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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 48 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 3 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. 4