Download 1929–2000: no comparison!

1929–2000: no comparison!
Jean-Pierre Béguelin, Chief Economist
OCTOBER 2002
Stock markets have been on the slide for nearly three years now and the decline unfortunately gathered pace over the summer. Share prices in developed
nations have sunk so fast across the board that fear are mounting about an impending depression, with all its accompanying ills of deflation, mass unemployment and widespread impoverishment. With this in mind, it is well worth
comparing and contrasting the current shape of our economies with the situation prevalent during the classic Depression Years of the 1930s. We only need
to look at the USA as, even with the euro in existence, the so-called contagion
effect – when America sneezes, Europe catches a cold – appears just as true
today as it has always been, especially when it comes to financial markets. The
differences between now and the 1930s are so striking that a few charts
showing, side by side, the paths of key macroeconomic data from October 1929
for the historical period and since March 2000 for the current downswing will
be enough to demonstrate that comparisons are not, after all, odious.
Comparison between 1929 and 2000: no need for a magnifying-glass
Even when it comes to stock market movements, we do not need a magnifyingglass to spot the differences. As Chart 1 (see page 2) demonstrates, although
the S&P Composite index has dropped some 40% since March 2000, it had
already slumped by 80% by April 1932 (31 months after the crash) and would
continue to fall a further 25% before hitting rock-bottom in July 1932. The
comparison is just as striking when it comes to more macroeconomic variables.
As we can see in Chart II (page 2), real GDP literally imploded in the 1930s,
contracting by 32% between the peak and the trough of the crisis, whereas the
US economy is now roughly 4% above its level for 2000 despite the recession in
2001 and last September’s terrorist attacks. A prudent observer would,
however, point out that national accounts were still in their infancy 70 years
ago. Kuznets, a Nobel prize-winner in 1971, was just trying to establish major
economic aggregates, such as GDP, GNP and National Income, so these
estimates were clearly not as reliable as they are today. Nevertheless, a comparison using industrial output – a more straightforward statistic to compute –
paints a pretty similar picture to the one for GDP (see Chart III on page 2).
Much the same can be said of the unemployment rate which climbed to 25%
when the recession was at its nadir in 1933 compared to less than 6% at
present. Despite their simplicity, these comparisons illustrate just how different
the states of financial markets and the economy today and in the 1930s are.
I - USA: S&P Composite index
120
100
80
2000-2002
1929-1939
60
40
20
0
-12
0
12
24
36
48
60
72
0 = Oct. 1929 and March 2000
84
96
108
120
II - USA: level of GDP in real terms
110
2000-2002
100
1929-1939
90
80
70
60
50
0
4
8
12
16
20
24
0 = Q4 1929 and Q1 2000
28
32
36
96
108
III - USA: level of industrial production
110
2000-2002
100
90
80
70
1929-1939
60
50
40
-12
0
12
24
36
48
60
72
0 = Oct. 1929 and March 2000
84
120
2
IV - USA: level of consumer prices index (CPI)
110
2000-2002
100
90
1929-1939
80
70
-12
0
12
24
36
48
60
72
0 = Oct. 1929 and March 2000
Va - USA: level of M2
84
96
108
120
Vb - USA: currency in circulation
150
130
140
2000-2002
120
1929-1933
130
110
120
110
100
2000-2002
100
90
90
80
80
1929-1933
70
70
-12
0
12
24
36
0 = Oct. 1929 and March 2000
48
-12
0
12
24
36
0 = Oct. 1929 and March 2000
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True deflation
So what about all the risks of deflation that fill the columns of the economic
press today? Chart IV shows to what extent current concerns about ‘deflation’
or even ‘pre-deflation’ have been grossly blown out of proportion. In the USA,
consumer prices (the CPI is already the least volatile of the price indices)
dropped by 7.8% p.a. between October 1929 and April 1933 compared to an
annual average increase of 2.3% between March 2000 and September 2001.
The disparity is so great that it cannot really be blamed on measurement problems or structural differences between economies and markets then and now.
Although the two periods do exhibit some similarities - a burst speculative
bubble, bad debts building up in the economy - we will not attempt to explain
why today is so different from the 1930s as a whole host of doctoral theses
would not be enough to do it, let alone analysing the libraries of academic research striving to elucidate the causes of the Great Depression.
Since 1963 when the Nobel prize-winner Milton Friedman published with Anna
Schwartz A Monetary History of the United States, the main factor that caused
the classic 1929-30 recession to degenerate into the depression of 1931-33 has
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been regarded by most economists as settled: the mistakes in monetary policy
committed by the Federal Reserve. Some, who claim to be ‘Austrian’ economists, refute, however, this accepted interpretation, asserting that it belongs to
the realms of fairy tales and make-believe.
The Federal Reserve did not create enough...
This point warrants closer examination. Confusion stems from the differing
behaviour of broad – say, M2 – and narrow monetary aggregates, such as the
high-powered money stock or bank notes in circulation. Although M2 (see
Chart Va on page 3) fell steeply between 1929 and 1933, the level of currency in
circulation (see Chart Vb on page 3) rose because the general public was so
worried about banks possibly failing that they increasingly shifted their deposits, which were not insured at the time, into cash. The Federal Reserve supplied
the bank notes, but did not create enough. Firstly, if every dollar withdrawn
from a bank had been replaced by a 1-dollar note, M2, which is the sum of
notes and deposits, would not have changed as one means of payment would
simply have replaced another. Secondly, as interbank clearing is rather efficient, the paying power is much greater for deposits – in other words, their
velocity is higher – than for bank notes so an economy needs more of the latter
than of the former to finance the same number of transactions.
Moreover, the banking system’s capacity to grant new loans was increasingly
impaired by the very withdrawal of deposits – technically, the ‘money multiplier’ effect faded – so liquidity became ever tighter. The Federal Reserve did
not completely realise what was happening as it did not have at its disposal
frequent enough data on banks’ balance sheets. All it could see was the rapid
rise of currency in circulation, giving it the impression that its monetary policy
was sufficiently or, even, too expansionary. It was partly this lack of information that prompted the Federal Reserve to hike the discount rate from 1.5% to
3.75% in early 1932 when gold was flowing out of the USA following the devaluation of the pound in 1931. This monetary tightening in the middle of a fullblown recession was the trigger for the dramatic depression that took hold in
the ensuing years.
...money between 1931 and 1933
This all looks quite obvious with the benefit of hindsight and it is not our intent
today to criticise policy-makers who reacted to the best of their knowledge,
information and understanding at that time. The Federal Reserve had cut the
discount rate from 6% to 1.5% between 1930 and 1931, but it probably did too
little too late, especially considering the downward spiral in prices that was
materialising. Today, the US authorities have fortunately not committed the
same mistakes. We just have to hope that others will be wiser in future...but
disseminating the notion that monetary policy did not play a role as a catalyst
in the 1930s Depression stems from a complete misunderstanding of the way in
which monetary policy is transmitted to the real economy.
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