Lessons of depression
“Sir” Alan Greenspan, the chairman of the Federal Reserve, allowed the stock market bubble to inflate because he thought he could control its aftermath. This view derives from a belief that the depression of the 1930s was not caused by the preceding speculative boom but was the result of poor policies by the government and central bank. Following the continuing rout in the stock market and signs that the US economic recovery is petering out, we have reached the point when this historical thesis is about to be severely tested.
In a recently published book, Rethinking the Great Depression, economic historian Gene Smiley catalogues the errors of both the Federal Reserve and federal government during the 1930s. In July 1931, the Fed raised interest rates in order to fulfill its obligations under the gold standard (despite the fact that Britain had already abandoned it). Five years later, prompted by fears of inflation, the Fed doubled the reserve requirements of its member banks. Both of these actions were followed by a severe contraction of the money supply, which induced a further collapse of the stock market and economy.
The failures of the federal government during this period were more various. After the October crash of 1929, President Hoover urged companies to maintain wages, which resulted in falling profits and investment during the early years of the depression. Hoover also signed the Smoot-Hawley tariff bill which led to a reduction in world trade. The actions of Hoover’s successor, Franklin Roosevelt, were even more destructive to the business environment. During his first administration, Roosevelt created the National Recovery Administration which was mandated to control production through the creation of industry cartels. The NRA had the effect of discouraging business spending.
Once the failure of his initial policies became manifest, Roosevelt changed tack; declaring war on big business and its leaders, the “economic royalists” in his phrase. In 1936, a tax on undistributed corporate profits was introduced in order to make big corporations more accountable to their shareholders. The effect was to further discourage investment. According to Smiley, between 1930 and 1940, net private investment amounted to minus $3 billion.
The problem with this interpretation of history is that it ignores the relationship between the boom of the 1920s and the ensuing bust. The roaring twenties had been a period of rapid business investment, accompanied by an overvalued stock market and a great accumulation of private sector debt. When the market collapsed and demand evaporated, businesses were left with excess capacity and households with too much debt. Even before the Federal Reserve raised interest rates in 1931, it had been observed that the attempts of households to improve their balance sheets by increasing saving and decreasing outlays was producing debt deflation. Keynes called this phenomenon the “paradox of thrift”: as households saved more, they reinforced deflationary pressures, which increased the real value of their outstanding debts. According to Keynes, monetary policy became ineffective under such circumstances.
The differences between today and the early 1930s are manifest. There is no gold standard and the American banking system is in an incomparably stronger state. However, there are some similarities. First, as a result of the stock market booms of the 1990s, there is excess capacity in many industries which is causing downward pressure on the prices of internationally traded goods. Secondly, the global economy is carrying too much debt, contracted at a time when people believed in the “new paradigm” (no economic downturn) and the “new economy” (higher economic growth). Last year, the Fed staved off a recession by encouraging a housing boom in the US. This produced only temporary relief as households accumulated even more debt while awaiting for the promised recovery. If the economy now fails to recover under the effect of low interest rates, the textbook history of the great depression will need revising.
The fund management industry does not care unduly about the returns it earns for investors, since it charges a fixed commission for managing money in good times and bad, regardless of performance. The rapacity of this industry is unbelievable. William Bernstein, author of The Four Pillars of Investing, observes that charges on the average US stock fund have increased by over a third during the last two decades. Since fund managers were consolidating during this period, which produced cost savings, fees charged to investors should properly have fallen.
At last, an investors’ champion has appeared on the scene. His name is Jonathan Compton, a 49-year-old former fund manager and broker. Compton is establishing an investment firm which promises to do more than expensively ape the movements of the stock market index. His firm will not charge a management fee in any quarter when investors’ funds decline in value. Instead, fees will only be payable after investors have received a certain fixed return. The idea of no-gain-no-pay seems a reasonable proposition but, strangely, it is not allowed by the Financial Services Authority. Given the regulatory and competitive absurdities of the investment world, Compton has chosen an apposite name for his company: Bedlam Asset Management.