Where's The Bottom?: The Depression and Other Precedents

October 1, 2008

No question captures this year’s mood of mounting fear than the investor’s lament, “where’s the bottom?’  One can be talking about share prices, economic activity and — let us hope not — general prices.  Like the 1930’s, the phenomenon of weakness is global and follows a prolonged period of brisk asset price appreciation and real-side growth, and like then, a malfunctioning financial system with extreme distrust is the source of the drag.

One should expect to hear the term “depression” thrown around.  The 1930’s are the gold standard for how badly economic conditions can go wrong.  The data from that period were extremely set apart from anything experienced since.  It is comforting to see how much worse a depression is than what has occurred so far, and to compare present conditions to a depression is to mis-characterize the facts.  The Great Depression was front-loaded into three years, 1930-1932, when U.S. real GDP plunged respectively by 9.0%, 6.3%, and 13.3%.  Growth was again negative in 1933 but by only 1.2%.  Only 1938 in the remainder of the 1930’s saw negative growth, and real GDP expanded by 5% or more in five of the final six years of the decade.  Nevertheless, unemployment, which peaked at 25%, did not drop below 10% until the 1940’s.  Exports and business investment suffered the biggest hits.  The table below chronicles the growth of real GDP and its major components from 1930 to 1933 as well as 1938 and aggregates the annualized changes for the three years to 1932 and six years to 1938.  The column heading C represents private consumption, I represents investment, G represents government expenditures, X stands for exports, and M for imports.

1930 -9.0% -5.4% -35.3% +10.2% -17.4% -13.0%
1931 -6.3% -3.1% -37.1% +4.3% -17.0% -12.7%
1932 -13.3% -9.0% -73.7% -3.4% -21.7% -17.0%
1933 -1.2% -2.3% +65.7% -3.7% +0.5% +4.1%
1930-2 -9.6% -5.8% -52.5% +3.6% -18.7% -14.2%
1938 -3.6% -1.6% -34.8% +7.3% -1.0% -22.3%
1933-8 +5.4% +3.8% +35.5% +5.1% +7.6% +4.0%


Just a few weeks after the start of the sub-prime-inspired banking crisis in 2007, David Wheelock of the Saint Louis Fed developed an incisive power point dissection of the causes and policy mistakes of the Great Depression.  Along with the above table, several lessons are highlighted.  Angry voters should not compartmentalize business from taxpaying households. If companies are left hanging out to dry, consumers get walloped as well, because incomes and jobs suffer.  Secondly, countries need to guard against protectionist trade barriers.  All nations were trade war losers in the early 1930’s. Thirdly, policymakers need to guard against deflation, which is when prices drop in a general sense.  Japan experienced a mild strain of deflation beginning in the late 1990’s, but U.S. consumer and wholesale prices plunged roughly 25% and 32% from 1929 to 1933.  Drops of that magnitude encouraged consumers to postpone buying things in hopes of catching lower prices and translated very low nominal interest rates into painfully high real, or inflation-adjusted, costs of finance.  The Federal Reserve made a fatal error, ignoring an imploding money supply, which fell 10% per annum in the worst years, and as such mistakenly thought that monetary policy was much more accommodative because of low nominal interest rates than in fact such was.  If at all possible, this error will not be repeated.

A second historical parallel to current problems occurred in Japan during the decade to 2002.  It’s closest resemblance to the depression was not the drop in prices as the rates of decline were widely different in the two episodes.  The main similarity rather occurred in share pricesThe Nikkei fell 80.5% from a high of 38,916 at end-1989 to a low in 2003 of 7,604, and the U.S. S&P index had dropped by 84% by July 1932. In a five-year stretch, Japanese real GDP fell 2.0% in 1998 and by 0.1% in 1999, recovered 2.9% in 2000, but then edged up just 0.2% in 2001 and 0.3% in 2002.  Growth over those five years averaged 0.2% per annum and followed growth of 1.7% per annum during the previous five years to 1997.  What happened to Japan — a decade of malaise — seems more likely to be what may lie ahead than the Armageddon of the 1930’s.  Before the hard times, Japan had been so accustomed to experiencing robust growth that Tokyo officials had drawn a line at 3.0% to differentiate economic upturns from recessions for their nation.  That past standard has never returned to favor, even though Japan’s banking system was finally recapitalized earlier this decade

One can only guess where the bottoms may lie for G7 economies and markets.  This look backward suggests it will be very important to keep an eye on money growth and prices.  Could the reversal of commodity markets this summer signal a violent swing from a more general inflation through the benign range of disinflation and into the toxic zone of deflation?  Short-term money market rates must be driven down, lest business investment and employment trends take a nasty turn.  Finally, the failure of the Doha Round of multilateral trade talks loom as a serious and ill-timed blunder.  In the 1930’s, policy mistakes were made because of ignorance about business cycles.  If history is replicated, it will be due to the interference of politics more than a lack of knowledge.

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One Response to “Where's The Bottom?: The Depression and Other Precedents”

  1. […] but may not be innocuous if in fact such heralds the onset of deflationary global forces.  In a blog entry from October 1st, I noted sharply falling consumer and wholesale prices were a distinguishing feature that still […]