The 2008 credit crisis versus the 1929 depression

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By Adrian Clayton

Not since 1929 has an economic event had such a profound affect on the world’s economy as the current US sub-prime meltdown.

This development has far reaching systemic risks that could still be felt for years to come. Possible implications include the cost of money escalating globally, a severe slowdown for the world’s economy and significantly reduced returns for investors on world markets. This points towards a horrible but still not Armegeddon-like outcome like 1929!

Whilst at Alphen we doubt a depression will emanate from the credit crisis, it remains a prognosis being spoken about by Joe-Public and being fueled by segments of the media. As a result, we thought it appropriate to briefly sketch the background to the 1929 market collapse and subsequent depression.

Most people believe the depression started after the market corrected on the 24th of October 1929, the well-known ‘Black Thursday’. This is incorrect. The catalyst for the depression was the action taken by the Federal Reserve back in 1928, when a concerted effort to slow down the US economy was implemented and the tool was higher interest rates. In August 1929 the US economy was already in a recession and the Fed continued to raise rates. The breaking point occurred in October – Black Thursday. Share prices collapsed on the Thursday and went into free-fall the following Monday and Tuesday. The fall was breathtaking (the Dow lost 89% between September 1929 and July 1932), with the volume of shares traded on the first day of the correction three times the daily average. What followed was the Wall Street malaise migrated to Main Street. Investor losses were widespread, wealth was decimated, lost confidence was pervasive and began to affect business in a meaningful way.

Unemployment rose from 3% prior to the recession to 25% at the depths of the depression. For those employed, wages fell 42%. GDP in the US halved from $103bn to $55bn, this being affected by deflation, which ran at 10% per annum. World trade in unit terms plummeted 25% and in dollar terms by 65%. Speculators attacked the dollar and switched to gold. In response, to protect the greenback, the Fed was forced to raise rates further, this drained liquidity from the financial system and created an increasingly difficult environment for businesses. Less liquidity placed serious strain on the banking sector and banks began to fail. In fact, 9000 banks failed in the 1930’s. Depositors panicked, removing monies out of their accounts and preferring to stash this at home.

This problem was accentuated by the Fed ignoring bank failures and leaving deposits uninsured. At one point the Fed had allowed money supply to decline by 30% in the financial system and banks became so risk averse that they restrained loans. This hurt consumer expenditure and business confidence, in turn damaging employment and followed through to consumers not being able to service their debt. A virtuous damaging economic cycle unfolded that is now referred to as the Great Depression.

In summary with respect to the causes of the depression, historians ascribe it to five factors:

1. The stock market crash – caused by excessive speculation and popped by interest rates rising.
2. Bank failures and the problem that bank deposits were uninsured causing a complete lack of confidence in the banking system.
3. A lack of confidence reduced consumption, reduced business activity, depleted employment, increased repossessions and ballooned stock or inventory levels for businesses. This further raised the cost of doing business.
4. The US created the Hawley-Smoot Tariff in 1930. This was designed to restrict imports by taxing imported goods. It resulted in retaliatory tariffs, further deepening the economic crisis.
5. The US experienced a severe drought in the Mississippi Valley in 1930 causing serious financial losses for farmers and resulted in large scale urbanization.

The end of the Depression can probably be ascribed to two factors, firstly the election of Franklin Roosevelt in 1932. He created many government agencies and programs to end the economic malaise. This was known as the ‘New Deal’. The second factor that stimulated economic growth, particularly via employment, was the US’s decision to enter the Second World War in 1941.

The obvious question is whether the current episode could cause a repeat of 1929? We believe three important differences distinguish the two periods. Firstly, as against 1929, regulators today are highly proactive and have a full appreciation of using loose monetary policy to curb a negative confidence spiral. Secondly, as is evident from the developments in the US and Europe, the other key difference between 1929 and 2008 is the way the Fed and certain other European Central Banks (e.g. Ireland) have underwritten bank deposits. This ensures depositors maintain confidence in the banking sector. Thirdly, national regulators are working collaboratively to shore-up the financial system and maintain liquidity levels during a crisis of confidence, this was seen when the ECB, BOJ, Fed and BOE injected liquidity into the markets on various occasions simultaneously.

In conclusion, we believe the periods have enough differentiating factors to prevent a repeat of 1929. However, excesses built-up over two decades are now dissipating and this is unlikely to be a short-term event that will be fixed overnight. We feel the end will be in sight when the US property market stabilizes in a meaningful way and when liquidity levels rise again in the financial system and banks feel confident to transact with each other and with borrowers in a conventional way. Until then, the ebbs and flows of confidence will be revealed in choppy markets.

Source: Adrian Clayton, Alphen Asset Management, October 6, 2008.


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