Comparisons between 1930 and 2008

It is very clear we are in an historic economic period. As I have said (maybe too many times?) before, "History Repeats (or at least it rhymes)". But which period are we comparable to? The 1930s or the 1970s? This is the big question because the proper investment (and survival) strategy are almost opposite.

The 1930s was a period of terrible deflation leading to economic Depression. There are a lot of parallels between then and now. Are we headed back to the 1930s, or worse? Some would have us think so, in which case sell everything and go 100% to cash and hide it under the mattress.

On the other hand, this period could be more like the 1970s. Again, there are many reasons to think so. And the strategy in this case would be to buy everything possible that is a real asset. Paper money (cash) just becomes more worthless every day with inflation and a stagnant economy. Real assets will grow in value at least as fast as inflation reduces the value of a dollar.

I won't try to answer the question because there is not enough information to know for sure (and if I really knew this answer, I could name my price). But I did find some interesting academic notes on the subject from an Eric Rauchway, an economics professor at UC Davis and author of a noted book on the Great Depression. You can read his notes or hear his podcast at this web link:

http://www.econtalk.org/archives/2008/12/rauchway_on_the.html

If you don't want to take the time to listen or read in entirety, here are a few bullets that compare the 1930s to now, paraphrasing the author / interviewee, Rauchway:

• Fed raised interest rates, first in 1928 to attract foreign investment; Followed by drop in consumer spending. Immediate transfer via the uncertainty mechanism to the real economy.
• Parallel, recent drop in automobile purchases after Fed raised rates in 2006 to cool economy;

• 1930: people afraid they will lose their jobs;
• 2008: Bankers afraid they will lose their jobs and be unable to pay their bank borrowings back. Strange that Treasury Secretary Henry Paulson is angry about that, given the history. Nice parallel with the 1930s.

• Hoover administration created the Reconstruction Finance Corporation in 1932,
• Similar to the Troubled Assets Relief Program (TARP) in 2008.

• RFC originally going to lend money to banks to prop them up. Realized that this is not going to work and they have to recapitalize the banks. Hoover doesn't like the idea of buying bank stocks (nationalizing) in return for the capital (big mistake, as it helps bring public support on board and eliminates moral hazard).
• We recently went through in a few weeks what we went through from January 1932 to March 1933 back then. We sped it up, and we accepted bank equity or warrants in exchange for capital. However, the speed discomfits consumers. Banks now are rather cautious in lending, as a result of speed and uncertainty. Consumers are not yet spending.

• In the 1930s, Fed administrators were frustrated that the banks weren't lending after being recapitalized; RFC said it would lend in their stead, only to find that there weren't enough qualified borrowers.
• Maybe we'll recover much quicker too (because the bank recap was sped up). Uncertainty about what may happen next is offsetting, (though and is holding back lending). Lending encouragement is working as shown by declining spreads between various lending classes like mortgage rates and Treasuries. We must avoid being too conservative in our qualification of borrowers and must make borrowing very attractive with excellent rates and terms;

But here are ways the two periods are quite different, to the benefit of the current period:

• Hoover signed the Smoot-Hawley Tariff Act, with some zeal. Contrary to the myth that he was a laissez faire ideologue. Not a stand-idly-by guy.
• So far we have avoided any protectionist legislation, like rescinding NAFTA. Protectionism shuts off a need source of capital flow.

• Hoover became increasingly desperate through 1932. At some point you have to say Hoover should have been doing more. Hoover tried to coordinate businessmen to prevent a drop in wages. Ineffective, can't get enough businessmen to agree.
• We now know that direct government control of the economy does not work. Nixon proved again in 1972 with wage-price freeze. Get around it by letting companies laying people off--pay higher wages but hire fewer people. This keeps consumers buying, if fewer consumers;

• In early 1930s, unemployment was about 25%, annual figures: just shy of that in 1932, about that in 1933.
• From that experience we know now that unemployment is necessary, so wages will fall to a point to entice firms to hire workers; but if people don't have jobs, economy won't recover, people don't have any money to buy things, so firms have no money to pay for more employees. Circular flow of macroeconomics understood and hard to navigate politically.

• Difference then vs. now: no unemployment insurance, no deposit insurance, no old age pensions--state level and some private stuff, but tapped out by 1931 or 1932. Agricultural difficulties of the 1920s also used up some of these social welfare resources (in farm states).
• Now there is an extensive social welfare safety net at the state and national level; Feds can create money if needed, to keep people fed and sheltered; can also provide funding to states if needed and can provide medical care and food stamps, programs not in place in early 30s.

• In 1930s as people lost jobs, they drew money out of their savings, putting pressure on the banks. Banks already suffering because foreign debt was going into default (post WW1); stock related debts (margin accounts) going into default; municipalities and states going into default. No brake, no way of softening the blow.
• Today we have FDIC deposit insurance, hence eliminates runs on banks. Banking system won't collapse.

• In 1930s, there is a stark contrast between Hoover in 1930 and Roosevelt in 1933 (with hindsight). Hoover doesn't do anything to stop the bank runs. People's savings just vanish, no recourse. Lack of confidence in the system with no deposit insurance, people wondering if their bank will be next.
• We have many protections in place today to avoid bank runs as witnessed recently, especially Indymac

An even earlier depression in 1894, was the worst depression before the Great Depression. It was 40 years before the 1930s Depression (notice the 40 year cycle?) and somewhat fresh in people's minds, pretty horrible, but we don't have good measures. What happened to banks in 1894? There were pressures on banks.

There is controversy over how bad the unemployment was and how contraction of the money supply contributed to the 1894 Depression. But in 1930s, the money supply contraction can't be laid at Hoover's feet--the Federal Reserve was at fault for that. They created money on one hand to recapitalize failing banks, but took it away with the other, believing if they didn't it would create uncontrolled inflation (which we now know is better than uncontrolled deflation and is the stated goal of Bernanke and probably L Summers to come).

Hoover did increase spending, limited by institutions of the day (or lack thereof) and circumstances. But the Federal government wasn't big enough in the early 1930s to have a big effect on the total economy. Hoover tried to create big increases of public works by working with the state governments. But too little, too late, not enough stimulus."

These are the conclusions, in short, of Eric Rauchway. They are even better understood by Ben Bernanke and also by new, incoming Chair of the Council of Economic Advisers, Christina Romer. She is said to be more an authority on the Great Depression than Bernanke.

Logically, the best way out of excess debt is inflation. Inflation allows the debt to be paid in ever cheaper dollars, at the expense of the lendor, of course. But that is a story for a later day. So, if Bernanke and Romer have learned from the 1930s and do everything that it is said Hoover, and then FDR did not do, namely not doing enough to stimulate the economy, I think it is a solid bet they will ere on the side of over-stimulation which will lead to inflation and a run in hard asset prices.

Dialogue on Housing Deflation - from ArizonaRealEstateNotebook.com

Cbass // Apr 27, 2008 at 7:12 pm

Brian,

So you mean to tell me that prices for goods and services can not increase while our economy stops growing or goes into a recession just becuase there is supply?

en.wikipedia.org/wiki/Stagflation

“Demand-pull stagflation theory explores the idea that stagflation can result exclusively from monetary shocks without any concurrent supply shocks or negative shifts in economic output potential. Demand-pull theory describes a scenario where stagflation can occur following a period of monetary policy implementations that cause inflation. This theory was first proposed in 1999 by Eduardo Loyo of Havard University’s John F. Kennedy School of Government.”

Just an example of some smart dude who agrees my thoughts are possible.

Brian McMorris // Apr 28, 2008 at 9:19 pm

CBass, I don’t think you and I are very far apart on this. I concede the idea of some level of stagflation at a time like this. Today we have “demand shocks” rather than supply shocks. That demand comes from the BRIC nations and is outside our Fed’s control.

I don’t know that residency at Harvard makes this guy smarter than you or me. But yes, anything is possible. But there is no real proof, yet, for this theory that was postulated in 1999 (stagflation that results from loose monetary policy).

The most often cited example of Stagflation came in the 1970s and was the result of supply shocks (in oil and base metals). The supply constraints, accompanied by rapid demand increases in Asia (as Japan and Korea underwent a huge expansion) did result in inflation. But monetary policy probably had little to do with it. A wage inflation spiral was a reaction to the “materials” inflation, but that was in a time of powerful unions that no longer exist. It took Volcker’s interest rate shock therapy in 1980 to break the cycle of wage increases gained by striking unions ending the phenomenon known as “inflationary expectations”.

The “stag” term suggests flattish growth that is behind the rate of inflation. If inflation is at 5% and nominal growth is at 4%, that is stagflation, and not really so bad. It is just important to be invested in hard assets during such a period so that investment earnings beat inflation.

But this scenario is a lot different than the Depression that many are predicting, which requires a Deflation. I say we already have a housing depression (deflation), as compared to the 30s for example. But the other elements of the 30s Great Depression, are not in place and very likely won’t be if the Fed keeps the economy from panicking by pouring on liquidity.

packerbacker // Apr 29, 2008 at 5:52 am

Brian-

I think you are smart. I like what you say, but someone should slap you for this. You say, “we are already in a housing depression-as compared to the 1930’s” A quick google would show you that during the Great Depression, around 25% of people were forclosed on, unemployement was over 20% and household income dropped 40%.

Brian McMorris // Apr 29, 2008 at 6:20 pm

Thank you for the compliment and comments. But see that I limited my statement to “housing depression” which I borrowed from Dr. Shiller himself. He is the greatest authority maybe in the world, on the history of housing pricing, and has lots of historic data to back up his comparisons. So I am comfortable with that statement.

Average national price is down about 15% from its peak now, and more or less in freefall. He concludes, and I have no reason to differ, that it could easily drop another 15% before it bottoms. That will be as big a drop as the 30s. I am not sure the source where 25% of homes were foreclosed in the 30s. I have not seen numbers that high. I don’t necessarily believe everything I read when I google.

As for unemployment and household income dropping, this time is different. I am not saying we are in another Great Depression, just the contrary.

What makes this time different, is we have the lesson of the 30s to teach us how to respond to the housing depression, so problems will not be magnified. We will probably not have 40% foreclosure, because this time, the banks started acting early to deal with their bad loans. The Fed also got into the act early because of Bernanke’s expertise on dealing with conditions that lead to broader economic depressions, including acting aggressively to cut interest rates and simultaneously supply liquidity (in numerous ways) to keep the banking system from imploding.

It did implode in the 30s and that is why foreclosures went so high, the banks could not afford to negotiate with the home owner, do short sales, or hold bad mortgage portfolios. The banks then were S&Ls with no where to go for help (there was a Fed, but it wasn’t ready for the problems it faced).

If you find economics interesting (you can probably tell that I do), I will share with you a very credible source on Depression era statistics, causes and effects: Mr. Ben Bernanke. Here is a speech of his from 2004 (so not colored by the current situation):

http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm

In it Bernanke quoted a study by economist Milton Friedman, published in 1963, that proves that monetary contraction was the proximate cause of the Great Depression. There are many examples given as evidence, but I will let you read it there rather than fill this space with quotes. This is why we see Bernanke’s Fed has been so dramatically increasing liquidity, much to the consternation of CBass and others. But Bernanke and others are on record saying it is much easier to fight easy-money induced inflation, than contraction-induced deflation. The housing crisis on its own contracts money supply (basically evaporating paper money in the form of mortgage liabilities). Bernanke’s Fed has responded by expanding it in other places, probably for a net zero effect. But we won’t know for a few years.

So, I stand by my earlier positions defending monetary expansion, but appreciate the opportunity to explain why.