Here we are in the sixth year the economic plague we call the Great Recession. Although the Great Depression lasted twice as long it did not infect as much of the world. Are there lessons to be learned from this earlier crisis? The classic work on the Great Depression is The Great Crash 1929 by esteemed economist John Kenneth Galbraith. Professor Galbraith’s book is a magnificent work of research and his account of the events surrounding and contributing to the cause of the Great Depression is greatly admired and studied. His description of the events from 1928 to 1940 is enthralling and enhanced by his elegant language. A very high standard for economic literature, but does his analysis rise just as high and does it help us understand our current financial crisis?
Tuesday, March 26, 2013
Lessons from the Great Depression
It is acknowledged by Professor Galbraith and most other economists that the trigger event of the Great Depression was the loss of money in the stock market. Investors were stopped out of their margin accounts when the market suddenly declined. These margin accounts were constructed by using broker’s loans (loans collateralized by the securities purchased on margin). The popularity of this type of loan increased substantially during the 1920s from one billion early in the decade to more than 6 billion in 1928. A billion in 1929 is equivalent to a 100 billion today. Banks were not deterred from making these loans since they could “borrow money from the Federal Reserve Bank for 5 per cent and re-lend it in the call market for 12.” Not unlike the sweet arbitrage the banks could make in the prelude to our Great Recession by packaging mortgage loans into large bonds and turning a substantial profit by holding the bonds for a couple of years. During both periods people realized there was a speculative bubble, and that eventually the bubble would burst. This fact did not deter speculation even though voices were warning of impending disaster. Paul M. Warburg of the International Acceptance Bank in March 1929 predicted unless the “unrestrained speculation” was halted an eventual collapse would “bring about a general depression involving the entire country.”
The irony is everyone benefited initially from the bubble’s rise. Caution was not a serious concern. There was a general feeling among speculators that the market was supported by three strong legs. The action of speculators was one leg of support for the market. The second leg was the upward momentum of exuberant expectation of a continual rise. The third leg of support was a general sense that there was nothing to fear since who would move to deflate the bubble. In other words ineffective regulation was seen as support for the market since the government was unlikely to act and everyone in the market was benefitting from the rise. Unfortunately, no one stopped to consider how other investors would react if the market turned downward and whether there would be time to exit.
After the Great Depression, Professor Galbraith pointed out, “it has become obligatory for the regulators at every opportunity to confess their inadequacy, which in any case is all too evident.” In March of 1929 the Federal Reserve Bank began daily meetings. They did not inform anyone outside the Fed what the subject of the meetings concerned. Suspicion and rumor focused on the stock market, but that was unconfirmed. During 1929 there were some breaks in the market caused by rumor, but overall the speculative stampede continued. Corporations and even wealthy individuals lined up to provide more liquidity as the banks struggled to provide more and more funding for brokerage loans. By that summer these loans were growing by “$400 million a month.” There was concern about the degree of speculation that these brokerage loans implied. These concerns were dismissed as coming from people who “simply did not know what was going on.” The 1920s were the period when Wall Street arose as an investment opportunity for the public. It was a very immature industry without a history and a culture of caution and restraint. This exuberance was supported by the highly-regarded academic community. In the autumn of 1929 the foremost American economist of the time, Professor Irving Fisher of Yale made his often quoted estimate of the market, “Stock prices have reached what looks like a permanently high plateau.”
Irving Fisher’s comments reflected the fact that stock speculation had become part of the culture. This trend during the 1920s legitimized an activity that had not earned a place in the economic system through trial and error. Likewise, in the Great Recession housing speculation and expansion of the mortgage market to include lower and lower income participants would also prove disastrous. When A&E launched the TV show Flip this House in 2005 starring Armando and Veronica Montelongo house speculation or flipping was an accepted get rich scheme. Two years later the Housing Bubble burst.
One of the most interesting sections in Professor Galbraith’s book is his debunking of the suicide myth surrounding the Crash of 1929. He shows that statistical analysis supported a slight rise, but nothing to justify the media's characterization of crowds standing on sidewalks waiting for the next businessman to jump to his death. The media similarly misled the public in explaining the cause of the crisis. Instead of looking at the government they focused on finding someone in the private sector to blame. There were Bernie Madoffs in the Great Depression, but like Madoff they were crooks not promoters of speculation.
The real tragedy was the Press’ failure to understand what happened and outline what to watch out for in the future. Professor Galbraith made it clear in his 1954 summary, “It would be unwise to expose the economy to the shock of another major speculative collapse.” Do you recall anyone in 2006 drawing a parallel between the Housing Bubble and the Stock Market Bubble of 1928? I do not. Why? It is because the gurus over complicated it. We would be better off to simply look into get rich quick schemes and asset bubbles for the next financial crisis rather than a trend line of monetary expansion.
There is no quick way to riches. There is only hard work and slow steady returns. Blaming the cause of financial disasters on lack of self-control or greed is counter-productive. These are characteristics of the human species. Criticism is better directed at the people who create our economic institutions and fail to structure them to constrain speculative impulses and greed. Speculation is only a problem when the economic system lacks proper controls. The problem is an economic system without proper curbs, not people who lack adequate self-control.
When Professor Galbraith asks himself what the cause of the Great Depression is he looks first at why business activity slowed. He finds his answer in the unequal distribution of income. His argument is that if the middle class had more money they could sustain the economy. Isn’t it much more likely that with the financial shock of their monetary loss in the Crash many wealthy investors lost their appetitte for new investment? Looking back we know private investment collapsed reducing job creation and economic growth. These two factors are the cornerstones of business activity. Professor’s Galbraith’s explanation lacks credibility since middle class income levels did not change until after business activity slowed. The Great Depression was led down and kept down by business people unwilling to take risk.
What we can say definitively is that people lost money. Losing money has quite an impact on people. Imagine a gambler from New Jersey arriving in Las Vegas with hope and cash-filled pockets. He leaves his bags with the front desk and goes straight to the tables. Six hours later he has lost 75% of the money he brought along on his vacation. How enthusiastic is he going to be to go back to the tables after dinner? This is precisely what happens after a financial bubble bursts. The shell-shocked business people and investors are not going to charge out of their trenches into the battle again. They are going to hunker down, reassess and wait for a “real” opportunity. Professor Galbraith misses the real causes of the Great Depression and misunderstands the pivotal role of banking and business in making the system work. The problem is the system, not the people in the system.
Rereading this book made me realize Professor Galbraith focused on stock speculators and not on the characteristics of the financial system which nurtured speculation. We now know that the crisis would not have occurred if margin loans were disallowed. We also know that the stock exchanges could have employed curbs to retard large daily movements. Risk curbs also could have been created to protect novices in the market by tying their investment actions to the facilitating brokerage firm. In other words, if the clients of a brokerage firm lost a certain percentage of their client’s money, funds could be removed from a reserve account required to be held by the brokerage firm to reimburse their clients for bad advice. This technique would tie an investor’s risk to a firm’s risk, making both parties act with more caution. Another problem in almost all financial crises is excessive leverage. Leverage is easily regulated by market rules.
When economic conditions are not persuasive for business expansion investment is going to dry up. Without new investment an economy is going to slowly decline as loans are repaid and money is removed from the economy. It is not the potential for investment that matters, but actual new money coming from banks to create new business lines. More investment means many more jobs and more money looking for products to purchase. Whether this money is equally shared is not significant. One rich man spending an extra $100,000 or 100 people spending an extra $1,000 makes no difference to an economic system.
Seventy-seven years later a speculative bubble again devastated the economy, an event we now call the Great Recession. The two events are almost twins. The approach of the Great Recession could be seen by a blind economist, but not by a sighted economist looking for help from a government regulator. Sighted and blind economists before and after both crises suggested fine tuning government action was the key to avoiding a repetition. The whole idea of government action doing anything to improve an economy is an inheritance from Galbraith and Keynes. Their focus on government as our financial savior implies the coach is more important than the players. It is the team on the field that plays the game and determines the outcome, not the coach. When the players refuse to play a loss is inevitable. Even if the coach implores the players to play harder and the general manager increases their compensation, if the players decide not to expend all their effort in a game, the team will lose. Speculators did not cause either crisis. The economic field was not prepared properly for the intensity of the game.