First, the stock market. At a current Standard and Poor's 500 index value of 1,100, the index's price/earnings ratio, on a nominal basis without discounting for earnings that aren't really earnings (un-expensed stock options issued to management) or adding back hidden losses (extraordinary items not reported in the income statement) is about 19 times. In 2000, it peaked at about 28 times. In 1929, the market's P/E ratio was ... 30 times? 40 times?
No, at the peak of the bubble, in September 1929, the market's P/E ratio was 13.5 times. Radio Corporation of America, that era's premier glamour stock, its Cisco or Google, sold on a princely P/E ratio of 28 times. The entire stock market had a total valuation of around 85 percent of gross domestic product, compared with 180 percent of GDP at the peak of the 2000 bubble and about 95 percent of GDP today.
In the economy as a whole, GDP had increased by 15.3 percent in the 4 years to 1929, while inflation had hovered around zero. Short term interest rates fluctuated between 4 and 5 percent; later commentators have accused the late '20s Fed of running an excessively easy money policy, but real short term rates were higher than in 2000, let alone today.
The United States ran a persistent trade surplus (this was a problem, as I'll come back to), but had a healthy savings rate, and a substantial Federal budget surplus, even after tax cuts, throughout the late 1920s. In the corporate sector, balance sheets were strong -- corporations issued more than $10 billion in stock in the four years to 1929, compared with a net buyback of stock in the four years 1996-99, and the average corporate debt-equity ratio was less than half the 110 percent reached in 1999. Brokers' loans, so frequently cited as an immediate cause of the collapse, totaled $8.5 billion in September 1929, less than 10 percent of the value of outstanding stocks; 86 percent of the increase in bank credit in the 4 years to 1929 went to this dubious purpose, but that was still less than 8 percent of GDP.
Domestically, therefore, the U.S. economy of 1929 was less overvalued and far better balanced than that of today, with President Calvin Coolidge and Treasury Secretary Andrew Mellon's fiscal and economic policies having been enormously superior to those of either President Bill Clinton or President George W. Bush.
Internationally, the picture was less serene. The U.S. trade surplus was a problem for a number of European countries, which were struggling to repay war debts incurred during World War I, at a time when inflation (which would have eroded the debts) was non-existent. Britain in particular suffered from an overvalued exchange rate, having returned to the Gold Standard in 1925. Britain and its Empire needed a modest Imperial Preference tariff, to balance somewhat the much higher tariffs imposed by its trading partners, but it wasn't going to get one from the feeble Stanley Baldwin government of 1924-29 or its big-spending mildly Socialist successor that took over in May 1929. The German economy, hyperinflationary in 1923, had been restored to considerable prosperity by 1929, but it needed prosperity to continue so that reserves could be rebuilt in the heavily wounded German banking system, and political nasties from both extremes could be fended off.
Nevertheless, internationally as well as domestically, economies in 1929 seemed to be in decent shape, and there was no obvious reason why recovery should not continue. The U.S. stock market was only modestly overvalued, and any crash, being smaller in terms of GDP, should have had a much less deflationary effect than the relatively larger drops we have seen in 1987, 2000-02 or 1990s Japan. So what went so terribly wrong, and what can we learn from the disaster that followed?
First, monetary policy. As Milton Friedman and Anna Schwarz conclusively demonstrated in their 1963 "Monetary History of the United States" the Fed, which had pursued a modestly accommodative but sound monetary policy in the late 1920s, allowed U.S. money supply to drop by a third in 1929-32, precipitating the depression. This is a comforting theory; presumably the Fed would never do anything so obviously stupid again, and therefore we need not fear any recurrence of the disaster.
Modern observers' comfort in this area may be too sanguine. For one thing, the collapse in money supply did not begin until December 1930, when the second leg of the 1929-32 downturn was well under way. It was caused, not by misguided tight money policy on the part of the Fed (the Fed dropped the discount rate to around 1 percent quickly after the 1929 crash, and kept it there) but by the collapse of a number of banks, specifically the New York-based Bank of the United States on December 11, 1930, which itself was caused by the economic downturn -- corporate failures in the garment district, not defaulting brokers' loans. By 1930, there was no J. Pierpont Morgan to organize a bank rescue such as had been undertaken in 1907, so the collapse even of a medium sized bank, albeit with allegedly 400,000 depositors, caused a crisis of confidence in the U.S. banking system and a consequent reduction in the country's monetary base. Thus the reduction in money supply was more imposed by events on the Fed than caused by it.
Presumably, since the United States now has deposit insurance, this particular disaster wouldn't happen again, assuming the deposit insurance paid out quickly and without excessive bureaucracy. It does indicate however that the Fed is not in sole control of the nation's money supply, and that if something happens that the Fed's computer models haven't provided for (a Fannie Mae collapse?) its reaction may be misguided or excessively delayed.
Second, trade policy. The notorious protectionist Smoot-Hawley tariff, signed into law by President Herbert Hoover in June 1930, was imposed on the world by a country with a substantial trade surplus. It thus caused a collapse in world trade, followed by a financial meltdown in Europe and a blizzard of protectionism worldwide. One of the greatest policy mistakes ever made, though arguably not greater than Hoover's second blunder 2 years later (see below.)
Here we do have some defenses. The United States, far from being in trade surplus, is running an enormous trade deficit, currently around $650 billion per annum, 6 percent of GDP. Any U.S. move towards Smoot-Hawley style protectionism, quite likely in a downturn from either Presidential candidate though more so from a President John Kerry than a re-elected President Bush, would severely damage world trade, as in 1930. It wouldn't however push the world's trading system into a collapse, since, unless it led to immediate foreign retaliation, the U.S. trade deficit would presumably be reduced somewhat by any such silliness.
Third, government spending and taxation. While government spending was flat in nominal terms in 1929-32, it increased by 15 percent in real terms, and from 9.1 percent of GDP to 14.8 percent of GDP, in three years. This in itself hampered the economy, by diverting more resources into the less efficient and productive public sector. However, much more damaging was the action of the Hoover administration and the new Democrat Congress in early 1932, panicking about the Federal budget deficit and imposing a huge tax increase in the middle of what was already the deepest depression in memory. Government revenues, which had already increased from 10.1 percent of GDP in 1929 to 11.4 percent of GDP in 1931, jumped to 14.0 percent of GDP in 1932 and 15.2 percent of GDP in 1933, while the top rate of Federal income tax soared from 25 percent to 70 percent. By following Maynard Keynes' developing prescriptions for recession on government spending, while totally ignoring them on revenue, Hoover caused the worst possible economic outcome, making this policy mistake even slightly more unforgivable than Smoot-Hawley.
Here we have no protection at all. Tax and spend government is already three times as large as in 1929, and the $413 billion Federal deficit in the year to September 2004 is already the largest ever in nominal terms, albeit likely to be exceeded in the current fiscal year to September 2005. The government debt market, which had no difficulty in absorbing Hoover's modest Federal deficits, is currently sustained by an enormous wave of money from Asian central banks, which can stop buying Treasuries as easily as they started. In a recession, therefore, there would be great pressure from the bond markets to repeat Hoover's mistake of increasing taxes, while neither Presidential candidate, nor either party in Congress, has shown any sign of restraint on Federal spending.
So there you have it. We're no more protected against Fed incompetence than in 1929-32, somewhat better protected against misguided protectionism (at least, instigated by the United States) but altogether less well protected against tax-and-spend happy government.
Ladies and gentlemen, there is not the slightest reason why it can't happen again.
(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2004) -- details can be found on the Web site greatconservatives.com.
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