In a recent article titled "Step Right Up and Test Your Central Banking Skills against the Scariest Economy of All," I encouraged readers to:
[Apply] your economic and policy beliefs to early 1928 conditions, and then [ask] how your decisions might have played out. Imagine you're [New York Federal Reserve Bank chief] Benjamin Strong, puzzling over a strange brew of rising stock prices, uneven economic recovery, suspect banking practices and unusual strains in Europe's monetary system.
I argued that global conditions in early 1928 were oddly similar to today, but skewed in a direction that would cause our current policymakers to apply even stronger stimulus than we've seen in 2013.
Consider these observations about early 1928:
- Consumer prices were deflating about 1-2% per year.
- House prices were stagnating.
- The unemployment rate was significantly above its low in the previous business cycle.
- The European monetary system was at risk of coming apart at the seams, due to England's struggle to maintain its link to gold at an overvalued exchange rate (replace "gold" with "Euro" and "England" with "periphery" and you have today's conditions in Europe).
- Germany was near the end of an unsustainable borrowing binge that fueled extravagant local government spending (like China today) and facing near-certain sovereign default (like Japan today).
The analogy suggests to me that today's Fed is threatening mistakes that aren't unlike those of the 1920s Fed. But what about the stock market, you ask?
Unfortunately, a few market characteristics fit the late 1920s timeline pretty well. First, P/E multiples, which I touched on in the first article, place today's stock valuation at levels similar to the latter part of 1928.
Second, stock prices separated from corporate profits in the first half of 2013 in a way that's comparable to market performance in late 1927 and early 1928.
Here's the 1920s picture:
And here's the current expansion:
Once again, the message is that the very conditions the Fed strives to create - buoyant asset prices and super low interest rates - have a history of ending badly.
As I wrote in the earlier article, the Fed cut rates only slightly in July 1927 (from 4% to 3.5%), and the stock market promptly went vertical. In the following year, policymakers acknowledged the easing was a mistake, but their attempts to discourage speculators (which included reversing course and lifting rates to 5% by July 1928) weren't strong enough to stop the bull market.
With few limits on margin debt and the U.S. stock market just about the only game in town for speculators, the manic rally built on itself until the October 1929 crash. Today's policymakers would have presumably cheered the 1920s speculation, which now goes by the name wealth effect.
How do we reconcile a 1920s Fed that feared speculation, and yet was still badly burned by it, with a 2010s Fed that encourages speculation? One way to look at it is that 1920s policymakers emphasized the long-term hangover that eventually occurs after asset prices are pushed above fundamentals, whereas current policymakers prefer to celebrate short-term benefits.
Economists or Trekonomists?
More fundamentally (and here's my usual digression into basic causes of our boom-bust economy), today's policymaking is dominated by academic economists relying on a tangle of abstract models that are full of holes and contradictions. These economists are the ivory tower equivalent of Trekkies, unable to suppress their obsession with an alternative world that bears little resemblance to the real world. And their self-preservationary groupthink has spawned ever more dangerous bubbles. (End of digression - look for past and future posts about specific fallacies in macroeconomics, such as this one and this one.)
Getting back to the 2013 vs. 1928 stock markets, the Fed's current overreach doesn't present the exact same risks that built up in the late 1920s. But similarities between the two periods are strong, and especially when you account for the global backdrop as I did in the earlier post. Moreover, these similarities are just as relevant as the comparisons to the 1930s that we hear constantly from economists defending current policies.
Finally, there can be little doubt that today's Fed-fueled asset price rallies merely bring future price appreciation forward to the present. Asset prices eventually return to fundamental values, and as they do the Fed's cherished wealth effects work in reverse. This is another risk that should be considered when you decide whether to take Bernanke's bait and "reach for yield" in stocks and other risky assets.