1929 and 2007: two crises, similar causes, similar effects?
There are by now probably hundreds of thousands of media articles and blog posts around the world that deal with the current economic crisis and many of which refer to the “Great Depression” of the 1930s as an aftermath of the stock market crash in 1929. Most mainstream media give room to opinionated articles and columns that, while likening some of the causes of today’s crisis to that of 1929 onwards, most maintain the view that today is different because not only are all world currencies off the gold standard but also has economic science made great progress in analysing previous “mistakes” and providing sure-fire remedies and recipes for central banks and public policy.
(See more statistical material in our References section!)
Some clarification: many of you will date the “real” crisis to 2008 and the Lehman Bros. bank failure. However, I suggest that the real mess began in 2007. The difference between both crises is really that one (the “modern” one) was about a bubble in housing, while the 1929 crisis is best remembered for the stock market bubble and then crash (Black Thursday, Tuesday or, in Europe due to the time difference, Friday).
So, the differences are basically two-fold: 1929 saw a stock market crash followed by bankruptcies and market contractions and disruptions of previously unknown global proportions while 2007 onwards saw and sees a housing market contraction and crash that then began to spill over into the rest of the economy. The other difference is that back in 1929 officially most nations affected were on a gold-standard, i.e. they had currencies that were redeemable in specie while nowadays nations have actually committed themselves (often by virtue of becoming members of the International Monetary Fund) to abolish their previous gold backing for their currencies.
However, if we look closely and look out for similarities there appear some striking features of budgetary and monetary foolishness then and now:
- Back in the 1920s, while monetary supply could not as easily be expanded as nowadays in the time of fiat money free from any implicit restrictions by redeemability, credit expansion (and thus money available to debtors for credit-financed stock purchases) still rose to epic proportions due to leveraged stock buying.
- In the run-up to the beginning bust in 2007, money and credit rose manifold and first inflated a stock market bubble, then a real estate bubble (and maybe today, 2009 and onwards, again a stock market bubble).
- In both cases, “assets” were bought with forever mounting amounts of credit and
- in both cases credit was extended and money was borrowed under the assumption that the assets bought would appreciate faster than compounded interest and principal. That, if anything, is the ultimate type of (reckless) speculation.
- What aggravated the current crisis then was unsound financing practices by banks, such as
-”carry trades” vulnerable to currency exchange risks
- and maturity mismatching whereby a bank would finance long-term debt with short-term loans which had to be rolled over every few months while the underlying “asset” might run for up to thirty years. When interest rates rose eventually not only would refinancing become more difficult and certainly more expensive, the latter assets would reciprocally depreciate, further curtailing the borrowers’ capital base.
In hindsight anyone can see that these were hare-brained schemes, but still at the time almost everyone involved marveled at the financial prowess of the participants in these reckless schemes.
In this post we won’t go into all the details such as the “virtues” of securitisation and the oh-so-clever rocket-science mathematical models as they, while adding to the sheer size of the mess, are all but ornaments and would cloud the underlying arguments that stem from sound monetary practice or the lack of it.
Some striking similarities – 1920s and 2000s
In an article titled ‘Cheap Money, Gold, and Federal Reserve Bank Policy’, then Economist of the Chase National Bank of the City of New York Benjamin M. Anderson Jr., Ph. D stated in the “Chase Economic Bulletin“, Vol. IV, No. 3, August 4, 1924:
” … The present glut in the money markets, with excessively cheap money and its attendant evils and dangers to the credit structure of the country … Since November 21, 1923, the Federal Reserve Banks have increased their holdings of Government securities from $73,000,000 to $477,000,000, …
The situation is abnormal and dangerous. … even if we have not blown up a price bubble, we have been blowing up a credit bubble, especially in the form of long-time debts. States, municipalities, agriculture, and other borrowers have borrowed excessively because money has been cheap. Banks have invested heavily in long-time bonds. A great volume of short-time money market funds has been diverted to capital uses.
Misled by the artificial excess of money market funds, many of us believe that investment capital is likewise abundant. With a change in the business tide, … we should see this illusion dispelled. … Men who use money market funds at low rates for capital purposes may expect a rude awakening when the tide turns, … Rediscount rates should be regularly kept higher than market rates, … Both discount rates and long-time interest rates will go sharply higher, and the folly of those who engage in long-time plans on the assumption that cheap money is to persist indefinitely, will become clearly manifest. … Cheap money is always dangerous, and there are always possibilities of a bad flare-up in it. By itself, however, it can accomplish little. … But when there comes a concomitance of cheap money and general hopefulness, even though the hopefulness be based on fallacious conceptions, grave dangers always exist. … If we allow things to drift, … grave dangers lie ahead.” [Emphasis mine; I have left out all passages that referred to the special circumstances pertaining to the then existing gold standard and hence the then influx of gold into the US while I believe I have not by this altered those parts that allow for a comparison with today's situation.]
So, this was in 1924, with another five years to go until the whole house of cards came tumbling down in 1929 and with which the “Roaring Twenties” came to an abrupt end. Surely one can’t uphold a theory that this crisis was not predictable five years before the bubble burst, as here we have an economist who predicted just that. And eighty years from then, with hindsight and another eighty years of economic research, a zillion times greater computing power than at any time before in history, with better documented data from national statistics offices and from international bodies such as the IMF, the World Bank, the OECD and many more, “no one”, e.g. at the Fed, was able to spot the crisis in the making?
In my opinion, there’s only one way to square that circle: to own up to the fact that since then (i.e. since the 1930s) the “science” of economics must obviously have greatly regressed, at least mainstream economics surely has, since in all other fields of scientific endeavour progress has been made, tools have been honed, old fallacies been weeded out and predictions have become more precise?
What is it one “cannot see”?
Well I clearly saw things coming although I must admit at the time I did not “take the temperature” daily, esp. as I didn’t continuously watch the US or e.g. Spanish money supply aggregates, stock market quotations or price-/earnings ratios which I only began focusing on since mid-2007 when I began to see the financial tsunami building (and then also began sounding the alarm as many others had done long before – however, since the websites I posted to at the time have since become defunct I have decided to now open my own blog as a permanent haven).
Why this crisis will be similar to 1929 pp. in many ways yet much more disastrous in the long run
Let’s look at some truly impressive statistics:
What you can see here is
- The monetary supply was virtually stable from 1913 (when the US Federal Reserve Bank was established) until the beginning of World War II (when Roosevelt and the Fed began “to print money” to “pay” for war expenses).
- It rose, albeit moderately, from the moment onwards that the US-Dollar was taken off the gold standard.
- Due to the again unbacked monetary expansion to pay for the Korean and esp. the Vietnam war efforts the money supply began to multiply for the first time in the Fed’s history, yet still that growth was “negligible” compared with today’s monetary base.
- Then Nixon took the US-Dollar completely off the gold standard in 1971 as other central banks demanded their gold in exchange for their overvalued (resp. underfunded) dollars and the gold backing had not been expanded anywhere near the amount that effectively unbacked- new money had been brought into circulation.
- Ever since, money supply growth has taken on an exponential form and the nature of exponential growth is that it eventually spirals out of control if not checked. In that respect the US-Dollar is no different than the German Mark in 1923 or the Zimbabwean Dollar in recent history.
There’s no monetary theory out there that can explain how this could ever be unwound but by an eventual debasement of the currency (a bust) if by theory we mean something that is in itself logical and/or can be corroborated by historical data that fit the theoretical predictions. I know, there are people who even got the Nobel Memorial Prize in economics for upholding untenable constructs that pass as science, however, what we are talking about here is a theory that complies with facts and/or is logically sound.
Remember, Anderson in the above article above all spoke about the expansion of credit and as we saw in the diagram above, money supply at the time had been kept in check due to the gold standard. The latter is the big difference between then and now, when and while unbridled credit expansion, time and again through the ages, is one of the main causes of such a bubble and its contraction a main reason for its bust.
Let’s therefore look at credit:
Since the US Fed has discontinued this broadest money base series (for reasons best known to themselves but it makes one wonder: “Looking back into history economic data was only kept a secret in failing economies”), we have to look elsewhere for continuation. Another source is at Shadow Government Statistics and we are greatly indebted for their continual supply of their Alternate Data Series:
Now we need to look at the time series that belongs to the critical period “back then” in the 1920s which is a bit difficult since the St. Louis Fed‘s M3 begins in 1959 only and was discontinued in early 2006.
There aren’t many time series easily accessible “out there” that show the complete stretch from around 1913 (founding of the current US Fed) up to today, but here is at least a rough one:
So, what have we found so far?
- A relatively clear link between credit expansion and “bubbles” and
- a clear link between monetary and credit expansion and price inflation,
both of which we will further corroborate with historical data in future posts though.
From here it gets more complicated, since the bubbles in, say 1929 and 2000 were stock market bubbles, the one that just burst from 2007 and ongoing was a real estate cum maturity mismatch and credit overstretch (“securitisation”) bubble.
Therefore time series that look at either a price index such as CPI or at stock markets and their P/E ratios or at real estate prices need not necessarily run convincingly in parallel if and when the focus of a bubble shifts between asset classes (cf. the tulip mania in the Netherlands etc.).
Also we would probably want to know what drives the choice of the “next asset to be hopelessly inflated” in the first place.
In forthcoming posts we therefore will try and elucidate these connections and causalities further and maybe try and understand what makes easy money shift suddenly from one asset class into another as was recently seen in the aftermath of the tech bubble which seems to have then become a housing bubble and is now a … (put your best guess here :-) ) ?
From there we then need to make good on the last section of our present heading, the “similar effects” – we will have to show how the immediate effects will be rather similar, such as rising insolvencies, unemployment etc., while probably being followed by another effect which will be far more serious and devastating in the medium term: the total destruction of the currency and world trade – because that’s what is different from last time: there’s no backing for the “money” in question, as predicted by Jefferson and many other great thinkers. No value means zero value. Period. And without money there’s only barter. Barter, however, allows only for rather direct exchanges, it s highly unlikely you can try to exchange tires against wheat to buy rubber, then pay with some of your tyres for electricity etc. to make more tires and so on. Barter is also more costly, not only in terms of work inolved, and the huge efforts required to find (a) suitable (chain of) trading partners but also because you cannot break down your money substitute into small enough units, e.g. you can’t break up a tire to pay for e.g. half a kilowatt of electricity; there’s likely always one party in direct exchange that “overpays”. And last but not least you cannot calculate, all you can do is use your best guess as to how to evaluate each other’s goods or services in any more or less direct exchange. Most market information, such as the relative value of an hour’s work at a hairdresser’s as compared to an engineer’s or at a soup kitchen, is impossible to work out correctly. What is equally damaging is that no one knows how to extend credit or borrow so any greater projects that require the employment of outside capital have to be postponed or become incalculable. All that requires a means of exchange, a “tertium comparationis“, and that can only be sound money.