Calm before the storm - Towards a Greater Depression?

Although the stock markets and the global economy are booming, everything is not well in the global economy. I, along with our firm (GnS Economics), have been the “harbingers of doom”.

In this entry, I will envisage a historical analog to the current situation in the global economy. I will argue the current situation has many alarming similarities with the ‘Roaring Twenties’ that then led to the stock market crash in October 1929 which started the Great Depression. This indicates the conclusion that the global economy is dangerously close to the repetition of the economic catastrophe of the 1930’s.

The information on the 1920’s and 1930’s reported below are based on excellent summaries by Nicholas Crafts and Peter Fearon and Gary Richardson et al.

Roaring twenties and wobbling twenty-tens

Recovering from the post WWI-slump, the Americans enjoyed a decade of consumer boom led by automobile and building sectors during the 1920’s (hence the ‘Roaring Twenties’). During that time, the US became the world’s largest exporter and, between 1924 and 1931, it also provided some 60 percent of global private lending. The newly born central bank, the Federal Reserve or the Fed (established in 1913), was also providing easy credit. These conditions created a perfect setup for a stock market boom.

In January 1928 the Fed did a turn. It tightened monetary policy and started to sell government securities which it had accumulated especially during the latter part of the 1920’s. The Fed was fully aware that these operations could be destabilizing for the markets and tried to gently deflate the stock market bubble by progressively making the bank borrowing more expensive. But the higher rates made more funds available from the non-bank sources. The credit conditions eased and the speculation about the stock markets actually increased. Complacency took hold. Many thought that stock markets could not go anywhere but up.

The similarities with the current era are striking. China has continued to grow rapidly after the crisis of 2008 relying on housing, infrastructure and industrial investments. It has become the largest trading nation in 2013. After 2008, China has also been the sole source of the private debt growth and her debt has reached astronomical levels (see Figure 1). Moreover, the major central banks have provided extremely easy credit during the last nine years. This has led to a unprecedented asset market mania across the globe.

The actions of the Fed in 1928 could as well be a description of its actions this year. The Fed has done the exact same operations with the same caution but the credit conditions have eased (see Figure 2) and the speculation in the stock markets has increased (see, e.g., this and this). Just like in 1928.

The Great Depression

In October 24, 1929, following a few months of poor corporate results, the bottom fell out of the stock markets. In just four trading days, the Dow lost 25 % of its value. The markets bottomed out only two and a half years later in June 1932 having lost almost 90 % of their value. From the peak (August 1929) to the through (March 1933), the output of the US fell by 52 percent, the whole sale prices by 38 percent and the real income by 35 percent.

Four key elements have been identified as the main culprits to the massive economic fallout known as the Great Depression:

1. A wave of bank failures in the US, which lead to a financial paralysis and to a fall in the monetary stock.

2. A raise of the US import duties in 1930 and some other protectionist policies which led to an expedited decline of the world trade.

3. A rise of the interest rate by the Fed in late 1931 and during the winter of 1932-33 which worsened the financial fallout.

4. The gold standard, which transmitted the crisis across the globe.

Could this happen again?

At the first look, the repetition of the Great Depression seems like a far-fetched scare. For example, the central banks and the authorities are now more aware of the risks of financial crashes. Still, there are worryingly many confluence points between the onset of the Great Depression and the current economic environment.

One country, China, has been responsible for the most of the global (debt fueled) economic growth during the past nine years. The elevated, speculation ridden stock market in the US is a clear candidate for the inflection point and, while banks in the US are doing fine, the same cannot be said about their European counterparts. Thus, the characteristics present in the US before the onset of the Great Depression are now spread among three leading nations or unions: China, the Eurozone and the US.

At this juncture, an informed reader points to the modern central banks by stating that they have the means to stop any market mayhem. Even though this where the case, the ability of the central banks to stop the main element of a deep depression, bank failures, has not really changed since 2008. The central banks provide liquidity for the commercial banks, but they cannot recapitalize them. That is the responsibility of the governments, which currently are heavily indebted, especially in the Eurozone. Moreover, because the interest rates are already close to zero or even below, there is really no room for more monetary easing.

The likelihood of a major crisis is growing

If (when) a new financial crisis hits, the European banking sector may have just two options: bail-ins (using depositor money to cover the losses) or bank failures. Both options will necessarily worsen the crisis. If countries enact protectionist policies at the same time, three of the four main elements of the Great Depression are already present. Fortunately, there is no gold standard, but the tight global financial network will almost surely transmit the crisis across the globe.

Although the likelihood of a repetition of the Great Depression is still somewhat subdued, it is growing fast. The continuing monetary stimulus of the central banks, the relentless debt growth in China and the roaring global asset markets are creating massive imbalances that need to be settled sooner or later. The later it gets, the closer we are to a global economic catastrophe.

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