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The Worst in History (1929-30 vs. 1999-00)

May 10, 2000

The economic contraction that started in 1929 was the worst in history. Given the scale and importance of this event, it is remarkable how little is generally known about both its course and its causes. Most probably, this largely has to do with the predominant conviction that the central banks and governments of today possess the superior wisdom and the better instruments to keep everything under control. Why bother about foolishness in history?

In principle, there are two diametrically opposite explanations of the unusual severity of the Great Depression of the 1930s. One strongly associated with the leading economists of the Austrian School (Mises, Hayek) regards the Depression as the unavoidable, disastrous end of the unsustainable, structural maladjustments which the monetary and financial excesses had inflicted between 1927-29 on the economy and the financial system. In this view, the severity of any depression is largely predetermined by the magnitude of the economic and financial maladjustments that have accumulated during the preceding boom.

This view about the ultimate cause of the Great Depression predominated among economists around the world until the early 1960s. But one book, appearing in 1963, radically changed that view, at least among American economists. It was Friedman's and Schwartz's classic, Monetary History of the United States. This book categorically postulated that there had been neither inflation nor any money or credit excesses in the 1920s that could have caused the economy's collapse between 1929 and 1933. From this followed the conclusion that the Great Depression essentially had its crucial cause in policy faults that were made during these years.

To quote a decisive passage from the book, "The monetary collapse from 1929 to 1933 was not an inevitable consequence of what had gone before. It was the result of the policies followed during those years. As already noted, alternative policies that could have halted the monetary debacle were available throughout those years. Though the Reserve System proclaimed that it was following an easy-money policy, in fact it followed an exceedingly tight policy."

For American economists, the views expressed in this book on the role of monetary policy in precipitating the depression have become standard history and the standard explanation of the Great Depression. One important, inherent conclusion of this monetarist approach for the future was the comforting message that sufficient monetary easing is enough to prevent a serious recession after a boom. This is, for sure, one assumption of central importance behind the currently prevailing bullishness about the U.S. economy.

Considering the still-booming economy and the reigning optimism about the economic outlook, the Federal Reserve responded in October-November 1929 with admirable promptness to the crash. On Nov. 1, when the selling panic was barely one week old, the Fed slashed the discount rate to 5% and a fortnight later to 4.5%. On Oct. 25, one day after Black Thursday, it had instantly reduced its buying rate on acceptances from 5 3/8% to 5%. This was followed by a rapid sequence of further cuts to 4% on Nov. 21. Yet the economy collapsed across the board with unprecedented and unbelievable rapidity like a house of cards.


We have always favored the explanation of the Great Depression tendered by Austrian theory. Of the various considerations speaking in its favor, one appears to us compelling, and that is the extraordinary speed and breadth of the economy's plunge. Consider that real GDP fell in 1930 abruptly by 9%. Such a virtual collapse can only happen to an economy that is badly out of balance and therefore highly vulnerable. The big contraction in the money supply by 42% to which Milton Friedman attributed the Depression only started in late 1930, not in precedence but in coincidence with the economic collapse. The one big event that had preceded the economic collapse was the start of the stock market crash.

Yet the role of the crash in precipitating the economic and financial disaster is highly controversial among American economists. It is estimated that the stock market crash involved a wealth destruction of about $85 billion in total. Capital losses in the first wave of the crash in late October and early November 1929 amounted to about $25 billion. This compares with a decline in the stock of broad money between late 1930 and end-1933 by $13 billion. But for Milton Friedman, the money supply's shrinkage was the one and only decisive mechanism that drove the economy into the protracted, deep depression. And what's more, this monetary shrinkage in his view had no other cause than coincident, bad policies of the Fed.

We would never dispute the decisive importance of the following, drastic monetary contraction during those years, but it grossly defies any logic to discard the prior, rapid and huge wealth destruction through the stock market as almost a non-event. In the logic of the Austrian theory, the booming stock market had operated to prolong the boom by unduly boosting wealth-related consumer spending. As soon as stock prices collapsed, this artificial element in consumer spending evaporated with a prompt and, heavily negative effect on economic growth in 1930.

In reality, personal wealth is not the only victim of such a crash. Overall liquidity is the other victim. It is a gross mistake to measure liquidity only by changes in the money stock. Far more important is the liquidity of assets, financial assets above all, in the markets. In times of loose money, low interest rates and booming markets, corporations, financial institutions and consumers tend to reduce their cash balances in favor of financial assets, regarding them under given bullish market conditions as highly liquid assets.

As long as the stock market kept booming, the vast stock holdings represented, indeed, highly liquid assets for their owners. But the plunging stock prices transformed these huge stock holdings abruptly into illiquid assets which could only be liquidated at a heavy loss. Considering the amount involved in this wealth and liquidity destruction, we don't have the slightest doubt that the stock market crash was the most important, immediate cause of the ensuing depression. The pattern of the depression might well have been radically different from what happened had it not been preceded by the stock market catastrophe. But this implies, indeed, that the Great Depression primarily originated in the excesses of the preceding boom.


With these questions and aspects in mind, we have drawn a comparison between events and excesses in the late 1920s and in the late 1990s. How do the monetary and credit excesses in the two periods compare in kind and scale?

Before we come to the tremendous differences, first an important common feature: In both periods, credit creation took place overwhelmingly outside the banking system - that is, through the securities markets and the money markets. Also common to both periods is the complete absence of Federal government borrowing. All the borrowing and lending that took place was on account of the private sector, businesses and consumers.

Next, we have to point out that credit is the most neglected aggregate in American history books about the 1920s. In their voluminous Monetary History of the United States, Friedman-Schwartz don't bring one single figure about credit growth, but instead pages and pages of detailed figures about money growth from month to month. They don't even mention the ill-reputed brokers' loans for stock speculation, totaling $8.5 billion at their peak in September 1929. Consumer borrowing in the form of installment loans played a great role in fueling the consumer spending boom in the 1920's, but statistics about their extent and source of finance are non-existent.

As explained in past letters, one critical measure of credit "excess" is growth of credit relative to the simultaneous nominal GDP growth as the statistical denominator of growth in economic activity. During the four years from end-1925 to end-1929, U.S. GDP grew by $13.9 billion, or 15.3%, from $90.5 billion to $104.4 billion.

Over this same period of four years, corporations issued securities for $27.4 billion, of which more than $10 billion was equity. Total bank loans increased by about $8 billion during these years, mostly for mortgage lending. Further considerable lending took place through institutions outside of the banking system, chiefly savings banks and building and loan associations. However, no statistics are available. The habit of America economists to focus exclusively on the money supply and to ignore credit has a long tradition.

Yet despite the lack of comprehensive statistics, the available evidence leaves no doubt that there was rampant credit creation. This recognition is very important because, in striking contrast, the money supply grew only modestly. Between 1925-1929, broad money grew by no more than 10%, from $50 billion to $55.5 billion. Demand deposits at banks in late 1929, at $22 billion were no higher than in late 1925. But this weakness in money growth, as already mentioned, had its cause by no means in lacking credit expansion but in the fact that credit creation occurred overwhelmingly through the securities and money markets, essentially involving no money creation. Stock prices, at any rate, more than tripled, and the total value of all shares listed on the New York Stock Exchange soared from $27 billion in 1925 to $89 billion at their peak in early September 1929.


This brings us to one of the most important and most striking differences between the boom of the 1920s and that of the 1990s. It concerns the financial strategy of corporations. At the time, corporations took full advantage of the abundant availability of cheap capital and issued bonds and stocks vastly in excess of their investment needs. In 1929, almost 70% of total corporate issues in securities were in stocks. To quote Schumpeter on this point: American corporations "eventually entered the Great Depression with a financial outfit which was nothing short of luxurious." Many of them could finance their investments for years to come with the funds they had raised during the speculative mania of 1928-29.

What did the corporations do with their surplus cash? Well, they did put it straight back into the stock market, but through a different channel. Instead of buying stocks for their own account, they lent these funds in large part as call loans at 10% and more to brokers, who financed soaring margin loans for the stock speculation of their clients. In the last 12 months before the crash, brokers' loans increased by 50%.

However, this over-liquidity of corporations amassed from the heavy issuance of securities had further monetary implications. For the banks it entailed the loss of their traditional chief borrowers. As the lending to corporations came to a complete stop, the banks had to look for alternative sources of revenue. After all, they embarked aggressively on two new outlets: investments in corporate bonds - and stocks through affiliates – and security loans, that is, loans to buyers of stocks and bonds against bonds and stock collateral. In the last analysis, it was the banking system that fueled the boom in the bond and the stock market, partly though purchases for their own account, partly through loans to other buyers of stocks and bonds.

To cite from a contemporary report by the League of Nations about this development: "The credit expansion after 1927 in the United States went largely to the financing of speculation. According to available statistics, no less than 86% of the total increase in bank credit was used for that purpose. Thus was laid the foundation for the stock-exchange boom which followed."


Now to the present, with the postulate of the Austrian theory in mind that every economic and financial bust is in large part a function of the scale of excesses in the preceding boom. The gauges to look at are self-evident: first, stock valuations; second, money and credit expansion; and third, economic fundamentals.

As to valuations, the collapse of the stock market started in early September 1929 with the price-to-earnings ratio at a level of 13.5, after a high point of 16.2 in January. In comparison with a traditional 10 to one ratio, these valuation levels unusually high looked at the time. Measured against the ratios of today - around 29 for the S&P 500 index, around 35 for the S&P Industrial Index and more than 200 times earnings for the Nasdaq - those of the late 1920s appear almost insignificant. To mention another measure: Before the 1929 crash, the total capitalization of listed stocks tallied with about 100% of GDP. This time, it has been almost 200%. In short, present stock valuations vastly exceed those in the late 1920s.

Next: underlying money and credit expansion. How do they compare for the two periods? As already mentioned, money in its broadest measure increased during the four years between end-1925 and end-1929 by 10% while narrow money (Ml) stagnated. For comparison: During the four years from end-1995 to end-1999, broad money (M3) has grown by a stunning 41 %, or more than twice the simultaneous GDP growth.

If money growth has been record-breaking, it is wildly outdone by credit growth, which, like in the 1920s, is overwhelmingly taking place outside of the banking system. Mr. Greenspan has presided over a credit explosion that simply defies reason and comprehension. Looking exclusively at the inflation rate, he readily sanctioned a free-for-all in credit creation. In 1995, total financial and non-financial credit had expanded by a little more than $1 trillion. After a rise to $1.4 trillion in 1997, credit flows abruptly swelled to more than $2.1 trillion in 1998 and further to $2.25 trillion in 1999. In comparison to GDP growth of $459 billion in 1998 and of $500 in 1999, credit creation has been truly running amuck.


Yet there is still another critical and dramatic difference between the two periods to be noted. It concerns corporate finance. In the late 1920s, as already expounded, American corporations frantically bolstered their liquidity by issuing equity vastly in excess of their financial needs for investment spending. In the past years, American corporations have pursued the diametrically opposite policy. They frantically depleted their liquidity and embarked on an unprecedented borrowing binge to finance acquisitions and repurchases of their own stocks. For the S&P 500 companies, for example, the debt-to-equity ratio has shot up over the last 10 years from 84 to 116.

For sure, a fascinating difference. But why? Of the two patterns, the one of the 1920s hardly needs explanation. Bolstering liquidity in times when booming markets offer cheap capital for the long haul, is just traditional corporate financial strategy. Yet the massive issuance of new stock may well have played an important role in breaking the boom in 1929.

The puzzling part is what has been happening in the late 1990s. Even though high tech companies are heavily tapping the stock market with IPOs, the corporate sector, as a whole is the big net buyer in the stock market on account of soaring acquisitions and stock buybacks.

Purchasing shares with record-low dividend yields around 1% at sky-high prices above book value with borrowed money that costs at least 6-7% is clearly at odds not only with corporate tradition but also with a reasonable profit calculation. In short, it's a folly. But the widespread adherence to this folly suggests a general compelling reason which is, indeed, easy to identify: unprecedented obsession with short range maximization of shareholder value.

Plainly, under this imperative corporate governance philosophy has radically changed in the United States. But for the better or for the worse? The bullish consensus view claims dramatic improvements in corporate efficiency and takes it for granted that this change - in conjunction with the new technology – is essentially at the heart of the U.S. economy's astonishing, recent growth performance.

Yes, corporate strategy and policy in the new market climate have in many ways radically changed. In their frenzied endeavor to increase shareholder value, corporate managers resorted mainly to two devices. Reckless financial leveraging and a cost-cutting mania. Financial leveraging implies to run down cash balances and to substitute debt for equity. The emphasis on cost-cutting as a means to raise profits and share prices has implicitly fostered mergers and acquisitions in preference to new capital investment. Under this new American capitalism, buying existing capacity has precedence over creating new capacity, while paper wealth creation through booming stock prices has precedence over wealth creation through real capital investment. And the use and allocation of real resources has led to a major shift in the composition of GDP towards private consumption, rising to its largest ever share in current GDP growth.


What are we really looking at in the United States? A supply-driven new paradigm economy or history's greatest financial bubble masking the economy's bad fundamentals? Comparing present economic and financial conditions with those in the late 1920s is a shocking exercise. Consider that the U.S. economy in the 1920s had zero inflation for years, owing to high productivity growth. It had a persistent surplus in savings and in foreign trade, and it had strong profit growth in 1928-29. Not to forget moreover the opulent cushions of liquidity that the corporations had accumulated through stock issuance while the stock market was booming. Is this unprecedented prosperity or unprecedented illusion?

And how do these economic and financial fundamentals look today? In short, they make miserable reading in every single respect. All of them are negative. What's more, negative in the extreme. Despite substantial statistical manipulations the U.S. inflation rate is above 3%, the highest rate among industrial countries. America has the lowest domestic savings of all time and the biggest trade deficit of all time. On top of being a low-saving, low investment economy, America is now a capital-consuming country, reflected in the fact that the current rise in foreign indebtedness exceeds net domestic investment.

Ominously, corporate profits, as measured by the official income statistics, have been virtually flat for more than two years, even though the economy has been booming at record growth rates. The stampede of both corporations and private households out of liquidity and into debt during recent years is without precedent.

First question: Is the incredible stock market boom a reflection of real value created in the economy, or is it a purely credit-driven paper bubble? Second question: What are the chances that the Fed will be able to prevent a devastating crash of the stock market and engineer a soft landing of the economy?

Our preliminary answer: The accumulated financial excesses and economic imbalances are far too big for such a happy end to be possible. Their huge scale essentially implies a disastrous bust. Under the influence of the monetarists, most American economists hold the view that it lies in the hands of a central bank to prevent any such bust from happening by simply "printing money." But by focusing narrowly on the banking system and the money supply, they overlook two snags. One is the monstrous scale of credit creation to which the U.S. economy and its financial system have become addicted to in the last years, and other one is the channel of this credit creation. Just as in the 1920s, it is overwhelmingly taking place outside of the banking system, through the financial markets Essentially, any disruption in these financial flows has the very same adverse effect on economic activity as a disruption in bank lending, irrespective of what is happening to the money supply. The usual pattern and early indicators of such disruptions are declining asset prices and widening interest rate spreads between papers of different quality. Considering the vast sums involved in the markets, it should be clear that the biggest danger to the U.S. economy looms in the financial markets, including the currency market and the derivatives markets.

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