Lessons from the Great Depression

Lessons from the Great Depression

          
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Lessons from the Great Depression

Preparing for a Tough Year Ahead
Management in a Two-Speed Economy, Corporate Development & Finance
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    The downturn has evoked dark memories of the Great Depression of the 1930s. Although we think that the current crisis will be deep and prolonged, we are not yet so pessimistic as to think that it will closely resemble the slump of 75 years ago. Having said this, we believe that a glance back to those gloomy times can be instructive for the leaders of today’s companies.
    The Economic Climate: Some Disturbing Similarities

    It is interesting to compare the U.S. economy in 1929, when the Wall Street Crash occurred, with the U.S. economy in 2007, when the mortgage-backed securities market collapsed and triggered the credit crunch.

    The two downturns were precipitated by major speculation in financial assets. In early 1928, the Dow Jones Industrial Average reached a low of 191. By September 1929, it had risen to a peak of 381. Stocks were highly valued according to all measures and about 10 percent of the market capitalization was bought on credit. Only during the technology boom of 1999 to 2000 were stocks more expensive than in the summer of 1929. It was the low-interest environment that followed the bursting of the technology bubble that allowed the real estate bubble to grow so spectacularly until August 2007.

    As in the years leading up to today’s crisis, the U.S. Federal Reserve in the 1920s tried to stop speculation: the central bank had ongoing concerns about speculation on Wall Street. Its policymakers drew a sharp distinction between “productive” and “speculative” uses of credit, and they were concerned that bank lending to brokers and investors could fuel a speculative wave in the stock market. But the efforts to persuade banks to decrease lending for speculative purposes were unsuccessful, so policymakers opted to raise interest rates in order to discourage lending. Monetarist scholars—notably Milton Friedman and Anna Schwartz—have come to consider this move a strategic mistake that served as a catalyst for the 1929 crash. Not dissimilarly, the Fed attempted to discourage real estate speculation by raising interest rates from 1 percent to 5.25 percent between 2004 and 2006.

    The overall indebtedness of the U.S. economy (of consumers, corporations, government bodies, and financial sectors) before the Great Depression was around 160 percent of GDP. This was about 40 percentage points higher than the long-term trend of 120 percent of GDP, yet it was significantly lower than today’s level of more than 360 percent. The federal government was even running a budget surplus at that time.

    Like today, consumer debt in the years before 1929 had increased significantly. Mortgages for private householders increased by 150 percent between 1920 and 1929 (to $27 billion, equal to 26.2 percent of GNP). Moreover, the innovation of installment credit—which allowed borrowers to pay back a lump sum through periodic payments—boosted consumer spending during the 1920s and caused a boom in industries such as carmaking, furniture manufacturing, and broadcasting. The volume of outstanding installment credit more than doubled between 1924 and 1929, from $1.6 billion to $3.5 billion (equal to 3.4 percent of GNP). At the end of the decade, the credit allowance of a large proportion of the nation’s consumers had been exhausted.

    Some economists believe that an additional factor leading to the downturn of the 1930s was the unequal distribution of wealth. While workers’ salaries grew by 8 percent between 1923 and 1929, manufacturing output rocketed by 32 percent. Thus, by the mid-1920s, the ability of most Americans to purchase durable goods, new automobiles, and new houses started to abate. At the same time, huge cuts were made to the top income-tax rates. As a result, by 1929, the richest 5 percent of Americans received 33.8 percent of total income, whereas today’s wealthiest 5 percent receive 22.3 percent.

    Another indicator is trade balance statistics. In the 1920s, there was a stable surplus and the United States was a net creditor with a positive international investment position of 14 percent of GNP in 1930. Today, the United States is running a deficit (of $794 billion in 2007) that has to be financed by the inflow of foreign investors’ capital (−17.6 percent of GNP).

    But today’s figures are not uniformly worse than those of 80 years ago. The corporate debt figures (as a share of total debt) show that companies were worse off in the 1920s: debt increased from 44.6 percent to 46.3 percent between 1925 and 1929. In the second quarter of 2008, the debt figure amounted to 33.6 percent.

    Moreover, during the Roaring Twenties, the U.S. economy experienced tremendous GNP growth rates—up to 15.9 percent in 1921. While these were much higher than the GNP growth rates of today, they were subject to significantly greater volatility: growth amounted to 12.1 percent in 1923 and then dropped to −0.2 percent in 1924 before rebounding to 8.4 percent in 1925. Today, by contrast, GNP growth rates are more stable, if less spectacular: in the last five years, the United States has enjoyed annual growth rates of more than 2 percent.

    What Happened in the Great Depression?

    The Great Depression is generally seen to have begun with the crash in the U.S. stock market on Friday, October 25, 1929. It was followed by Black Monday, when the stock market fell 13 percent, and Black Tuesday, when it fell 12 percent. The market lost about $30 billion in just three trading days—roughly 30 percent of the nominal U.S. GNP (for 1929). As the Great Depression evolved, the U.S. stock market decreased further, losing 89 percent of its value between September 1929 and July 1932. It was not until 1954 that stocks finally reached their pre-Crash level.

    Reduction of Industrial Output/Companies’ Profit Losses. In the summer of 1929, warehouses were full of unsold inventories. The cutback in consumer spending after the Crash intensified the incipient recession. Lower demand led the Industrial Production Index to fall from 110 in October 1929 to 100 in December—an annualized decline of 41 percent. In 1930, the index fell a further 21 percent between January and December. While dividend payments remained stable between 1929 and 1930, retained profits decreased sharply, from $2.8 billion to −$2.6 billion.

    Bank Failures. Banks faced losses on their loans to investors who could not repay because of their own losses in the stock market. In addition, they suffered credit losses from companies that were suffering from consumers’ decreasing demand. In a desperate bid to raise money, banks tried to call in their loans ahead of schedule. When depositors started to withdraw their savings, the banks often did not have enough liquidity to serve them. This caused other depositors to panic and claim their cash, ruining the banks. During this time, long queues of people wanting to withdraw their savings were a common sight. The authorities appeared unable to stop bank runs and the collapse in confidence in the banking system. From October 1929 to October 1930, about 750 U.S. banks went bankrupt. By March 1933, more than 5,000 banks had failed, wiping out the savings of millions of people.

    The Worsening of the Crisis Because of Bank Failures and Further Cuts in Consumer Spending. The U.S. economy’s credit and money supply system began to dry up as banks collapsed and as those who survived stopped lending to companies. This, added to the fact that consumers were cutting their own spending, led to a fall in investment and output. The knock-on effect was ever-worsening unemployment figures. In 1929, just 3.2 percent of the working population did not have a job. By 1933, that figure was 25 percent: more than 12 million Americans were out of work. This, in turn, caused a further decrease in consumer spending. Between 1929 and 1933, personal disposable income declined by roughly 26 percent—equivalent to $59 billion.

    Deflation. Lower investments and the contraction of consumer spending led to falling output and prices, or deflation. This created additional problems. For one thing, it increased the difficulty of paying off debts. The economist Irving Fisher concluded that borrowers’ efforts to reduce their debts by selling assets actually led to an increase in the real debt burden because the liquidation of debt could not keep up with the speed of decreasing asset prices. (See “Irving Fisher’s Debt-Deflation Theory.”) (Between 1929 and March 1933, nominal debts declined by 20 percent, while the purchasing power of the U.S. dollar rose and real consumer indebtedness increased by 40 percent.) Between 1929 and 1933, private household wealth fell by more than $100 billion—a sum roughly equal to 100 percent of nominal GNP in 1929. In addition, falling prices encouraged people to hoard cash rather than spend it, thus lowering consumer demand even further. In the end, the U.S. GNP dropped by 29 percent (in terms of 1929 prices) and by 46 percent in nominal terms between 1929 and 1933.

    What It Meant for Companies

    All industries were affected by the Great Depression, at least to varying degrees. Food processing, chemicals, and the tobacco industry were quite recession proof. Other companies that came through the downturn successfully were suppliers of nondurable consumer goods and services, industries with highly innovative products (for instance, refrigerator manufacturers: the number of refrigerators sold increased by 30 percent between 1929 and 1933), and businesses that benefited from necessary structural change (such as the petroleum industry). Producers of industrial, durable, and luxury goods or products that were not innovative suffered substantial losses. (For further details, see the table “How the Great Depression Affected Different Product Categories.”)

    Small and medium-size companies suffered the biggest decline in profits. On average, those with total assets of less than $50,000 suffered profit losses of more than 25 percent in 1932. By contrast, major corporations—those with total assets of more than $50 million—continued to be profitable. The fact that major corporations were mostly net creditors receiving an interest income helps explain how they managed to remain profitable in such difficult times.

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    Government and Central Bank Actions During the Crisis

    The initial actions of the U.S. Fed after the Crash were similar to those taken to tackle some of the economic crises of the past 20 years: it violated its standing order to limit operations to $25 million a week, and it bought $160 million worth of securities in the week ending October 30 and a total of $370 million by the end of November. Together with the open market expansion, the rediscount rate was lowered to 5 percent on November 1, 1929, and to 4.5 percent on November 15. Further sharp decreases of the rediscount rate followed in 1930 and 1931. In June 1931, it was just 2 percent.

    After the United Kingdom went off the gold standard in September 1931, the Fed started to increase the discount rate up to 3.5 percent in order to hinder the outflow of gold. The resulting rise in interest rates caused more business and bank failures.

    Herbert Hoover, the U.S. president from 1929 to 1933, conducted a fiscal policy that accelerated the economic decline. He was convinced that a balanced federal budget was crucial to restoring business confidence, so he cut government spending and raised taxes. But in the face of a crashing economy, this only served to reduce consumer demand. To boost the economy, Hoover then opted to support protective tariffs to block imports. The intention was to stimulate the economy by boosting sales of U.S.-made products. The Smoot-Hawley Tariff Act was enacted in 1930, establishing the highest average tariff in American history.

    Things changed with the arrival of Franklin D. Roosevelt, who became president in 1933. His New Deal policies were enacted in 1933, leading to the implementation of the Works Progress Administration, the Social Security Act, and the National Labor Relations Act. In addition, the dollar was devalued against gold.

    In the end, World War II helped bring an end to the long years of economic depression. U.S. employment and prosperity returned to pre-Depression levels.

    Today Is Different

    Some economic indicators suggest that we are now facing a crisis even worse than the Great Depression. But there are reasons to be optimistic that this twenty-first-century crisis, although it promises to be deep and long, will not be as damaging as its twentieth-century counterpart.

    • There are no rigid rules—such as the gold standard that pegged currencies to gold. As a result, currencies can adjust to each other more easily, and central banks can take action to stabilize the monetary system. The Fed’s expansion of the balance sheet by 145 percent since September would not have been possible in 1930.

    • Governments have been willing to intervene to protect people’s savings. As a result, there has not been a severe bank run of the kind that was commonplace in the 1930s.

    • Governments have learned from President Roosevelt’s actions—taken four years after the Wall Street Crash—and have quickly introduced fiscal stimulus packages. For instance, the U.S. government has set aside $800 billion and China has unveiled a package worth $586 billion.

    • Governments are now significant contributors to GDP. Today, the U.S. government’s contribution is 37 percent, compared with 11 percent in 1929. This fact, together with the size of social security systems, is an important stabilizing factor.

    These factors make us optimistic that the Great Depression was a one-off event. Governments and policymakers have the tools to counter the worst effects of today’s downturn. But avoiding another Great Depression will come at a price: the debt burden of governments (and, therefore, taxes) will be significantly higher, growth rates will be lower because private households and corporations with excessively high levels of debt will need to save rather than spend in order to restore their balance sheets, and inflation will be seen as a way to reduce real debt burdens. If there is to be no repeat of the Great Depression, neither is there going to be a quick return to the boom years.

    Sources and Further Reading

    Bernanke, B. S., “Money, Gold, and the Great Depression,” Remarks by Ben S. Bernanke at the H. Parker Willis Lecture in Economic Policy, Washington and Lee University, Lexington, Virginia, March 2, 2004.

    Bernstein, M. A., The Great Depression—Delayed Recovery and Economic Change in America, 1929-1939, Cambridge University Press, 1987.

    Bloomberg.

    Census Historical Statistics of the United States.

    Datastream.

    “Echoes of the Depression—1929 and All That,” The Economist, October 2, 2008.

    Fabricant, S., The Output of Manufacturing Industries, 1899-1937, National Bureau of Economic Research, 1940.

    Fabricant, S., “Profit, Losses and Business Assets, 1929-1934,” National Bureau of Economic Research, Bulletin No. 55, 1935.

    Fisher, I., “The Debt-Deflation Theory of Great Depressions,” Econometrica, October 1933.

    Friedman, M., and Schwartz, A., A Monetary History of the United States 1867-1960, Princeton University Press, 1963.

    Kindleberger, C. P., The World in Depression, 1929-1939, University of California Press, 1973.

    Persons, C. E., “Credit Expansion, 1920 to 1929, and Its Lessons,” Quarterly Journal of Economics, November 1930.

    Smiley, G., “Great Depression,” in The Concise Encyclopedia of Economics, December 12, 2008.

    Smiley, G., Rethinking the Great Depression: A New View of Its Causes and Consequences, Ivan R. Dee, 2002.

    Temin, P., Did Monetary Forces Cause the Great Depression? W.W. Norton & Co., 1976.

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