Great Depression or Great Opportunity?

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Today many economists agree the Fed first caused the economic and stock market boom and the subsequent crash via an easy money policy. And they made it worse with a tight money policy. No doubt this go around economists will say this crash was also caused by Greenspan's easy money policy that created the housing boom (and the toxic mortgage derivatives this spawned) and channeled good money into overvalued real estate and other non-productive projects.

Bernanke is an expert on the Great Depression and no doubt he wants to avoid a repeat at all costs. In 1930, the Fed did nothing to stimulate the economy. All they did was raise interest rates. They felt it was a normal recession that would work its way out without government help. The problem was compounded by the Hoover Administration because, in an attempt to balance the budget, they increased taxes. This had the opposite effect of what was intended. It put more workers out on the street, with many corporations and municipalities subsequently defaulting on their debt obligations.

What concerns me today is that the government is creating an artificial stimulus to buy up bad mortgage derivatives to try and undo the excesses of the past. And although this may result in a short-term recovery, it doesn’t help to revive lasting prosperity. By creating a false recovery, another world financial crisis is in the works. Investor confidence has to ultimately be restored. Continually raising the debt ceiling does nothing to restore this confidence over the long term. Spending a trillion dollars to prop up bad mortgage debts won’t create new jobs or a new prosperity, but I don’t want to get ahead of myself here because what the Fed is doing now is totally different from the 1930 Fed actions.

Other striking similarities with the Great Depression:

In my research, I found it interesting that Hoover also came into office with a substantial surplus. He left office with a substantial deficit due in great measure to out of control Congressional spending. Congress overrode his vetos on relief spending and Veteran's bonuses that brought the budget from surplus into deficit. Then--as one of our Presidential candidates is advocating now--he raised taxes. However, despite this (or perhaps because of it), tax revenues actually collapsed.

The pre-Depression peacetime Federal Government taxed 5 percent of gross national product (GNP) and spent 5 percent; that’s a balanced budget. The Depression-era Federal Government taxed 5 to 7 percent of GNP and spent 8 to 10 percent with higher tax rates. The result: In the 1932 fiscal year, tax revenues decreased by a whopping 50 percent. Despite higher tax rates and deficit spending, unemployment remained high for a decade. The unemployment rate as late as 1940 was more than 11 percent, and it took a major world war (that brought defense spending up to a whopping 35 percent of GNP) to bring that number down.

Frankly, I don’t see either Presidential candidate advocating sound monetary policy. (The other candidate in the recent debate actually advocated more government handouts to support bad mortgage loans, a policy that will add to the deficit while doing little to stimulate economic activity).

In the 1930s, deflation rose as high as 50 percent. Banks saw the value of their collateral on loans decrease by this much or more in many cases. The banks began to worry that if their borrowers defaulted their collateral wouldn’t cover their loans, and this is what causes banks to fail. Depositors saw these potential loan defaults as a sign the banks were shaky and (pre-FDIC) withdrew their deposits. In other words, it was a run on the banks.

The solvent banks also were becoming nervous that their loans were being jeopardized by deflation and believed it was time to become liquid and move their assets into the safest place: government Treasuries. The problem with this is they became less willing to loan money for private projects, and this further hurts the economy. During the Great Depression, safe interest rates (government paper) moved lower while borrowing companies in the free market. Even those with stellar credit history had to pay much higher rates. This is exactly what’s happening today as the credit markets and banking system freezes up. This process feeds on itself, and it creates less demand for goods and more unemployment. The way to reverse this is to restore solvency to the banking system, and this is what Henry Paulson and Ben Bernanke are attempting to do.

If the world continues to value liquidity and safety over investing then Treasuries (and gold) will continue to be in demand. I have always felt that gold would be most sensitive to inflation (and it still likely will be if and when inflation heats up again) but currently we are in a deflationary spiral like the Great Depression. Note that gold rallied during the inflationary 70s, but it has also held its value very well and acted as a safe haven during the Depression.