it is likely that by 2012 the ratio of
federal spending to GDP will be at a new high level never before seen in
peacetime. As with bank failures, this time around an excessively accommodative
Federal Reserve is likely to monetize the additional debt and thereby cause
rapidly accelerating inflation.
Tax increases in a downturn: Probable. Obama has already promised tax
increases, which he will probably make larger than planned to attack the $1
trillion deficits. That's precisely the mistake Hoover made. McCain hasn't
promised tax increases, but appears to have no great philosophical objection to
higher taxes and a commitment to reducing the deficit - it thus looks like tax
increases will be forthcoming from him, too.
Abandonment of capitalism: Probable. The principles of capitalism will
have little popular support in the years ahead, as in the 1930s. Hence there
will be no immediate opposition (other than from politically discredited
industries) to daft new schemes of regulation that destroy market incentives.
Obama has some idea how markets work, but the barons in the congressional
Democrat majority don't, so there is likely to be some truly damaging
legislation in our future. Even if McCain becomes president, he appears to have
no instincts as to which controls and restrictions would wreak most destruction
so "compromise" legislation with congressional Democrats might be as bad or
worse than under a president Obama.
Destruction of capital markets: Possible. This is the big question-mark.
In the 1930s, the Glass-Steagall Act, by separating investment banking from
commercial banking at the bottom of a recession, when capital was scarce and
entrepreneurial spirits non-existent, produced investment banks that were truly
undercapitalized and indeed unprofitable - even Merrill Lynch, among the
largest of them even then, lost money over the decade of the 1930s and survived
only through subventions from Charles Merrill's mother's trust fund. The result
was a level of capital-raising in bond and stock markets throughout the late
1930s that was below that at the bottom of the 1920-21 recession, in a much
larger economy. It is not unimaginable that draconian legislation along the
same lines, backed by popular outrage against Wall Street, might have a similar
effect.
Thus not all of these factors operate to repeat the 1930s exactly; on the other
hand, some of them merely promise a more inflationary version of that sorry
decade, which would probably be even more unpleasant. While a re-run of the
Great Depression, with or without hyperinflation, is still by no means
inevitable, we are a lot closer than we were a month ago.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
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