Learning Lessons: The 1930s

Insight: Learning Lessons From The 1930s

By Ian Harwood, FT | 30 June 2008

The Great Depression of the early 1930s has cast a long shadow over subsequent decades. Then, the major economies suffered a collapse in output, profits and employment on a scale unprecedented either before or since. And, crucially, this world-wide economic meltdown accelerated the breakdown in international co-operation among the major powers, fostered aggressive nationalism and contributed mightily to the genesis of the Second World War. Determined to avoid a repetition of the global economic disaster of the early 1930s, policy-makers have ever since striven to learn the right lessons. The parameters of the global trading and payments system were reconstructed on a growth-friendly basis at the very beginning of the post-WW2 period. And policy makers have done their utmost throughout to avoid the gross errors made by their predecessors. The very first G7 economic summit, convened in 1975, was designed primarily to head off the risk of renewed protectionism amid what was the worst ever economic downturn seen since the early 1930s. And the Fed’s supportive lender of last resort stance in the wake of the October 1987 stock market crash stood in stark contrast to its lack of response to the crash of October 1929.

In the early years of this century, moreover, the Fed acted aggressively to head off what it perceived to be the very real threat of outright consumer price deflation. And this year, of course, the Fed has acted swiftly to pump liquidity into a banking system threatened by the bursting of the housing and credit bubbles. In this latter regard, the US has been extremely fortunate to have had at the Fed’s helm an economist who cut his academic teeth analysing how the collapse of the US banking system in the early 1930s had played the key role in transforming a not untypical recession into the Great Depression.

The fact the Fed is doing its utmost to keep the US financial and economic show on the road, however, doesn’t ensure there will be any early end to the economic downturn. Indeed, there is good reason to be very cautious. At present it is the beleaguered US housing market which is receiving the most attention. Any erstwhile optimists have long since abandoned hope of any early recovery. And it is generally accepted that the adjustment of activity, sales and prices to previous excesses will be a long drawn-out affair.

The US consumer, moreover, is looking increasingly vulnerable. Not only is the fragile housing market likely to have adverse spill-over effects upon households’ propensity to borrow and spend, but banks are becoming more and more reluctant to lend. Consumer spending is also likely to be progressively undermined by record inflation-adjusted energy prices and contracting employment. Ever since the mid-1990s US consumer spending has surprised by its vigour, year after year. Now the stage is set for the opposite to happen.

The US quarterly flow of fund statistics, moreover, reveal that the non-financial corporate sector remained in substantial deficit during Q1 2008, rendering it vulnerable to the credit crunch which the latest Fed bank lending survey signals has fast-intensified. As for corporate profits, one of the most overlooked developments of the recent past has been the weakness suffered by the whole economy, or NIPA measure of non-financial profits. This actually fell in 2007, for the first time since 2001.

If you believe— as I do— that profits are a key driver of the business cycle, this decline in whole economy profits goes a long way towards explaining why business confidence, investment and employment progressively weakened. There is, moreover, no reason to expect the downward pressure on profits to ease. And weakness of whole economy profits in the late 1990s gave early warning of the similar fate which lay in store for the more closely-watched S&P profit measure.

Against such a downbeat economic backdrop, core inflation promises to remain well-behaved, sky-high commodity prices notwithstanding. Corporate earnings, however, look extremely vulnerable, as does Wall Street. In such circumstances, a strategy of overweighting government bonds and underweighting equities seems wise.

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Normxxx    
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