Great Depression vs. Now
Since many prominent economists, politicians, and fund managers are forecasting a depression, I decided to explore the differences and similarities of this moment in economic history with the Great Depression.
Then:
Now:
The present moment shares many similarities to the time proceeding and during the Great Depression. However, the most obvious difference is the trigger of the crisis. It is unclear how quickly the economy will recover from the pandemic and even more unclear if the virus has triggered the beginning of a prolonged depression. Only time will tell.
Another big difference this time around is monetary policy. Central banks are working together to prevent a deflationary depression like the Great Depression and aren’t constrained by the gold standard like many were back then. We are in uncharted territory and no one knows how things will play out.
To better understand the variables, let’s explore the most alarming resemblances of the present moment to the Great Depression including the stock market crash, debt levels, wage stagnation, inequality, and asset bubbles.
1. Stock market crash
Over the course of recorded history, economic productivity has been up and to the right but there have been times when asset prices accelerated faster than productivity growth and crashed even faster.
The stock market is seen as a forward-looking indicator of economic growth and its price represents the value of future dividends discounted by the time value of money.
Money losing companies of today can become the most profitable companies of the future just as the highest dividend-paying stocks of the present could collapse in the next downturn. Professional investors make educated guesses (gambles) on the future to determine the current price for each equity.
However, there are other variables that determine prices including interest rates and sentiment, which are hidden catalysts of stock market booms and busts.
When interest rates are low, corporations can justify borrowing money to expand. Low interest rates also force companies to use their cash because of the lack of compensation for holding it.
It is important to differentiate nominal interest rates from real interest rates. Hypothetically, there could be a nominal interest rate of 0% and a real interest rate of 5% if the value of cash is increasing by 5% annually. This dynamic is why 0% interest rates are often accompanied by alternative actions like Quantitative easing (QE) by central banks.
Then:
The 1929 stock market crash and subsequent deflationary depression is the most stunning example of the boom and bust cycle playing out. Both the climb and downfall were exacerbated by interest rate policies and sentiment.
September 1929 marked the beginning of the end of a decade long speculative bubble driven by low interest rates, easy credit, and irrational public participation in the stock market. The Wall Street Crash of 1929 set in motion an over 80% decline in the Dow Jones Industrial Average.
The crash was precipitated by stock prices outpacing fundamentals. The higher the market went the more investors wanted to participate until sentiment reached euphoria. The participation was enhanced by high leverage as speculators borrowed 10x their assets at low interest rates to gamble on prices going higher.
High leverage magnified losses as the market dipped in September of 1929 and started plummeting in October. The biggest banks intervened shortly after by placing large bids above the trading price of major equities, kind of similar to a QE program. The Dow Jones Industrial Average recouped over 50% of its losses over the next 5 months before restarting its historic slide for another 3 years.
Interest rates rewarded cash hoarding during the crash and depression by providing a higher return than productive assets like stocks could produce. In 1931, the nominal interest rate was at one of its lowest levels in history but the real interest rate was close to 15% because of price deflation.
The newly formed Fed was constrained by the gold standard and the Hoover administration clung to economic dogmas like maintaining a balanced budget. The money creation needed to end the deflationary trend didn’t sufficiently occur until the country’s entrance into WW2.
Now:
The pandemic began in Wuhan China and spread around the world in the course of a few months. At first, the effects of the virus were downplayed by most media outlets as not as bad as the common flu. However, all it took was basic math to determine what was coming. Although preliminary at the time, the R0, serious/critical, and death rates pointed to the inevitability of a global health crisis.
The pandemic ultimately hit in the United States and the country was placed into a forced lockdown, crashing markets.
After the fastest stock market decline in history, the Fed aggressively stepped in to save the system.
The Fed dropped interest rates to 0% and began “unlimited” asset purchases to stop the steep decline in the bond market. Congress passed massive spending programs to provide money to businesses and individuals.
The crash may have triggered a depression if it wasn’t for the Fed and US congress stepping in to stop the vicious deflationary spiral much like what occurred in the Great Depression.
Although some fear the policy measures the US has taken could lead to inflation, deflation in the short-term might be more likely as the rest of the world clammer for US dollars and people hoard cash.
Dollar demand remains high because of its reserve status. More than 50% of international outstanding debt is denominated in dollars. Many countries and foreign companies are in desperate need of dollars to service their debt and many more flee to the dollar as a safe haven.
As the public gets past the shock of the pandemic, further stimulus could become politically harder. If the US doesn’t continue to provide money to those who need it, the same vicious deflationary cycle of the great depression could happen. Even if money is distributed sufficiently, public sentiment could favor saving instead of the spending needed to realize inflation. Most likely, certain things will increase in price and other things will decrease.
If the Fed continues to support the market and expand the money supply, a Great Depression style stock market crash seems unlikely. Investors might actually flee to the relative “safety” of the stock market if there are no other alternatives.
At the time of writing, the S&P 500 has retraced more than 50% of its declines and seems detached from the economic realities many individuals are experiencing.
2. Debt
Debt enables economic expansion by funding company and country operations and initiatives. Debt can become a serious problem when its growth doesn’t translate into further economic progress.
There is little systemic risk when a single poorly managed corporation defaults and goes bankrupt. It’s actually a good thing when this happens because another more productive company can repurpose the assets of the failed company to produce economic growth. However, if many defaults occur at once, the banks that lent the money could be at risk of failure. If many banks fail, the entire financial system could collapse and a depression could ensue.
When a financial collapse happened in the United States during the Great Depression and to a lesser extent in the 2008 financial crisis, it caused price deflation as money was destroyed.
Then:
Interest rates were low and lending was loose for decades leading up to the great depression. Cheap credit led to large increases in outstanding debt and bubbles in asset markets, strikingly similar the lead up to the 2008 crisis.
As the roaring 20s ascended into the great depression, a cycle of debt defaults led to contractions in the money supply resulting in a deflationary spiral. The value of the dollar climbed higher as asset prices imploded, which led investors to hoard cash instead of putting it to work in productive vehicles, which then led to further economic contraction.
The United States was on a gold standard and other countries could redeem their US dollars for the precious metal. As the economic concentration turned into a depression, interest rates were increased to stop the outflows of gold from the United States. However, the interest rate increase further exacerbated the deflationary depression.
These factors lead the newly elected president FDR to confiscate all gold and ban its ownership by the public. Once enacted, the federal government had full control over the money supply and could better manipulate its price to produce the desired economic result.
Internationally, the situation was much worse. After WW1, the victorious nations of Europe (France, British Empire, etc.) owed US banks large debts for financing the war. These nations forced the losing nations (Germany, Austria–Hungary, etc.) to pay reparations. These reparation payments could then be used to pay back the United States for its financial aid.
The only way the European winners and losers of WW1 could pay off their debt was to borrow more from US banks, creating an odd catch-22. When the American economy began to contract, lending tightened and Europe’s ability to obtain US dollars diminished causing local currencies to weaken and debt defaults to begin.
A stark example of the consequences this international debt structure was seen in the Weimar Republic. Germany suspended the gold standard while financing its war effort primarily with debt. After the nation lost the war, it began expanding its money supply to paper over its devastated economy. The country experienced a combination of hyperinflation and high unemployment, which led to dire political tensions. The National Socialist German Workers’ Party took over and soon the world was at war again
Now:
Global debt levels are over 3 times the world’s GDP and the majority of it is denominated in US dollars. The pandemic shutdown makes it impossible for many companies to generate income, making interest payments more difficult and defaults likely.
World central banks had already massively expanded their balance sheets to purchase assets the free market was unwilling to acquire since the 2008 financial crisis. Central banks are now doing this even more aggressively to prevent another financial collapse.
Unlike the Great Depression, the United States is not constrained by a gold standard and can expand its money supply as much as it desires.
The Fed doubled its balance sheet in late 2008 to purchase mortgage-backed securities and doubled it again over the preceding years. The Fed started to sell off its assets in 2018 and the stock market began to plunge before the Fed reversed course. Since the pandemic, the Fed has committed to do whatever it takes to save the economy and has again doubled its balance sheet.
The next two largest banks, the European Central Bank (ECB) and the Bank of Japan (BOJ) have expanded their balance sheets even more than the Fed since the financial crisis.
These foreign central banks have even experimented with negative interest rates, which means the lender is forced to pay the borrower. So far this policy has done a better job destroying their banking industry than stimulating economic growth.
The United States is in a privileged position to create money and distribute it because of the US dollar’s reserve status. When other countries expand their local currency it can lead to high inflation if there is no offsetting demand. This inconvenience is especially true for developing nations that don’t have enough US dollars. What is occurring in Lebanon at the time of writing could be a harbinger of what’s to come in many other nations.
3. Unemployment and Wage Stagnation
Unemployment reaches high levels when the economy contracts and people lose their job. Wage stagnation occurs when new technologies expand economic output but fail to proportionately increase incomes for the majority of workers. It also, more disturbingly, occurs when monetary expansion flows into assets held by the wealthy. This happened in the lead up to the Great Depression and is also happening now.
US unemployment from 1910–1960
Then:
Leading up to the Great Depression, workers were being displaced by new technologies. Average salaries didn’t rise in tandem with production, resulting in underconsumption that fueled consumer debt growth. This debt growth fueled corporate earnings growth, rising stock prices. Rising stock prices fueled financial speculation until asset values overheated.
The stock market crash led to bankruptcies and bank failures, displacing millions of workers. Unemployment hit highs the world hadn’t seen until the pandemic we are in now.
Now:
Unemployment in the United States reached historic lows just before the pandemic. Much of the new job creation was in the service sector which was decimated as businesses like bars and shops were forced to close.
At the time of writing, jobless claims have reached absurd highs and the unemployment rate is projected to reach levels similar to the great depression. However, the increases may be temporary as the economy begins to re-open but it is hard to determine what the employment landscape will look like post-crisis.
Although unemployment reached record lows before the pandemic, the labor force participation rate had been in decline since the turn of the millennia. Millions of workers dropped out of the labor force as the population aged and as manufacturing in the United States was offshored or automated. Millions more were underemployed as their education level didn’t equate to a proportionate job.
The extraordinarily high level of mass incarceration in the United States also contributed to the unemployment and underemployment problem.
The United States has the highest rate of incarceration in the world per capita and in total. It is much harder for the formally incarcerated to find employment after reentering society.
Wages have also remained flat for the majority of earners since the 1970s, despite increasing productivity gains.
These employment dynamics have led to a similar situation the country faced in the 1930s. People are forced to take on increasingly high debt to consume the surplus of goods and services productivity increases have created.
Unemployment will reach levels not seen since the Great Depression and financial aid may not be sufficient to avoid considerable pain. Political unrest could ensue if corporate America gets bailed out as ordinary Americans struggle to pay rent. This dynamic could play out across the world and cause new political movements to come to prominence if job losses aren’t quickly recouped after the pandemic subsides.
4. Inequality
Technology increases economic productivity and produces goods and services. The creators of technology are usually highly skilled and limited in number. These workers are compensated accordingly by the shareholders who risk capital to produce economic growth.
Advances in technology often displace lower-skilled workers by automating labor. This displacement is magnified when corporations employ workforces outside their home country.
These factors result in lower prices for consumers and higher profits for producers. It also creates higher wealth inequality as incomes for the highly skilled as well as the owners of capital increase.
Then:
Economic inequality contributed to the great depression as the majority of the population didn’t have enough income to purchase the goods and services productivity gains produced.
Technology gains brought about mass manufacturing, producing cars, radios, and other wonders. Consumerism spread across the population and aided the assimilation of the country. No matter who you were or where you came from, you could define yourself through purchasing decisions.
Calvin Coolidge, president from 1923–1929, promoted small government, laissez-faire economics, and low taxes. His policies resulted in inequality as producers kept more of the wealth they created and relatively less money was redistributed to lower-classes.
The top .1% owned around 25% of the wealth of the United States in 1929. It took massive spending programs, the highest taxes in history, and a world war to end this trend. During and the decades after the great depression, the top .1% owned under 10% of the wealth as a new middle-class was born.
Now:
Economic inequality began to increase again in the 1980s and is now at similar levels to 1929. Advancements in technology have produced great wealth for shareholders, especially the ones that have benefited from the IT revolution. Automation, labor offshoring, and tax policies have all intensified the divide between the rich and the poor.
The economic lockdown has exacerbated inequality as millions lose their incomes and the price of basic necessities grow. So far, the economic interventions by the Fed and Congress have favored owners of capital. However, some spending programs have put money directly into ordinary American’s hands.
Time will tell if the United States enacts similar policies to FDR’s New Deal. The current administration has been calling for massive infrastructure spending programs and both political parties seem ready to sign legislation to send further checks to the population. We’ll see.
5. Asset bubbles
Productivity gains produce wealth which flows to income earners and owners of capital. When wage growth doesn’t keep pace with productivity, wealth tends to flow into assets like stocks and real estate. Asset bubbles are also expanded by low-interest rates and loose lending policies.
Then:
Asset prices became significantly elevated in the 1920s with the CAPE ratio hitting a historic high not surpassed until the dot-com bubble and again in 2018.
The economy was in a lesser-known depression at the start of the 1920s, brought on by reduced government spending after WW1. As the economy made a painful transition from wartime to peacetime, many opportunities presented themselves.
There was a rapid growth of consumer goods like cars, radios, telephones, and the infrastructure needed to enable it. The resulting network effects transformed society to an extent not seen again until the start of the next century when the internet enabled the wonders we live with now.
As economic growth increased, more capital chased even greater returns until asset prices overheated and crashed.
Now:
Asset prices are at similar levels to the excesses of the late 1920s. Inequality, debt, and new technologies brought on its rise but it is unclear if a sharp correction is imminent.
At the time of writing, the total market cap to GDP is 138%. This level is close to its historic high and might increase as GDP declines. The stock market also has an alarming concentration at the top with a few mega-cap tech companies commanding high share prices.
What I worry about
I doubt the economy will repeat the devastations of the Great Depression. I think the readiness of the Fed to expand the money supply and the willingness of the government to spend will result in a much different outcome.
However, I worry about how and to whom this money will be distributed. I doubt every income hole can be papered over.
I worry about the second and third-order consequences of economic dislocation. Some saw a bubble in housing before the 2008 crash but almost no one knew how its popping would lead to a near global economic collapse.
The 2008 financial crisis was like a heart attack and interventions were directed accordingly. This crisis is like blunt-force trauma, shattering bones, and internal organs. No one knows exactly what will result or how to fix it. So policymakers throw everything at the problem hoping the system survives.
I worry about how inflation and deflation will transpire. Will assets owned by the wealthy like stocks and real estate continue to go up while many lose their jobs and can’t pay rent?
I am concerned about the politics that could ensue from the perceived unfairness that will undoubtedly arise from policy interventions. Polarization before the crisis was off the spectrum, where will it be after?
I worry about how economic conditions play out internationally. How will nations without a US liquidity swap line view the US bailing itself out? I worry the reserve status of the US dollar could be challenged as the Fed massively expands its balance sheet to prevent debt deflation.
In times of crisis — like the one we are in now — formally impossible societal transformations can be enacted. I worry we are at risk of adopting economic narratives that enable the conformity of thought, producing compliance, and limiting agency. It is easier to subscribe to a popular mood that confirms biases of past economic and political ideas than forge new ways of thinking that might be unpopular.
No one knows what the future holds but I doubt things will ever “return to normal.” However, as a millennial, I am optimistic about the opportunities that will present themselves as the generational cycle turns.
“Only a crisis — actual or perceived — produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around. That, I believe, is our basic function: to develop alternatives to existing policies, to keep them alive and available until the politically impossible becomes the politically inevitable.”
― Milton Friedman
This article has allowed me to put to writing my observations and thoughts as I am quarantined in my apartment. I would love to hear your comments and I hope you point out the places where I have erred.
This article was the second half of a previous article I posted on the economy.
