Monday, July 06, 2009

1929: The Sequel

This is the text of a webcast I did last week. To view the slides, etc:

1929: The Sequel

By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College SD

The Great Crash of 1929 did not literally repeat in 2008. As we will see, there is one crucial difference between the two episodes and it likely will be our savior. Nevertheless, striking similarities between the two crashes are evident. Foremost, as shown on slide 2, in both instances the economy was in recession BEFORE financial crisis struck and in that sense the financial system could not be said to CAUSE either economic downturn, only to exacerbate problems in the real economy like inventory gluts, softness in construction and real estate markets, and energy price spikes.

In both periods, the financial system proved to be EXTREMELY fragile due to the use of leverage, the purchase of speculative assets with borrowed money. In both periods the bursting of asset bubbles, real estate bubbles followed by corporate equities bubbles, led to the destructive processes illustrated on slide 3. When commercial and housing real estate markets softened in the 1920s and recently, corporate balance sheets weakened and mortgage default rates increased, which in turn increased asymmetric information, the great bane of financial institutions then and now.

In both crashes the “bank problems” listed second from the bottom were particularly potent. In the face of elevated default rates, damaged balance sheets, and high levels of uncertainty about future business conditions, banks raised the interest rates they charged some borrowers and stopped lending entirely to many others. That slowed business investment which led to further decreases in economic activity, even higher levels of default, and, ultimately, bank failures, and a massive degree of additional uncertainty.

Of course the crashes of 29 and “aught eight” are not identical. As Mark Twain once said, history rhymes rather than repeats. During the Depression, small banks bit the dust first, with the big ones staggering only in the later stages of the economy’s three-year death spiral. Today, it is the big boys who first fell but the pollution their crashing and burning creates is now suffocating smaller institutions. As summarized in slide 4, the changing but always inept nature of banking regulation explains why small banks gave way first during the Depression while big ones could not withstand last year’s crash. Prior to World War II, most Americans and their politicians possessed a morbid fear of large financial institutions. Andrew Jackson vetoed the re-charter of the Bank of the United States, pictured on slide 5, partly because he thought the institution had grown too large and powerful. Some 80 years later, a government fearful of the power accumulated by investment banker J.P. Morgan created a new central bank, the Federal Reserve System, but simultaneously tried to limit its influence by dividing it into 12 districts, also shown on slide 5. For similar reasons, throughout much of the nation regulators forbade banks to operate a branch across the street much less across state lines. As a result, most banks outside of the major money centers were tiny affairs that, even if conservatively run, were highly susceptible to local economic shocks. Places that allowed branch banking, including California and Canada, weathered the Depression much better than adjacent territories dominated by unit banks because they suffered many fewer failures.

That led regulators to conclude, erroneously, the bigger the better. In the years leading up to the current crisis, regulators not only allowed banks to grow large they actually strongly encouraged them to do so with the “Too Big to Fail” policy. Concocted in the aftermath of the Continental Illinois failure in 1984, TBTF policy promised that the government would prevent systemic financial crises by aiding the largest financial institutions should they face insolvency or bankruptcy. Because the government charged nothing for the guarantee and never made clear which companies were covered under it, many financiers used TBTF as an excuse for constant, rapid growth, mainly through the acquisition of smaller institutions. TBTF encouraged other types of excessive risk-taking as well by promising government aid in all events. Because risk and return are positively correlated, it essentially generated private profits with public money.

I am not, however, one of those folks who puts all the blame on the government. Properly understood, both the Depression and the current crisis are examples of a broader phenomenon I call “hybrid failures.” As slide 7 jokes, by this I do NOT mean a Prius that won’t start. Rather, as in slide 8, a hybrid failure is a combination of classic market failures like asymmetric information, asset bubbles, positive and negative externalities, and public goods INTRICATELY INTERTWINED with government failures like the creation of perverse incentives, misguided regulation, the inability to foresee and fix problems before they cause major economic disruptions, and implementing counterproductive bailouts.

Slide 9 summarizes the hybrid failures at the heart of both the 1929 and 2008 crashes. You’ll quickly perceive that they are identical. If we zoom in more closely, however, differences appear. The 1920s real estate bubble was not as big as the recent one shown in Slide 10. The stock market bubble of the 1920s, however, was much bigger than the fluff that survived the dotcom bust. We’ve already seen that very different yet equally misguided banking regulations played a role in both crises, as did the inability of the government to foresee the perverse incentives those regulations gave rise to. The most maddening thing about the “aught eight” debacle was that it was the 7th time in American history that regulators allowed mortgage originators to take full commissions upon closing and the 7th time that a mortgage securitization scheme exploded in our faces.

Finally, and most importantly, while fiscal stimulus, TARP, and other recent bailout attempts have hardly been unqualified successes to date they do not appear to be as disastrous as some of the policies implemented during the early stages of the Depression. The Smoot-Hawley tariff was extremely destructive and is unlikely to be repeated. We are also unlikely to repeat the creation of a bad bank, which works better when it has to liquidate numerous small institutions, as the Reconstruction Finance Corporation and the Resolution Trust Corporation did during the Depression and the Savings and Loan crisis, respectively.

We will also likely avoid creating anything like the National Industrial Recovery Act, the infamous blue eagle of which is pictured on slide 11. The NRA sought, luckily in vain, to INCREASE real wages when the economy desperately needed lower real wages. Wages stuck at high levels due to deflation and the unwillingness of workers to accept nominal wage cuts were of course the proximate cause of the very high levels of unemployment that disrupted America’s social, political, and financial systems during the Depression. Even at 10 percent, the unemployment rate today is much less than half of that experienced during the hard winter of 1932-33.
Moving on to slide 12, the only government policy during the New Deal with a demonstrably positive effect on the economy was the devaluation of the dollar and the de facto abandonment of the classical gold standard. Because it had to defend the nation’s gold stocks, the Depression-era Federal Reserve could not appreciably lower interest rates or increase money growth in the aftermath of the stock market crash. It did not even replace the money destroyed when thousands of banks failed, paying just pennies on the dollar to depositors. As a result, the money supply actually shrank and the price level declined dramatically, effectively increasing real wages and real interest rates. By greatly loosening the link to gold, Roosevelt allowed re-flation and decreased real interest rates, thereby fueling the expansion of 1933 to 1937.

Loss of the gold standard cost us our long term price anchor but gave us in exchange tremendous domestic monetary policy flexibility. Today’s Federal Reserve does not need to maintain gold stocks or the value of the dollar in international markets. It can, if it wishes, decrease interest rates to zero, print prodigious quantities of money, and lend it to whomever it sees fit. In fact, after the failure of Bear Stearns the Fed kept a pretty tight reign on the money supply in order to support the value of the dollar in international markets. After the failure of Lehman, by contrast, it let out all the stops and, as illustrated on slide 13, essentially implemented one-half of Alexander Hamilton and Walter Bagehot’s famous rule of central banking and lent freely to all who could post solid collateral. In addition to its traditional discount window, the Fed now lends via seven new so-called term facilities. The only disappointment is that it provides the funds very cheaply, rather than at the penalty rate espoused by Hamilton and Bagehot, thus subsidizing private concerns with public money and increasing moral hazard and hence the probability of future crises.

Clearly, the Fed wishes to avoid the melancholy scenes depicted on slide 14 -- the dust bowl, the breadlines, and the public health crises that characterized the Depression. Thanks largely to its efforts, the sequel to the Crash of 1929 will turn out to have a much happier ending, at least in the immediate term.
Nevertheless, longer term, as indicated on slide 15, troubles loom. I was warning about the alarming growth of the national debt in 2007 and now of course am very concerned that the debt may cause interest rates to increase to levels that will hamper a robust recovery. Fears of a soft default or inflation are foremost as are concerns that foreigners will stop buying U.S. government bonds, at which point domestic crowding out may occur. I’m also concerned by the fact that the government has yet to price Too Big To Fail and other federal guarantees and backstops at anything close to market rates. That means, in effect, that the government is still subsidizing private risk taking with public money so it is only a matter of time before another financial crisis strikes. When and where it will occur I of course do not know but if the government doesn’t act decisively to force people to wager only their own money, I fear “The Great Crash III, They Did It Again” will be coming to an economy near you in the not-so-distant future.
I’m done. Thanks for your time and attention!


Anonymous said...

Dr Wright
In the high school where I work I noticed pictures on the wall in a class room of moments in history. One picture says the American Revolution ended at Yorktown (somewhat untrue) and there was another that stated the Great Depression ended with FDR's social programs but I have read that World War II had an impact on the recovery, since you have wrote of the causes of it and other problems later in history could you comment on the recovery from the depression?.... signed (your cousin) DP

Robert E. Wright said...

Nice question! I've answered it in a new post.