The Wrong Crash

By Martin Hutchinson

Yes, I know we've just had the 80th anniversary of the 1929 crash. So what? We can learn a lot from past crashes and economic disasters, but that particular one is looking less and less relevant to the position we are in today.

For a start, the stock market of 1929 was valued at a level that appears truly moderate by today's standards. The overall price-earnings ratio of the market at its peak of September, 1929, was a mere 13.5 times earnings. Even its hottest tech stock, Radio Corporation of America, never traded in that year above 28 times earnings.

One thing one can learn from those statistics is that valuation standards have changed. The investors of 1929 undoubtedly


  

thought they were at the top of a bull market. Indeed market trends since 1922 had indeed formed a major bull market, with stock prices rising around 350%, however reasonable the market's valuations at the peak.

It may well be that as the amount of capital gradually increases in the economy, its productivity becomes less, so that real yields on bonds, stocks and presumably real estate in 2009 are far below the level that would have been considered appropriate 80 years ago - and relative prices higher. This possibility would also be suggested by the curious behavior of capital productivity, as reported by the US Bureau of Labor Statistics since 1947. This rose steadily to a peak in 1966 and has been declining ever since, now to a level well below its initial 1947 level.

Naturally, a steady reduction in the productivity of/return on capital over a period of many decades could be one factor explaining the prolonged rise in asset prices and decline in yields coinciding with the loose post-1995 monetary policy. It doesn't explain or justify all of such a change because the period since 1995 is far too short a proportion of the overall 80 years since 1929, but it suggests that some portion of the post-1995 price rise, maybe a quarter, has been caused by a natural secular long-term trend, rather than artificially pumped up by the machinations of the Federal Reserve and Wall Street.

This thesis also suggests that our long-term future may be a grim one in which returns on savings are ever declining, and few people ever manage to accumulate enough resources to retire in comfort, let alone to afford the spiralingly expensive real estate in cities and the pleasanter suburbs. The glorious 1950s suburban dream of home ownership, even at a modest level, may in the end prove to have been sadly temporary.

To return to 1929, if the stock bubble of that year was so much smaller than recent ones - market capitalization at the peak was only about 85% of gross domestic product (GDP), compared with 180% in 2000 or 2007 - then its decline cannot have caused the Great Depression, or anything more than the first downward leg thereof in 1929-30.

Indeed, for the first time this generation has empirical evidence that the '29 crash is unlikely to have caused the depression. The 1987 crash, which was larger than 1929 in its one-day drop, caused no discernable economic depression. And the deep recession of 2007-09, while clearly triggered by a financial crisis, was accompanied only by a steady decline of stock prices with no great economy-sapping crash.

As this column has discussed in the past, the true causes of the Great Depression were the Smoot-Hawley tariff, the fall in US money supply caused by the banking collapses of 1930-33 and president Herbert Hoover's utterly foolish tax increases of 1932. The downturn was then unnecessarily prolonged by a number of president Franklin Roosevelt's New Deal polices, notably his ramping up of the size of government and the power of unionized labor. The crash of 1929 was not quite an innocent bystander, but damn close.

There are much more relevant economic crises than that of 1929 to look at, with more to teach us today. For one example, there is the British secondary banking crisis of 1973-75. In that case, as recently, money supply had been allowed to race ahead of itself in 1971-73 while banking deregulation had caused the appearance of innumerable fringe banks, all attempting to make money by lending to commercial and residential real estate.

The problem was exacerbated by a public expenditure bonanza by the incoming Labor government in March 1974, seeking to consolidate its tenure at a second general election in October of that year and to placate its unruly leftist supporters. Sound familiar? It should.

The real-estate overvaluation problem was solved by a few years of high inflation, touching 25% in 1975, which limited the decline in real estate values, instead causing nominal prices and incomes to rise to meet them. The fringe banks were liquidated through a "lifeboat" sponsored by the Bank of England.

The recession which resulted from the 1973-75 crisis was fairly mild, but the inflation certainly wasn't. What's more, the British economy never got back to decent growth in the next decade. Two years after the crash, a severe government funding crisis occurred, which resulted in the International Monetary Fund being called in, and a second more severe recession struck in 1979-82.

The 1973-75 UK experience strongly suggests that simultaneous fiscal and monetary stimuli are dangerous, and that the recovery from the resultant recession may be something of a false dawn.

The secondary banking crisis of 1973 is fairly well remembered; the British Overend, Gurney & Co crash of 1866 is almost completely forgotten, though it got some mention in the British press when Northern Rock went bust in 2007. This crash is interesting because Overends operated in a manner very similar to modern Wall Street, and very dissimilar to its contemporaries.

Rather than functioning as a private bank or a merchant bank, the two common operations at that time, Overend was London's largest discount house, trading short-term bank obligations and issuing 90-day paper of its own. Instead of being content with the highly satisfactory and consistent returns from this lucrative business, Overend (whose CEO lived in palatial state, more like a modern Wall Streeter than his contemporaries) used its short-term funding to invest in long-term ventures, essentially financing private equity through commercial paper. Naturally, when a liquidity crisis hit, Overend was unable to roll over its obligations, even though it had attempted to rescue itself by an initial public offering the year before.

In today's market, Overend would have been bailed out. Its size and interconnectedness made it the AIG of its day (and its tough and raffish reputation compared to its staid contemporaries increased the resemblance). In 1866, it was allowed to fail. The result was an acute but short-lived market panic, maybe a year of very quiet business in financial services, and then several years of renewed prosperity until the crash of 1873. "Too big to fail" proved to be nothing of the sort.

The third crisis from which we can learn was the simultaneous Mississippi Company (France) and South Sea Company (England) crashes of 1720. Both involved schemes to refinance their country's national debt through exchanging it for shares in growth companies (to be fair, even in the past year, we have yet to see a proposal for a federal debt swap into Google - maybe that is ahead of us.) The French scheme additionally involved issuing paper money, thus making its proponent, John Law, something of a hero to Keynesian economists.

In any case, both schemes collapsed, but the fate of the economies concerned was very different. In France, there were no recriminations (other than against the foreigner Law, who escaped), nor was there any significant effort to reform the financial or political system, or to limit investor losses. Consequently, investor confidence in the French monarchy remained shaky throughout the 18th century, hampering it considerably in that century's wars and eventually causing a budgetary crisis that set off the events of 1789.

In Britain, on the other hand, there was a House of Commons enquiry, several politicians and South Sea directors were imprisoned, and a partial bailout of the company was organized. Consequently, investor confidence in the British government remained strong, to its great future advantage. The one bad British policy was passage of the Bubble Act of 1720, preventing company formation without an Act of Parliament (this was not repealed until 1825). This legislation has been held by some economists to have held back Britain's industrial revolution by half a century or more.

The lessons of 1720 are thus that it is essential to maintain confidence in the financial system, and that misguided corrective legislation can damage the economy for decades. Again, there would appear to be applications for this wisdom today.

Federal Reserve chairman Ben Bernanke believes that today's monetary policy should be primarily governed by the lessons of the Great Depression. However, over the centuries, there have been other financial disasters, whose lessons appear rather more pertinent.

Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found at www.greatconservatives.com.