Of This & That...

A Depressing Recession-I

The author draws parallels with The Great Depression and tells us why it has not happened again

The "Great Recession" of 2007-08 certainly got part of its name from the Great Depression of 1929, which really has been the elephant in the room through this entire episode. I can recall writing many times in these last 6 years, drawing precedents and historical parallels with the period 1929-1933. Greater men have done the same: Paul Krugman reminds us almost on a daily basis that the Bottom of the Pyramid is the most important factor in fighting depression: it is jobs, not the deficit that holds the key.

Different aspects have been explored by different writers at different times, only some of which I will summarise below:

  • Was the Crash of Wall Street the 'Lehman Moment' of 1929? Or was Lehman the equivalent of the Wall Street Crash of 1929? Depends on which time period you are living in....are you trying to understand the causes of The Great Depression, or are you drawing parallels to understand the Great Recession?
    So was it the "poverty effect" of a sudden drop in wealth, that froze consumption and created a jobs crisis, which then spiralled downward after the Fed tightened liquidity in a knee-jerk, death-wish moment? Or was it the prior industrial expansion of 1920-29, with easy money fuelling an investment boom that then faced a demand lockdown....everybody was making things for nobody? And was the Wall Street reaction just a reaction to reality, a mirror image that scared the owner of the face?
  • Was it the protectionism and tariff barriers erected between Europe and the US, which reduced trade and deepened the demand slump?
  • Or was it the excessive inequality created by the boom of 1920, both in the stock markets and in the industrial sector? Or was it a combination of some or many of these factors, and what do we have in common for us to learn about the Great Recession of 2007-????
  • Was it the sticking to the Gold Standard, at a time when large trade imbalances had to happen in the aftermath of the First World War and the Treaty of Versailles? If some countries were pushed to the brink, notably Germany's Weimar Republic in 1920 which saw hyperinflation, then would an IMF-like body have provided the cushion needed to restore economic balance?

The purpose of this write-up is not to do a historical analysis of WHY there was a Great Depression at all, but why it has not happened again....by now, if history was to repeat itself, the worst effects of the Great Recession of 2008 should be kicking in.

Let us go back to understanding the above questions. First, stock ownership was not so high as to create a demand crunch that led to a 29% drop in GDP over 1929-33. Yes, investment demand may have collapsed, but for consumption to drop so precipitously, it would need additional factors. This perception about Wall Street being at the heart of the Great Depression was created by the likes of John Kenneth Galbraith, who seemed to have mistaken the barometer to be the cause (of the Depression). All this came from a time when stock ownership was rising, and the proportion of American population who owned stocks was also going up. But it is inconceivable that the bucket shops of the time could have been as all-pervasive as the Investment banks of Wall Street are today. In the absence of any data to support such a hypothesis, we should be giving Wall Street the benefit of the doubt.

I would like to point to the current success of "The Wolf of Wall Street", an over-the-top hyperbolic movie that makes demons of the current crop of traders on Wall Street. Now having joined the trade (of brokers and financial advisors), I know how untrue hyperbole can become folklore, even economic analysis.

But to get back to the Depression. Tariff barriers kicked in after 1933, when some countries started to run out of gold, which they had to repatriate as part of the Gold Standard system of trading. Even here, protectionism has become a favourite whipping boy of economic historians....after all, even the US had only 7% of GDP as exports in 1933. How big an impact could protectionism have had, with such low external exposure. Compare this to the current external exposure, where even insular India has 42% of GDP as imports + exports + CAD.

Which brings us to inequality, that other whipping boy of the popular media. Yes, another movie, "The Titanic" brings out the conditions of the time, starkly bringing out the contrast between the rich Caledon Hockley and our hero, Jack Dawson (Leonardo di Caprio). Is it a coincidence that "The Wolf of Wall Street" is both led and produced by the same star?

If you can see just how over-the-top the current folklore from the media is, why would we believe that the inequality depicted of 1929 is any truer? Those were the times of Chares Schwab and Andrew Carnegie, the JP Morgans and Rockefellers: we have the same spectrum of good and bad in today's big rich.

All periods of technological change have seen spurts in inequality, and much of it goes to those who drive that technological change. For those who complain about the current rise in American inequality, it bears a second look. Yes, some bankers did not pay the price for being at the epicentre of the Lehman Moment, and yes, some of them (though not the same ones) benefited from the largesse given by the Govt through TARP and the various QEs.

But along with that, we have to remember that America is seeing some 6 technological booms-in-the-making: shale oil, solar energy, biotech, robotics, nanotech and 3-D printing. This apart from the now-normal waves of the IT boom: the most recent being the obscene profits of the nerds at WhatsApp. Inequality irons itself out as technological progress slows and productivity growth goes through a cyclical downturn. Maybe we won't ever see this truism repeated, because we will have ever-accelerating technological progress for the foreseeable future.

Which brings us to the last point, the structure and situation of global financial markets. Like Sherlock Holmes who paid attention to the "dog that didn't bark", we should pay attention to the way things were, even if it means coming to the conclusion that "nobody killed Jessica Lal".

For 3 centuries before the Great Depression, the world had used what came to be known as the "Gold Standard", a system by which the currencies of Europe carried an underlying promise of redemption for gold. This kept a cap on excessive money printing, a big fear after the John Law Mississippi Bubble in France (1720). The Gold Standard worked well in a world with near zero real GDP growth, except after the Industrial Revolution; trade was a limited affair, and trade imbalances happened mostly due to war.

All this was slowly changing over 1850-1920. There was continuous real GDP growth after the 1880s, with electricity, automobiles and aviation joining textiles and steel-making. Communication and telecom spurred trade, and countries started to get a significant portion of GDP from international trade. The Treaty of Versailles and consequent war reparations created significant BoP problems, leading to the transport of gold. Britain and Germany were the early sufferers, with Britain going off the Gold Standard in 1931. This was the equivalent of the "Euro Crisis" in the Depression era.

In a world of continuous real GDP growth, if Money Supply does not keep pace, it will lead to deflationary pressures as less money chases more and more goods and services. This will obviously exacerbate pressures on economic inequality, and we will start to mix up cause with effect, i.e. inequality will be an effect rather than the cause. The underlying cause will be an anachronistic structure of world finance, a building that has outlived its utility in a fast-changing world.

Remember the institutions that came after the Depression: the IMF, the World Bank, multilateral lending by other regional institutions, the UN itself. The internationalisation of world trade had to lead to the internationalisation of its financial institutions, right down to the multinational corporations, your local, friendly, corner store MNC with its MNC bank in tow.

Currency markets, inter-bank lending and the swap market, if not the latter-day innovations like CDO/CLOs were all missing. Yes, the Fed made a grievous mistake in tightening money supply in response to gold outflows after 1933, creating a series of banking crises that bankrupted half of America's banks.

The author teaches, trades and writes at [email protected]




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