Saturday, 28 November 2009

Comparing The Great Depression with The Current Crisis

The two major financial crises that can be considered “world wide” in magnitude are the Great Depression of 1929-1939 and the current one, which became clearly recognisable when Bear Stearns had to be rescued in March 2008. In between, there have been many other shocks , including the 1920-1922 German hyperinflation and the late 1990s Asian collapse .All these events highlight missed opportunities to learn from the past but hopefully suggest new clues on how to anticipate and dampen the effects of future crises.

The International economy during the two world wide crises is different in one essential way. In the 1930s, the world was on the gold standard but by 2008 a great part of the world had floating exchange rates and all countries use fiat currency. Ironically, the 2 crises were similarly magnified and diffused by the structure of their monetary systems.

Bernanke and James [1] suggest the Great Depression worsened and spread internationally because the gold standard acted as a transmission mechanism for deflation and banking- crisis contagion. The asymmetry of the Gold standard was that countries who experienced gold out-flows necessarily deflated but countries who enjoyed gold inflows (notably France and USA) could hoard the specie and avoid increasing their money supply. In other words, avoid the necessary reflation which was in every one’s interests.
Leading up to 1929 all 4 major economies had overly tight monetary policy. Britain needed to be tight as gold was flowing to France and Germany; France chose not to recycle its gold, Germany needed credibility after the 1920-23 inflation and America was worried by its stock market boom. Deflation was concurrent and spreading.
Equally, banking difficulties were contagious. A crisis in one country led to instability in another. For example, when Credit Anstalt collapsed in May 1931, and exchange controls were enforced to prevent capital flight, there was immediately pressure in Budapest because deposits had been frozen in Vienna creating currency shortages for her trading partners. Two months later, German banking came under pressure and British depositors rationally withdrew money from Germany for fear of having their money frozen or devalued. Banking fears became infectious. Raising rates to remain on the standard, would deflate an economy, make debt (particularly short term debt) harder to service, endanger the banks and create fear of devaluation and capital flight .As Harold James[2] suggests, the change in the debt structure of banks and governments to a large increase of short term debt relative to long term debt made it more difficult to accommodate capital movement. Curing deficits made up of large short-term debt required raising rates, which increased debt servicing and heightened fears of the banks’ very solvency.
The Financial crisis that enveloped the world in the 1930s was the sum and culmination of many different problems. The very nature of the Gold standard intensified price- deflation and banking weakness, but there were other destabilising events. Florida had enjoyed a real estate boom in the 1920s when credit was made too easy by unregulated banks and irresponsible intermediaries. Wall Street soared from 1926-1929 and the speculative element increased dramatically with “ bucket shops “ which allowed gambling on the price of securities with leverage of 10 to1.Speculative commodity funds had accumulated large stores of grains and metals. When the crisis broke after the Wall Street crash there was a simultaneous collapse of real estate, securities and commodities. Agricultural economies suffered particularly badly as did the American consumer. Debt deflation ensued and consumers delayed their purchasing. Adherence to the Gold Standard and ignorance of modern macro economic ideas prevailed and monetary policy remained too tight for too long. Eichengreen and Sachs [3] showed that it was only when countries abandoned the standard like GB in 1931 and USA in 1933 that industrial production picked up. Those who remained late, like France (until 1936) never fully recovered.

The irony is that the current 2000s contagion has dangerous similarities . The current fiat system has equally transmitted banking crises and capital flight , however fiat has also transferred unsound credit practices , money creation and speculative fever around the world.
The root of the crisis lies with the unnecessary easy monetary policy following the 2000-2002 recession and the subsequent proliferation of easy credit ( particularly for the housing market ), leading to an unsustainable housing boom, and a vast unregulated derivatives market [4] .The key problem was that the FED’s 1 pct interest rate policy was matched by inappropriately low rates by many countries who feared asset market declines. In particular, the Gulf States, Hong Kong , China and other Asian countries who linked themselves to the dollar either formally or informally were forced to have commensurately low rates. The real estate boom in the US was then spread through the unnecessarily easy monetary policy around the world. Many countries have had unsustainable real estate booms which bust. USA,UK Spain , Ireland , Dubai all have huge problems. This is the opposite side of the 1930s deflationary coin.
Real estate derivatives have been used by banks and other financial companies (notably AIG) for highly leveraged trading .These complex instruments were often mispriced .Regulators and auditors missed the danger. In the 30s it was the extent of short-term debt that caused the problems. This time it’s the unregulated nature of debt in the derivatives market and the nature and size of consumer debt; for example 50 year mortgages, interest –only mortgages, teaser rates, sub prime lending etc..
When the USA housing boom turned sour, there followed a reinforcing cycle down. As real estate values fell, the value of mortgage backed securities in turn fell which put pressure on banks (which owned them ) to foreclose and withdraw credit to new real estate purchasers. This in turn pressured the property market and forced down the banks’ credit -backed securities. As one bank came under pressure , or one country witnessed capital flight, the globalization of this capital structure set off fears that trading partners , financial intermediaries and other banks would also be in danger of insolvency.
Why the similarity? The similarity lies because the fiat system has allowed a build up of credit and leverage around the world of unprecedented proportion. This time, unlike the 1930s, the problem was rooted in too easy monetary policy. A small fall in the value of the underlying assets is magnified by leverage and threatens the institutions and banks that own these assets. The very nature of a world real estate boom coupled with a proliferation of mortgage-backed securities has meant that assets are owned all over the world and a crisis in one bank or one country will set off dangers in all her trading partners. The Royal Bank of Scotland and AIG are both worthy of note. RBS in essence became a holding company of UK and US real estate assets and has a toxic asset book (guaranteed by the public sector) of over 50 pct of the government’s expenditure. This is a similar proportion as Credit Anstalt which had in effect been a holding company for the securities and assets of the Hapsburg Empire[5]. AIG had to be supported otherwise many Wall Street firms would have failed creating a systemic breakdown. The fiat system now acts as a transmission for banking problems and unsound reflation. Government deficits have exploded due to collapsing tax revenues and the injection of public money to support the monetary system. The US and UK in particular have monetised over 50 pct of their government debt and there is a possibility of a buyers strike. China may equally monetise if the dollar weakens enough to threaten her quasi-fixed exchange rate. The consequence is clear. The credibility of the fiat system , like the gold standard , is in question. In the last few days India , Russia , China and Vietnam have all bought gold and announced intentions to buy more. China has made clear the need for a new reserve currency; a basket of currencies including perhaps gold. Dubai has defaulted, Vietnam has devalued.

From the 1930s we learnt that our banking system had to be separated from securities trading to prevent a systemic crisis .Real estate credit had to be regulated and stock trading derivatives had to be exchange-based. It was learnt that deflation was hard to reverse and most importantly, government cooperation was key. We have not learnt; Glass-Steagall was disbanded and real estate credit became even laxer; the credit market in general became a source of monetary pilfering. The corporate world issued themselves stock options, raised money through the bond market and with that money bought back its own shares to enhance the value of their stock holdings and options. Fannie Mae and Freddie Mac have been nationalised.

The need for reform is clear. It is not the monetary system at fault but the way it is administered. The Fiat system needs governance and sound institutional support. Governments must understand moral hazard and cannot keep interfering with central bank policy to prevent necessary hard recessions as in 2000-2002. Fiscal deficits have to be kept within reason to prevent debt crises; perhaps there should be 2 government houses .The first one is elected to raise taxes and the 2nd house elected to allocate those taxes with a strict Chinese wall between the two. All derivatives must be on an exchange to allow losses to be settled continuously and immediately[6]. This will act as a necessary transparency to prevent companies like AIG misreporting losses. Most of all, the experience of Germany and the other belligerents in the 1920s and 1940s should be used in assessing debt. The size of the allies debt after both wars is comparable to the current debt, but the public were prepared to pay those losses through rationing and austerity because the wars seemed justifiable. The current crisis rooted in easy money, unsound banking and naïve regulation might not appear worth paying for. German hyperinflation was inevitable due to the inability to fund colossal short term debt , bloated by reparation. The UK and USA in particular ,and other countries too ,should face up to the current debt to GDP ratio quickly before the fiat system breaks down. They cannot just print themselves out of the problem. To quote Von Mises[7] on the demise of the Deutschmark ,the Continental and other debased currencies:

"'This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.'

"But then, finally, the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against 'real' goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.

If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last forever.

China in particular realizes the danger of fiat creation and has started reallocating its dollar assets , buying gold and investing in mining companies and commodity assets. It is important that many indebted governments act decisively before everyone else participates in the crack-up boom.

Simon GILLIS 27 xi 2009

Other references
Bernanke . The Macroeconomics of the Great Depression 1995.
Schubert. The Credit-Anstalt crisis of 1931. 1992
Eichengreen. The origins and nature of the Great Slump revisited 1985
North and Weingast. Constitutions and commitment. The Evolution of Institutions Governing Public Choice in Seventeenth Century England. 1989
Miskin.Global Financial Instability ;Framework,Events,Iissues. 1999
Galbraith. The Great Crash 1929. 1954
Bernanke. Essays on the Great Depression.2004

[1] Ben Bernanke and Harold James .The Gold Standard , Deflation, and Financial Crisis in the Great Depression: An International Comparison 1995

[2] Harold James. Financial Flows across Frontiers during the Interwar Depression 1992
[3] Exchange Rates and Economic Recovery in the 1930s. Barry Eichengreen and Jeffrey Sachs 1984
[4] 605 Trillion dollars as of Jun 2009. BIS report 11 November 2009
[5] RBS toxic asset book approximately £340 Billion vs. UK Government Expenditure of £540 Billion
Austrian State loss on Credit Anstalt Schilling 700 Million vs. Federal Budget of 1.800 Million Schilling
Credit-Anstalt Crisis of 1931 Schubert 1991

[6] On a futures exchange, the aggregate of all a company’s trades are collated. If the net total is a loss a commensurate margin needs to be posted by the start of business the next day or otherwise all trades will be closed.
[7] Von Mises . Human Action


  1. great post. At the same time you failed to mention the buildup artificial stimulation of the housing market via the FHA, Fannie and Freddie which where a a major contributor also imho.

  2. Technology is also a factor in both depressions. In the 1930's, trucks and tractors replaced 100,000 of horses/mules which in turn freed up million of acres of pasture to farm land which in turn caused crop prices and land prices to collaspe. Now the internet has allowed for globalization and allowed production to move to the lowest unit cost areas w/o any concern enviromental/labor laws.

  3. Thanks for the great analysis!

    I always wondered how much "events" in and of themselves even make a market move... more of a social mood movement that needs paying heed to.

    If you have a chance, check out:

  4. good stuff!

    any chance that an email subscription is offered?

    i know feedburner makes it quite easy.