The Great Depression vs. Today's Economic Crisis

As we enter 2009, many if not most agree that the US economy is struggling and that these struggles will continue. An increasing number of people have been making comparisons to the Great Depression. With that in mind, let's compare and contrast the situations:

Similarities

1. Both were preceded by an extensive period of credit-fueled bubbles. Before there was the Great Depression there were the Roaring '20s; likewise, before Depression 2.0 were the Greenspan, NASDAQ and housing bubbles. Consistent with Austrian business cycle theory, the end result of a credit-fueled bubble will be a corrective recession that purges out the malinvestments resulting from an excessive expansion of the money supply.
2. Both were marked by government interventionist policies designed to prevent falling asset prices. For instance, bans on short selling occurred in 2008 and at the beginning of the Great Depression. Likewise, stimulus packages were the prescribed remedy at the onset of the Great Depression, and are in vogue once again now. It's worth noting they were unsuccessful back then, and don't appear to be succeeding now.

Differences

1. There is a lack of a gold standard, which serves as a restriction to how much the money supply can be expanded. The dollar was devalued relative to gold during the Great Depression, so there were attempts to circumvent restrictions on the money supply, but ultimately the gold standard was not fully abolished until 1971, and so the Federal Reserve was a bit more restricted in how much money it could create. This restriction does not exist today.
2. America was not as debt-ridden during the Great Depression as it is today. Credit cards are a rather new creation, and the national debt and deficit spending were significantly lower.
3. America's debt is owned largely by foreigners. This introduces the possibility of economic warfare; foreign debt owners can devalue the dollar by selling Treasury bonds as well as dollar reserves.
4. All major currencies are fiat currencies, and the US dollar is the world's reserve currency. This helps the United States in a way, as central banks have been inflating their money supply along with the US dollar to maintain parity of sorts. In this way, the US gets to export its inflation.

Conclusions

1. Because of the similarities, it is reasonable to expect asset prices to continue falling in real value. It is easiest to define "real value" as the price in gold; in other words, assets will fall relative to the price of gold.
2. Because of the differences, currency devaluation is much more likely. Iceland and Argentina, which I've previously written about in articles for SeekingAlpha (here and here) is much more likely. Those who argue for deflation and a scenario similar to Japan are not considering that the Federal Reserve under Bernanke is willing to use unorthodox measures to inflate; Japan was more cautious, and did not heed the recommendation of economists like Paul Krugman, who had called for the Bank of Japan to fully monetize Japan's budget deficit by simply creating more money. As there are no restrictions on the Federal Reserve to expand the money supply as it pleases, currency devaluation is more feasible. Moreover, unlike Japan and like Argentina and Iceland, the US is a debtor nation -- not a lender. This increases the likelihood of a run on the currency, which will result in significant currency devaluation.
3. Because of the US dollar's role as world reserve currency, other economies may try to devalue their currency along with the US dollar to avoid the pain and chaos of decoupling. This would result in the value of all fiat currencies falling.
4. Depressions that are purely deflationary, like Japan and the Great Depression, last significantly longer and can be characterized by reversals that last for years. Roger Nusbaum noted this in his 2009 forecast, in which he expects a rally -- offering a comparison to the significant rallies that occurred during the '30s during the US's Great Depression. Inflationary depressions, though, have a much sharper and harder fall, and thus do not have genuine rallies until currency stability is restored.
5. While zero percent interest rates and quantitative easing are the tools currently being utilized, should currency devaluation begin to be an issue, raising interest rates will be the most likely and most effective way of preserving the US dollar's value. Paul Volcker's policies during the late '70s and early '80s are a historical precedent in this matter, and interestingly enough, Volcker has returned as an economic advisor. Should interest rates rise, this would likely send stocks falling.
6. Should foreign currencies devalue alongside the US dollar, gold and silver should rise. Should foreign currencies decouple, the US dollar may fall relative to them.

Disclosure: Long gold and silver.

Comments

[prudentinve...:]

Good summary!

2008 Dec 31 08:04 AM

[swygert@law...:]

Mr. Patel's summary of the similarities and differences between the Great Depression of the '30s and today's global financial crisis is excellent. However, a few other comparisons can be made. Central banks could do little to support the banking system then unlike today. One thing is the same, however: a pervasive and to extend unjustifiable fear about the future that obscures global economic realities for the future, one result of which is people with money closing their pocket books. It remains to be seen if the new administration in Washington will be able, through their market interventions, can get people to start spending at a higher level than they are now.

I agree with Mr. Patel that a major difference is the government's ability to create more infusion of dollars through bailouts not hampered by any gold standard. I think he is right in pointing out that printing dollars that have and will continue to take place over the foreseeable furtue will increase significantley the risk of deflation of the dollar which in turn will lead to inflation and continued difficult economic times for the world economy -- especially the U.S. for extended period of time.

2008 Dec 31 08:43 AM

[Ferdinand E...:]

There is no correspondence whatsoever between what is happening today in the global macroeconomy and financial market, and what happened before and during the great depression. It's possible to claim that there is though because people are capable of believing anything.

2008 Dec 31 08:52 AM

[ACCOUNTANT:]

Two huge differences that Mr. Patel did not mention include the facts that (1) During the Great Depression, there was no FDIC - hundreds of thousands of families lost everything when their banks failed. and (2) you also had the great multi-year dust bowl drought that occurred that totally ravaged the economy of the midwest. Any analysis between the Great Depression and today that ignores these two events is missing some of the key elements of the Great Depression.

These events are also part of the reason of why the market hit bottom in 1934, not 1929. Had these two events not occurred, the Great Depression could conceivably ended by 1930 or 1931 as just another recession.

In terms of the first item (i.e. banks) and its backlash, as a kid in the 50's and 60's, i knew of a number of people that still did not trust banks and kept most or all of their money in pure cash, hidden at home.

r. Banks is correct - there is NO correlation between then and now.

2008 Dec 31 09:53 AM

[alphadominance:]

Nicely put, I think there are eerily similar circumstances between our present situation and the Great Depression. While it's difficult to forecast accurately, I have my doubts about a speedy recovery. I suspect at the least we will have a protracted "flat" period as earnings and intrinsic value catch up with market values. Part of the problem is that virtually everyone is broke. The government, businesses and individuals are all cash strapped. How can we have a recovery without a return to greater consumption? However it works out I sincerely hope that America learns some fiscal discipline from this and reverses our course of negative savings and ever ballooning debt.
alphadominance.com/?p=...

2008 Dec 31 11:19 AM

[Jason Rines...:]

1) This was a really fine article Mr. Patel. I especially appreciated the cause and effect comparison of now vs. roaring 20's/1930's. I thank you for your time.

2) Great point Accountant on the Dust Bowl.

3) Information moves faster then that era. I am staying with my forecast this is a depressionary event, that America transitioning back to Save and Invest economy and that this transition will take three to four more years to complete and the beginning of the next Bull market will be 2013.

4) During this transition, Washington politicians will go. A comparison of then vs. now will show a voter revolution with 25%-30% of House of Representatives being ousted between the 2010 and 2012 elections. America should learn from the Roman Empire and establish term limits.

5) My investment strategy: Wait until end of Q1 which shall demonstrate further horrific earnings. The market will either retest lows or break the lows but the worst market news will be over (not saying the pain will be over though). 5 year buy and hold strategy in Health and Higher Ed (i own companies in both, to clearly state my position) . Also, by then as investors we shall have a much clearer picture on Washington fiscal policy in job creation in regards to:

a) Healthcare
b) Energy
c) Education
d) InformationTechnology
e) Price Discovery of Tier 3 Deravatives. If I was President would simply state the U.S. has to investigate the legality of all global deravative contracts, that of course will take years, the time needed for housing market to stabalize, labor reorganization and job creation to take place banks to repair balance sheets/M&A's and panic to subside. It was short-termed thinking, selfish and outright destructive to confidence of the investment community at large to defend the deravatives but not surprising considering personal vested interests by Central Banks and Wall St/Government execs.
f) Reinsating prior regulations that prevent excess leverage

2008 Dec 31 12:07 PM

[Rob Viglione:]

The most likely direction is for our elected and non-elected officials (fed) to do everything in their power to defend the position that spending must increase at all costs. The costs will turn out to be unsustainable.

Expect increased currency debasement and a rush to zero interest rates throughout the industrialized world. Destabilizing policy pushed over the last several decades to increase spending irrespective of real wealth measurements, such as real per capita income, has meant leveraging our civilization to build capacity that far outstrips sustainable consumption limits.

Rather than face reality and acknowledge that our society is over-leveraged, our public officials are borrowing and printing more on our behalf, further destabilizing our balance sheets and degrading the value of our currency. this is outright madness: public servants forcing us to borrow and spend, whether we like it or not.

Predictions are fairly easy: this situation is untenable in the long run. Timing is an entirely different story. We could very well pull out of this recession and enter another leg of this borrow-print-spend drama, but the end result will certainly be collapse and reversion to reality.

2008 Dec 31 12:17 PM

[DiggerUK:]

Thank you for the last two parts of you article.

The differences between "now and then" are invariably glossed over, or ignored by far too many.

I broadly support you conclusions.

My contribution is not part of the 'flations debate, a subject practiced by more people with crystal balls, than crystal thoughts.

I do not believe we will ever go back to a gold standard of old, but conclude that all fiat paper must have some relationship to gold if it is to be trusted, and avoid collapsing.

Many countries have suffered triple digit inflation. Mid war Germany and today's Zimbabwe show when inflation figures end with numbers to the power of 10, what was different. No gold in their banks.

The IMF bailouts are backed by it's gold reserves.

2008 Dec 31 12:32 PM

[Dr.Jackpot:]

One difference is that people are much fatter and physically lazy today and really don't want to work anyway. This gives them the excuse to stay home on unemployment and play with their computers and stock market.

2008 Dec 31 12:34 PM

[Teutonic Kn...:]

Mr. Patel's assessment is sound and structured, well articulated.

However, I have an observation that might be out-of-scope but nonetheless serving as food for thought.

The United States in 1929 looks a nation in its adolescence, still young and virile. Whereas, some 70 years later, today, the U.S.might have reached full maturity and even beginning showing signs of middle age.

That, coupled with the changed geopolitical landscape, where international trade had vastly multiplied, particularly with the emerging Asian countries such as India, China, and Japan, may complicate our recovery. Little precedent is known of the effects of intertwined relationships if the current crisis deepens.

2008 Dec 31 01:57 PM

[De Graaf:]

I see a lot of interesting comments but I didn't see this one passing by;

The situation now in relation with Japan is the fact that Japan had the wrong policies with a positive Rest Of World economy available for exports.
This time, the whole world is on its butt in recession. That gives a different recovery curve. Instead of a V-curve, you can expect an L or U-curve for the United States at this point in time.

Japan has got 'healthy' reserves and a better policy today. America is worst off this time because there just is no demand from other countries. The outcome looks awful, but so is the entire world economy in the coming years.

This, is a tough one to battle. Whatever the outcome, I expect to see a devaluation of the dollar currency or a severe deflationary period for the US. Either way, gold and silver assets will flourish to new highs.

2008 Dec 31 08:10 PM

[Hmm?!:]

Great article.

However, I do not agree with point (5). How can America payoff all those foreign held treasuries (approx. 50%)? A devalued US dollar reduces the cost of pay back and increases exports (jobs). What can foreign entities due? Sell back all the bonds at a deep discount? OK

I also do not agree with Accountant. On his first point, what does the FDIC matter this time around? The population has a negative savings rate. As for the dust bowl argument. I am not convinced that was a bigger factor than government policy. We also have to give the current environment a couple of years to develop any additional issues before an equitable comparison can be made.

Jan 01 01:31 AM

[Crocodilian:]

One salient difference is that the American financial system was much more robust in 1929 than it is today.

Consider: it took 3 years from the Crash and a collapse of manufacturing activity to bring on the banking crisis of 1932-33. By contrast, a %10-15 decline in home prices was enough to break Bear Stearns, Lehman Brothers (and without intervention, would have broken AIG,Citi, Wachovia, possibly JPM/Chase, possibly Bank of America)

It is striking how much _more_ robust our financial institutions were in 1929 than in 2007.

Jan 07 04:13 PM