Download Is it 1931, 1937, or 1939? - McGuire Performance Solutions

Is it 1931, 1937, or 1939?
SmartRamps Commentary – September 2011
Looking at current events, you could wonder whether financial markets are preparing for a
repeat of the economic crash of 1931, the heartbreaking double dip into a steep recession
of 1937, or the strong expansion beginning in 1939. All of those outcomes can be
potentially read from the news – but what is most likely ahead for the US economy?
1931: Greece and Credit Anstalt
In 1931, Credit Anstalt, the largest bank in Austria failed. Its failure is often credited with
turning a serious recession into the Great Depression. It was not Credit Anstalt’s failure
directly that was the problem, but the crisis of confidence that its failure sparked throughout
Europe and even the U.S. The question now is whether a Greek default would prompt a
similar crisis of confidence?
The Greek deficit situation has been long brewing. The country’s fundamental lack of
balance, without any attempt to regain a long term equilibrium, have only recently been
clearly apparent to financial markets. While Greece has recently attempted austerity
measures and has been the recipient of some bailout assistance, those steps have not
made the Greek situation better. They may, in fact have made it worse. That is, efforts to
increase taxes and decrease government expenditures in a recessionary period further
slowed Greek growth and lowered tax revenues.
The question now is whether EU policy makers are willing and able to take the steps
necessary to diffuse the crisis. Letting Greece default would be the simplest thing to do,
possibly in conjunction with leaving the EU. But a Greek default would mean German and
French banks that have lent to Greece would have to write down assets and some large
institutions would face capital shortages. That is the link to the Credit Anstalt’s failure. The
Greek default may not be an insurmountable problem itself, but the potential failure or
required bailout of large European banks would likely be a confidence problem of much
more serious proportions – and that does not touch on the question of what actions Portugal,
Ireland, Italy and Spain might take after a Greek default.
Looking at the issue from a U.S. perspective, few U.S. banks have any appreciable
exposure in the event of a Greek default, but if European banking institutions’ soundness
were questioned or if other European countries exited the EU as a precursor to a debt
restructuring, then some U.S. institutions would have potential problems. In this case, the
1931 scenario could quickly be repeated in 2011. I think this is a worst case scenario but it
is not something that one should dismiss altogether.
Why is this scenario unlikely? Since the 1993 founding of the European Union, hundreds of
billions of dollars have been spent to integrate the EU economies and to launch the euro.
Are countries like France and Germany willing to say that those efforts were in vain? If
countries on the periphery were to leave, even if the core remained intact, the value of the
euro and the EU would be greatly reduced. While there is major opposition to further
bailouts of Greece, the alternative of seeing Greece default and/or leave appears to have
even greater costs than bailing them out.
©2011 McGuire Performance Solutions, Inc.
1 The seriousness of the EU’s problems cannot be overstated, even though it has not
received widespread publicity in the U.S. One indication of the worldwide concern is that
there has been some conversation about countries outside the EU bailing out the EU (e.g.
countries like Brazil, China and Russia). The U.S. is notably not mentioned although the
Fed has in the past made substantial loans to many European banks.
1937: Unsupportive Macroeconomic Policy
If we successfully avoid a replay of 1931, is the U.S. economy then on the road to a real
recovery? Unfortunately, I am not quite so optimistic on that score. The U.S. economy
bottomed out during the Depression in 1933 with an unemployment rate exceeding 20
percent. While the unemployment remained much higher than desired the next several
years, it was at least declining – until 1937 when the U.S. went into another recession.
What caused the double dip? Economists still debate the point but the consensus is that
cuts in Federal expenditures and tax increases, both enacted under Roosevelt to balance
the budget, together with contractionary monetary policy were responsible. Current
concerns about the Federal deficit and efforts to reduce the deficit mirror the alarms raised
in 1937. That the recovery overall and especially of late has been so anemic likely reflects
that the relative size of the government sector has been shrinking for the past couple of
years, with government employment consistently falling.
Even with a relatively contractionary fiscal policy, the kind of meltdown starting from the
base of an already underperforming economy does not appear likely to me. Monetary policy
likely will remain expansionary enough (see below) to prevent returning to a full scale
recession as long as the situation in Europe does not spiral out of hand. However,
monetary policy by itself likely does not have the ability to increase growth to a level close to
what is needed to really move the economy forward.
1939: A Successful Operation Twist?
The key difference between 1937 and 2011 is that the Fed is not in a contractionary policy
mode. The Fed has driven short term interest rates to zero and has undertaken quantitative
easing, in both QE1 and QE2. And now the Fed is undertaking Operation Twist, trying to
reduce long term rates, to spur investment, even at the potential cost of slightly increasing
short term rates. Any chance it can do this?
This current Fed policy is not the first time the Fed has tried to deliberately flatten the yield
curve. Generally, Fed purchases of Treasuries are at the short end. But in 1961 President
Kennedy announced the Treasury would be undertaking Operation Twist, issuing more
short term notes than long term. Shortly thereafter the Fed explicitly endorsed the action
and stated it would be buying longer term notes.
Can they successfully reduce long run interest rates? The evidence from the first Operation
Twist is limited. The Fed at that time undertook policy in secret. We cannot evaluate how it
changed its holdings of short vs. long bonds, for example. However, a study by the Federal
Reserve Bank of San Francisco indicates that when the Fed announced the policy changes,
short term rates increased and long term rates fell, both statistically significantly. More
recently, since the announcement of the reincarnation of Operation Twist, long term
Treasury rates have fallen by almost one percent. The simple answer on Operation Twist is
that the Fed absolutely has the power to lower longer term rates.
©2011 McGuire Performance Solutions, Inc.
2 The unanswered question is whether the reduction in longer term rates will have an impact
on the economy. Unfortunately, the evidence on this point is not positive. With the original
Operation Twist, there was no appreciable increase in investment and the original Operation
Twist is not generally viewed as a success. It is not clear whether its failure was due to the
economy at that point not responding to lower long term rates or perhaps due to lack of
follow-through by the Treasury and the Fed. The program was announced in February and
the last indirect reference to the program was in April. So it may be that the experiment
simply was either too small or too short to have any impact.
There are at least three major changes with Operation Twist this time around. First, there
are far more long term Treasury bonds in circulation today, even on a relative basis, than
there were in 1961. Thus, the Fed has a greater ability to influence the slope of the yield
curve in 2011 than it had in 1961. Second, the Fed announced Operation Twist rather than
simply issuing a statement in support of a program initiated by the Treasury. Thus, the Fed
has ownership of the program and Bernanke clearly understands that the economy
desperately needs a boost. And third, the Fed appears to thoroughly understand the risks
and the potential of the economy sliding into a double-dip recession. Thus, Operation Twist
this time around will almost assuredly last as long as Bernanke thinks it is necessary and
effective in preventing a double-dip recession.
So is it 1939 again, or otherwise? With luck (which includes decisive action by the EU) it will
not be 1931 again. We are likely not going to replay 1937 either, mainly because Bernanke
appears ready to take dramatic actions if necessary to make such outcomes less likely. But
unfortunately, I think the only place I am going to see 1939 replayed anytime soon is in my
dreams. The macroeconomic implications of deleveraging from the lofty debt levels of the
pre-financial crisis world are going to play out over a long time. As the old phrase goes, you
run into debt but you crawl out.
Richard G. Sheehan, Ph.D.
Senior Vice President, Research
©2011 McGuire Performance Solutions, Inc.
3