1930
Revival in early 1930
The New York stock market leveled off in the first few months of 1930… and so did a variety of other indicators, including industrial production, imports, and employment. Employment actually picked up from the December level. Prices continued to decline in a number of commodities – cocoa, coffee, rubber hides, silks, copper, tin – during the first quarter, but less precipitously than in the closing three months of 1929. On May 1 President Hoover stated that the United States was not through its difficulties but that he was convinced that the country had passed the worst. Correct on the first score, he could hardly have been more wrong on the second.
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On one view of the depression, the continued revival of international long-term lending was vital. Those who blamed the depression on the preceding boom or inflation were typically not moved to make lending easy. They thought it necessary to put the system through the wringer, to liquidate the mistakes of the past and eliminate dead wood. Their ranks included such economists as Robbins and Hayek and, in the US government, the secretary of the Treasury, Andrew Mellon. Opposing them were many differing schools of thought, ranging from monetarists, market stabilizers, and interventionists to planners, all of whom thought it useful, however, to bolster rather than liquidate markets. The issue is fundamental. In a stabilized world, a recession in one part of the world economy is balanced by expanded lending by the depressed country. This finances balance-of-payments deficits of other countries and enables investment to be maintained. Britain operated such a mechanism in the years before 1914; it was unable to do so after 1929. The United States cut its spending on the products of the rest of the world. But neither it nor France proved able or willing to maintain the system with loans.
It is not entirely clear why this was so…
One reason was that many potential borrowers had lost their creditworthiness. Bankruptcy, default, currency depreciation, political coups, and especially falling commodity and asset prices made many domestic businesses and foreign countries unattractive risks for loans. Interest rates declined on relatively safe commercial paper in the United States and held steady for government bonds. From Augustv1930 the yield on second-rate corporate bonds (Baa) started upward.
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Tariffs
The conference to settle the details of the tariff truce, proposed in 1929 as a holding action while the tariff reductions agreed to in principle at the World Economic Conference in 1927 were worked out, finally convened in February 1930. The time was not propitious. The Smoot-Hawley Tariff Act had passed the House of Representatives in May 1929 and was under intensive study in the Senate….
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Let us agree that the Smoot-Hawley Tariff Act, after taking retaliation into account, was a deflationary force. The real failure, then, was in leadership. Hoover can perhaps be forgiven for thinking of agricultural tariffs in the 1928 presidential campaign. Tariffs were, as Schumpeter put it, “the household remedy” of the Republican party. The error was in treating it as a sovereign remedy, given to all who asked.
In finishing the narrative for this chapter of his book on the Great Depression, Kindleberger describes the disequilibrium of debt deflation. He says that credit came to a halt because falling prices meant assets did not support new lending while the lack of lending caused asset prices to fall further. He says that:
“the process remains puzzling. Did the decline in lending emanate from the demand or the supply side? The rapid reduction in interest rates suggests the former, but the New York capital market may well have been rationed, as London was unwilling to lend at lower rates because of the dubious prospects for debt service in a world of falling prices. Would a more experienced capital market have carried through a sustained revival of lending in recession, whereas New York, having overdone it in one direction, now overdid it in the other? The decline in prices and the halt of the precarious revival of long-term lending in the spring of 1930 are critical in the length and depth of the depression, as they led to the financial crisis of 1931. Their explication is still unclear, although they had nothing to do with the money supply.”
I say no; a more experienced capital market would have made no difference in 1930 and 1931. What invariably happens is that large trade imbalances become a flashpoint during periods of economic weakness. Nationalism takes over as ‘out-groups’ are blamed for economic trouble. Protectionism and trade conflict, then, are inevitable unless policy makers find a way to revive the economy. And if protectionism results in retaliation and lower economic growth, expect debt deflation to take hold until substantially more credit writedowns are taken and asset prices like property and stocks can again be supported by a conservative forecast of the stream of income they will throw off.
Source: “The Slide to the Abyss”, The World In Depression – Charles P. Kindleberger
History will surely prove you right about the capital markets. On the other hand, I’d contend that the direct effects of trade conflict on economic growth will pale in comparison to the second-order effects on the different points of conflict between China and the U.S. Brace for impact!
Yes, the trade conflict is just part of a larger economic battle. The key is that this battle in the 1930s lowered demand, lowered trade, decreased lending and decreased asset prices. All of this created debt deflation.
Hayek might have proposed slashing the deadwood, but the alternatives are the Japanese experience of twenty years of slowing falling prices while the economy stagnates. All that does is prolong the pain. Why buy a house if you know that it will halve in value over the next twenty years. Will you have paid enough off to make it still worth while. Why not just rent for that period and watch your rent fall annually. Hayek would have almost certainly stopped the party in the first place so the bubbles would not be bursting. Also if everyone expects prices to fall why make such risky loans because they will become millstones for the lending banks.
We have the same issues now. Some lenders are finding it hard to lend. Credit standards have risen but rightly so after the lax levels prior. Though that is not a bad thing. Stable credit rules mean lower risks long term. Banks that lowered their standards for easy expansion are suffering for it now. In fact if borrowers adopt a loan terms that are sustainable what is to stop US real estate values falling to levels not seen since the 80’s? In fact it could be that the best policy would be for banks to adopt pre deregulation credit policy. ie maximum mortgage of three times income with at least 10% deposit. That might lose them some business but it will reduce risks considerably. The other alternative of interest rates more aligned to credit risk means that defaults are far more likely. There is still too much debt and that needs to be eliminated or paid down. Either way that means blow trend growth until that process has been completed.
Of course, I agree with Hayek here too. The problem as I see it is how 1929 marked a turn from a complete rule of ‘let it burn’ ideology to one of an ‘always intervene’ ideology. The two aren’t mutually exclusive. You do have to reallocate resources and you do need to support the economy for fear of debt deflation.
The problem of debt deflation is that policy should also act to stop credit bubbles inflating as well. Hayek would have been the same. I am a Keynesian, but I do see the point of clearing debts, which encourage savings, which while causing the paradox of thrift, should not be used as a way to boost the economy as savings are consumed. Governments need to maintain a steady savings rate even during booms. This would slow down bubbles and restrict the lowering of interest rates during the collapse of an asset bubble. It also reduces the paradox of thrift after a crash because initial savings levels are higher. Keynes proposed reducing expenditure or raising taxes when the times are good, but that is forgotten by many.
In the US and UK savings rates were unbelievably low. So when the credit crunch hit savings rates for a while shot up from near zero to levels much higher. It would also give banks more funds so reducing their dependence on the interbank market which claimed Dexia today.
If interest rates had been held higher after the Dot Com crash then there may have been a much more subdued property bubble. In the UK the losses in the stock market in the 90’s pushed investors into buy to let property, which seemed safe in comparison.
You can still have debt deflation as in Japan but over a longer period. I prefer the short sharp shock. Much like the Swedish solution to the banks. Fast and brutal. It restores moral hazard, it means asset values get to the floor quickly. It exposes all those swimming naked once the tide is out. Doing everything in slow motion means that the bathers follow the tide out so hiding their nakedness. You can end up with a banking system that is still weak because no one has recognised that they have problems. That is what we have now. Weak banks hidden by the stress tests who have been exposed by the sudden possibility of a Greek default. The same applies to US banks who may have raised billions in capital but are still paying out their profits in mega bonuses. That is why Bank of America and Citibank look weak right now.
As I see it debt deflation can only be avoided by not having the bubble in the first place. My solution is to remove support from the markets let prices reach the floor quickly. Then once that is done have a long term jobs program which stops when the economy is as full employment of 2%. It can be tapered in the later stages, but should not stop as in 1937 or as in the 90s when the Japanese government stopped the stimulus periodically. Central banks should then maintain targets of savings rates, with banks having to maintain a deposit base. Trying to avoid debt deflation is like stopping a puncture by constantly blowing air into the wheel without actually repairing it.
How is any of that Keynesian? That’s the definition of Austrianism both during the up and down cycle. Yes, avoid the boom, 100%. Stop the QE, yes. But the point of Keynes is to have government work counter cyclically as it should since the sector balances mirror each other (non-government surplus equals government deficit). The reason to have automatic stabilzers as we now do is to attenuate the severity of the downturn and this is sensible policy. It is not about avoiding debt deflation but supporting the economy by preventing dead weight loss of profitable enterprises and those they employ which succumb due to the downturn in demand.
The counter cycle elements during a normal recession are unemployment benefits and maintaining spending until government revenues increase as a result of increased activity. That is Keynesian. I am not in any way suggesting cutting that element of the economy. In fact in the US you do not even have that as unemployment benefits end at 99 weeks. So how many million Americans have been cut out of the economy by that statistical trick? As for austerity I am against that, as it increases the private debt burden, and only works when done in isolation anyway in a booming world economy.
What we have now is not a normal recession, we are in a balance sheet recession. We have too much debt. The economy will stagnate for decades because of this. For example now I am in support of maintaining government spending regardless of deficits, that is not austrian. Allow the economy to recover. The problem with not allowing the debts to be written off is that asset values are overpriced and that is a burden on the economy. It raises the costs of entry to new enterprises and reduces their efficiency. All it does is maintain bubble asset values. During the “great moderation” central banks dived in with lower interest rates to stimulate the economy. What is also did was maintain deadwood, which would have normally been wiped out in a normal recession. That accumulated throughout the economy with each and every recession. Now we need a forest fire to clear out that dead wood. Recessions are essential in rebalancing the economy, and we have lost that insight. Small regular recessions are essential if not you get a big one, and that is where we are now.
In many ways the debt clear out of the ’29-’32 enabled the economy to rebuild without excessive debt, and set the foundation for the post war years. What we are facing now is worse. The debts not punishing the lenders but crippling the borrowers and governments for far longer.
In Japan the households with the exception of mortgages had big cash savings, unlike UK and US consumers now. And Japan are still not out of the woods, they have a stagnant economy still. What I am proposing with steady government spending is clearly counter cyclical and with lower debts the economy will be able to grow with a lower debt burden.
In Japan the households with the exception of mortgages had big cash savings, unlike UK and US consumers now. What I am proposing with steady government spending is clearly counter cyclical and
I an with you 100% but large parts of that thinking are Austrian.
Yes but I am not closed to other solutions. Austrians can be right some of the time, but austerity now is a mistake. Stop the bubbles not clear them up. Hayek and Schumpeter have a lot going for them but like in physics Newton is right for simple gravity calculations, Einstein right on even larger scales though fails at the extreme. Quantum gravity is the only solution at these extremes. Economics can be like that as well. Austrian can be right to stop the bubbles. Yet once things are at a certain point only Keynesian policy works. I am far more in favour of caps and collars for interest rates and leave the Fed to maintain the savings rate at say 10%, thus avoiding situations where banks are dependant on interbank funding, and financial stability of the banks. Fiscal policy is the best for solving unemployment.
It’s my understanding that the Smoot-Hawley Tariff Act of 1930 had little effect on the Great Depression because imports during 1929 were onlty 4.2 percent of GNP and exports only 5.0 percent.
https://en.wikipedia.org/wiki/Smoot-Hawley_Tariff_Act
This post is not about tariffs as the cause of the Depression. It is a verbatim excerpt from the beginning Kindleberger’s chapter on the slide into the abyss that focuses on his question at the end of the chapter on whether more developed capital markets would have ended the downward spiral. Read it again and you will see this is so.
That said, Kindleberger is entirely correct to say “Let us agree that the Smoot-Hawley Tariff Act, after taking retaliation into account, was a deflationary force. “
currency wars followed by trade ward followed by real wars. WW1, WW2 were real wars.
Well we have currency wars right now.