By Alexander Apostolides on March 20, 2009

GLOBAL CREDIT CRUSH I vs THE GREAT DEPRESSION I, By Christos Votsis, CFA

I have to admit that I was intrigued by a comment posted concerning the current financial crisis and subsequent remarks concerning the resemblance of our current economic woes to the era known as the “Great Depression”. I have to admit though, that I was dismayed by the fact that consensus opinion in that comment appeared to be geared towards the argument that the importance of the current economic downturn trails by a relatively wide margin the severity of the economic woes experienced during 1929-1933. We maintain that this is not the case as the implications of the current downturn are too far-reaching and too serious to be dismissed as just another recession. We believe that the economic and social crisis just beginning, and worldwide demolition of wealth, are revealing the uncomfortable truth.

As you all know, the world economy is now entering an exceptionally uncertain phase which is subject to considerable downside risks. Although in the past we experienced many other economic downturns, also embodying financial crises (most notably US housing woes in the 80’s and also Sweden, Japan and Asia in the 90’s), we maintain that the origins, severity and magnitude of the current economic situation can only be paralleled to the Great Depression. Yet our capacity to learn from the Great Depression is limited because of different policy actions and because we do not know how economies would have evolved after 1938 if politics had not intervened.

We also maintain that current government policy is unprecedented and hence this reinforces our optimism that the US economy will not end up in a Great Depression as it did in in 1930. Hence the result is that we must now endure not Great Depression II, but Global Credit Crash I, with adequate government intervention spreading the pain over a number of years implying a shrinking credit system, slow economic growth and declining profits in the business sector for many years to come. Although this by default implies further drops in asset prices and additional banking woes and deflation we believe that this will be prevented (or reversed) via exploding budget deficits, which will push up interest rates so far, however, that asset prices will start falling too far again. Hence inflation could surge again steeply in the future as governments will have to respond to exploding budget deficits by artificially suppressing interest rates again. Also with governments and central banks bringing private sector losses onto their balance sheets, fiscal deficits soaring in the next two years and with the US Fed and the Treasury taking a massive amount of credit risk, the long-term solvency of the US government could be put at risk.


In drawing the parallels between the current state of economic affairs and 1929 we first have to examine the roots of the current economic cycle:

In the 1980’s and 1990’s more and more countries (in Asia and Eastern Europe) entered the global economic stage. As they developed their domestic economies, huge industries were created, mainly aming to produce for Western markets. At a macro-economic level this led to a transfer in prosperity from the West to the East whose magnitute would have normally led to economic contraction in the West and to high economic growth in the East. This process would have eventually come to a halt as the West should had lost the purchasing power needed to offset production in the East. Moreover, the currencies in Asia and SEE should have appreciated so much that their cost advantage would diminish.

None of the above developments took place because many Asian countries kept their currencies pegged to the dollar whereas a lot of Eastern European countries opted for a link with the Euro.

In addition the Western Economies started to grow fast because various factors systematically supressed inflation (emergence of densely populated economies after the fall of communism providing the West with cheap products plus a high rise in productivity combined with relativel low wage rises). As a result, interest rates continued to ease. Investment in assets became more profitable as asset prices surged further boosting consumer confidence. Simultaneously savings steadily decreased while consumption borrowing went up leading to corporations and lenders to look the future with more confidence based on the assumption that asset prices would continue to rise against a high growth environment and low inflation. In the end this became a self fullfiling prophecy as easing risk premiums, high growth and rising asset prices continued to reinforce each other. What actually happened is that the West lost a great deal of its competitive position to the East. It was able to disguise this for decades by means of a credit explosion. Unfortunately, this was used for more consumption instead of being invested to create a future source of income.

Thus to begin with, the cause of the current cycle is in the credit bubble inflated over the past few decades. The background against which the amount of credit has grown so rapidly is falling inflation from the 1980’s upwards. Due to falling inflation long term interest rates were also dragged down. The lower interest rates fell, the more asset prices rose. Virtually all asset classes prices rocketed upwards from 1990 upwards. While housing prices, in particular, were rising, debts were mounting, particularly those of consumers and financial institutions as consumers starting borrowing more to buy houses but also to consume more. After all real wages have hardly risen over the past few years and rising asset prices offered consumers sufficient security to save less and borrow more. Simultaneously it was assumed that asset prices would continue rising and growth would remain high.

The cycle of indebtedness became a reinforcing spiral as low inflationary expectations led to relative flat yield curves suggesting lower earned credit spreads on loans by financial institutions that were subsequently forced to increase the provision of credit facilities in order to ensure high profitability. Credit spreads would have widened as indebtedness increased but this was avoided via financial engineering (bundling and reselling loans and spreading risks through the Credit Default Swaps market). Credit spreads were also kept low by the fact that the Fed and the Central Bank of Japan kept pumping more liquidity into the system than the economy could absorb, in an attempt to fend off deflation (deflation is disastrous for highly indebted countries). In fact there was so much surpluss money into the income that bankers and fund managers had little option but to take increasingly high risks. Thus based on an over-rosy outlook too much was lent on over-easy conditions.

Under these conditions, housing prices in the United States rose by around 160% in the period between 1991 and 2006. Then inflation started rising (very high commodity prices and extremely low interest rates) so the conditions were no longer perfect for asset prices. The Fed had to raise interest rates in an attempt to curb inflation. As soon as housing prices fell by around 8% from their peak, the credit crisis broke out. The fact that housing prices only needed to fall by so little in relation to the preceding rise shows how unstable the system was. After all, it was based on the perfect conditions and outlook for asset prices and the debt mountain built on top.

Back into drawing the parallels to the Great Depression we have read and understood that the later at its peak it was effectively “collective insanity”. We also maintain that there are conflicting interpretations as to the causes of the mayhem. The bottom line though is that the Great Depression threw the survival of the economic system, and the political order into serious doubt. Similarly in 2008, markets and business leaders came to doubt the durability of the financial foundations that had supported consumption and asset price growth after the New Economy fiasco.

Various explanations have been put forward to explain the Great Depression. Some blame the failure of self-correcting mechanisms; others blame the low money supply suggesting that the Fed chose to follow the wrong policies. Given the exactly opposite nature of current government policies, we cannot identify any similarities to the current crisis from this viewpoint. Traditional monetary policy proved to be ineffective at the first stages of the current crisis, thus other unorthodox policies have been used including massive provision of liquidity to financial institutions to unclog the liquidity crunch and reduce the spread between short-term market rates and policy rates; quasi-fiscal policies to bail out investors, lenders and borrowers. Even more unorthodox policy actions were utilized in order to reduce the rising spread between long-term interest rates on government bonds and policy rates and the high spread of short-term and long-term market rates (mortgage rates, commercial paper and consumer credit) relative to short-term and long-term government bonds. Even though it is too early to give any credit to the above policies we do maintain though that if it were not for the trillions of dollars committed to current government interventionist policies then the Great Depression could be dwarfed by the meltdown that we would be faced with.

Other economists blame over-production and under consumption. We do not have any evidence to support if this is the case today. However we do point out that this is one of the dangers that we could face in the near future if the consumer credit bubble does not deflate in an orderly manner.
Another school of thought blames the 1929 downturn to increased protectionism that finally led to less demand for US produced goods. We cannot draw any parallels to today’s crisis, but we would like to point out that today, government policies are becoming more and more protectionist (remember Obama’s “Buy American” logo?).

Other economists (including Ben Bernanke) in explaining the Great Depression cite the inherent limitations imposed to policy makers by the gold standard. We also recall that another school of though further villifies the gold standard system by blaming it for transmitting the problem to the rest of the world. Although we do not have a gold standard today, we would like to point out that we do have the Euro and plenty of involuntary currency interventions.

We like the explanation put forward by several economists that consider the key reason for the Depression to be the expansion of the money supply in the 1920s that led to an unsustainable credit-driven boom. I am sure that you can all see the similarities here to the current crisis. We also like the explanation put forward by the Austrian School of economics which blame the easy credit policies of the Federal Reserve during the 1920s (similarities to Greenspan’s Fed after 2000 anyone?).

The next view on the causes of the Great Depression is very closely related to our current situation and relates loose credit to over-indebtedness, which fueled speculation and asset bubbles. We are sure that you can all see the parallels to today’s crisis.

Finally we would like to point out that as in today, back in the 1920’s there were structural weaknesses in banking. Graham and Dodd (the fathers of security analysis) argued that prior to the Great Depression major banks were holding over inflated risky equity investments while also they made risky loans based on an over-rosy outlook. Graham and Dodd also argued that part of the the credit boom of the 1920’s was brought by investment banks that underwrote bond issues by practically insolvent companies in order to meet investor demand for fixed income investments. We are sure that you have all spotted the striking similarities to the current crisis here.

As a last point, I would like remind you all that the US Economy is in recession since November 2007 (according to the Economic Bureau). The financial crisis emerged in September 2008 following the collapse of Lehman. If it was not for the Lehman debacle (and Fannie Mae and Freddy Mac a few days earlier) then AIG and WM would probably not have had their credit lines cut off – and AIG could had been able to roll-over its derrivatives positions successfully. Prior to that we just had the subprime collapse and the credit crunch thing (I think that both emerged to the surface in early to mid 2007 – but the actual slowdown in the US economy started in 2006). Both the Subprime crisis and the credit crunch were precursors to the current financial crisis (more like mini-crises) but they were by products of the economic slowdown and not trigger events for it. We also remind you that through the 1920’s thrift failures were also very common.

2 comments:

  1. Comment By Alexander Apostolides.
    I had a bit more time to read it a bit more thouroghly - i dont dissagree with most things, but i stll insist that the difference between now and the great depression is not just the current pro -active aproach by governments.

    in 1929 the real economy was already in dire straights for 2 years. peolpe forget that globalisation did not begin in ... Read more1980 but it was in full swing in 1914 only to be cut short by war. It never recovered - in 1920 and 1930 the volume of trade were both lower and also more bilteral than before - thus suspect to tit - for tat protectionism.

    agricultural goods and mineral goods hit very low prices by 1927 and went trhough the floor inthe depression, we has the oposite before this crisis with agricutlral prices and other commodities going through the roof.

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  2. Reply By Christos Votsis:
    1. I never said that the only difference between the credit crash and the depression is the current (not so proactive) nature of government policies. Don't forget though that we are talking about two entirely different economies with major structural differences.

    I am glad that you are pointing out to me that in 1929 the real economy was already ... Read morein dire straights for 2 years. Similarly in December 2008 the US economy was in recession for 1 year (as announced by the US economic bureu). In fact though there is another interesting arguement put forward by the FT's Wolfgang Munchau that the economy has been in deferred recession since 2001 (I, I would like to pont out to you once more that the US economic slowdown actually began in 2006. So i guess that we both agree
    that in both cases the economomy had been deteriorating for 2 years prior to the trigger events that escalated things (don't forget that in 1929-1930 we there was a recession and not a depression)

    I am fully aware that globalisation did not begin in 1980. I am just saying that it escalated in the 80's and 90's. Don't forget that back in 1914 we were not talking about the BRICs, the Asian and European tigers and more importantly there was no Chinese Dragon. I would also like to point out that at the time there was a German "Dragon" trying to ... Read morerevive an export oriented economy and pay back war reparations.

    As far as the issue of commodity prices is concerned, we both seem to agree that at some point during both periods in question, commodity prices soared and then fell. The only difference here is that commodity prices fell only 6 months prior to the crisis. I do not have an explanation for the timelag involved. Nevertheless I would like to point to you that the role of the rural economy was much more important back then and that the markets today do not have the same information symmetries as in the 1920s and that the market dynamics are very different due to the fact that the world economy today is very different that what it used to be back in the 1920's. As you can recall I mentionned that back in the 20's there were constantly mini crises involving rural banks which had lent substantially to the agricultural sector. Similarly since 2003 problems emerged with subprime lenders with HSBC being forced to write-off 10 bn ... Read moreafter its acquisition of a distressed subprime lender in 2004. I can certainly see a parallel here between commodity prices in the 1920's and house prices today which started falling in 2005, but I will have to think a bit more on it.


    As far as the issue of unemployment is concerned I can recall reading some arguements that unemployment back in the 1920's-1930's was kept artificially high both in the US and the UK due to the state unemployment benefits available and the predominance of blue collar and rural workers with no career aspirations (I recall reading that a person who experienced unemployment back then claimed unemploymentan average of 8 times during the period 1929-1938.
    Finally please note that the real economy was not brought down by the rapid reduction of credit. Credit is still alive and kicking but credit growth is dead (and died mid 2008). The deleveraging process is still at its early stages and it is far more serious than what you may think.
    As far as you... Read more comment that "This is not a great depression - it a mighty credit crunch that hit the real economy hard instead" is concerned, back in early September I was talking to a bank client and mentionned with several valid arguements that the S&P 500 was about to face a meltdown and drag both the CSE and ASE with it. The bank's client took a good look at me and said "I disagree". I was waiting for him to go on and put forward his own arguments but he never did. To be honest I thought that his reaction was cool. So similarly "I disagree".

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