It was just over eight years ago that I wrote an article for Seeking Alpha entitled, "A History of Market Violence". The article was posted to the site on March 5, 2009, which of course was just one day removed from the final financial crisis bear market low that came the next trading day on March 6. It explored the mistakes that policy makers had made in the past during the Great Depression and were being relied upon to avoid this next time around. Many years have passed since this article was written, and stocks have gone from bear market lows to new all-time highs. But the question remains: what have we truly learned and what challenges, if any, remain?
Great Depression - A Quick Recap For Context
Before going any further, it is important to put the Great Depression into historical context. Just as the financial crisis is remembered as the stock market falling off a cliff the moment Lehman Brothers failed - it didn't work this way at all, as the stock market was actually higher a full week after the Lehman bankruptcy - so too is the Great Depression remembered as this period of perpetual catastrophic misery. Indeed, the stretch from 1930 to 1932 was particularly lousy due to repeated policy mistakes, but the economy subsequently recovered and experienced strong growth over the period from 1933 to 1937 with real GDP growth averaging a healthy 9%. It was only after the Fed started raising interest rates too quickly in 1937 when the economy rolled back over into another sharp recession through 1938.
So while more severe in magnitude and different in its causes, the path in the 1930s through the Great Depression bore a striking similarity to the 2000s with the bursting of the tech bubble from 2000 to 2002 followed by a strong recovery from 2003 to 2007 leading into the financial crisis in 2007 to 2009.
Of course, the key coming out of the financial crisis was to not repeat the same mistakes of the past made during the Great Depression.
What Have We Learned?
The following is a direct excerpt from my March 5, 2009 article. My purpose for sharing it is to explore what pitfalls we have avoided and what errors we may potentially be repeating still today. Between each of the seven items below, I have inserted my updated perspective eight years later as of today.
Many parallels may be drawn between the events surrounding the Great Depression and today. The following list represents the consensus view of the causes of the Great Depression and their correlations to today.
- Excessive debt and leverage - This is the root fundamental cause behind the Great Depression and today's episode that ultimately led to a banking crisis and a breakdown in the financial system. Banks reduced lending activity dramatically during the early 1930s in order to preserve capital and maintain survival. Banks today have also retrenched sharply, as the collapse of several major global financial institutions and the proliferation of toxic assets in the banking system has greatly undermined confidence, which has crippled financial intermediation and investment markets as a result.
2017 view: A reduction in bank lending activity has been one of the primary constraints in preventing a more robust and sustained economic recovery today, as many are still preserving capital today despite their balance sheets having been more than stuffed thanks to the post financial crisis policy response. Yet systemic risks remain among many banks around the world today eight years after the calming of the financial crisis.
- Monetary policy prior to the downturn - Despite minimal inflationary pressures, the Fed raised interest rates starting in early 1928 until the market crash in October 1929 in an effort to thwart speculative bank lending. This policy action ultimately helped start the downturn. Although the Fed did not raise interest rates leading up to the current downturn, it has been suggested that the Fed may have begun easing too late and lowered interest rates too slowly once it was clear that the financial crisis was getting underway in early 2007.
- Monetary policy during the downturn - The Fed tightened monetary policy far too soon during the Great Depression, leading to compounding deflationary effects. The risk today appears to be the opposite. The Fed has openly stated its commitment to maintain easy monetary policy for an extended period in order to combat prevailing deflationary pressures. As a result, it is likely that policy may stay too loose for too long, leading to the potential for compounding inflationary effects down the road and the development of new speculative bubbles.
2017 view: The risk today appears to be the opposite indeed! To say that policy makers have stayed loose for too long turned out to be an incredible understatement, as the Fed has more than overcompensated for their mistakes in the past by flooding the global financial system with capital. The development of new speculative bubbles remains a growing risk today.
- Fixed Currencies - The global commitment to the gold standard in the early 1930s and the need to maintain fixed exchange rates ultimately forced many countries to assume tightening monetary policies even if local conditions warranted a decidedly different policy response. This helped compound weakening economic activity worldwide. While the gold standard does not exist today, many of the world's largest economies in Europe share the euro currency, with many countries essentially maintaining a fixed exchange rate and taking on the same monetary policy despite vastly different individual economic circumstances. The potential economic instability of several countries in the Euro Zone not to mention the spillover effects of a mounting financial crisis in Eastern Europe may lead to more pronounced economic weakness from the region with subsequent feedback effects filtering through to the entire global economy.
2017 view: Just like the collapse of Long Term Capital Management now looks quaint by comparison, the fact that policy makers were wringing their hands about the implications of an economic meltdown in Latvia at the time now looks almost humorous by comparison to what we have today. The implied fixed exchange rate of the shared currency has brought the eurozone experiment to the brink. Policy makers were simply unable to prevent the symptoms that were first evident so many years ago, and now it appears more likely than not that the European Union (BATS:EZU) is headed for irreconcilable fracture in the coming years (perhaps the U.S. stock market (NYSEARCA:SPY) will begin to wake up to this reality at some point along the way). The subsequent feedback effects filtering through the entire global economy remains to be seen, but we are likely to get our first taste with the U.K. (NYSEARCA:EWU) now triggering Article 50 and formally beginning the process of departing from the EU. Put simply, history being repeated, only in a different form.
- Taxes - Two years into the Great Depression, the Hoover administration and Congress instituted a tax increase in 1932 in an attempt to balance the budget. This included a major tax increase on top wage earners. This tax increase ultimately resulted in a reduction in disposable income and a further contraction in consumer spending and economic activity. Roughly two years into the current episode, the Obama administration recently delivered a budget that included numerous tax increases in an effort to bring the now ballooning budget deficit back down to the $500 billion range by 2013. This budget proposal includes a major tax hike on top wage earners with income of $250,000 per year or more. While the ultimate impact of these policies today remain to be seen, characteristics of the recommended tax increases share some perilous similarities to those of the Depression and may serve to dampen economic activity once again this time around.
2017 view: President Obama repeated President Hoover's move by raising income taxes on the highest wage earners, but when the global financial system is being flooded by a liquidity firehose from central bankers, a modest tax increase on the top tax bracket ended up garnering a collective economic shrug.
- Protectionism - During the Great Depression, many countries engaged in protectionist trade policies such as tariffs and quotas in an attempt to promote domestic economic activity. This included the United States and the notorious Smoot-Hawley Tariff Act of 1930 and the Buy American Act of 1933. Such protectionist measures had decidedly negative consequences on global economic growth including massive contraction in global trade and foreign demand. Despite these past lessons, the protectionist instinct is building today in many countries across the globe. This once again includes the United States, which engaged in rhetoric opposing NAFTA during the Presidential election campaign, has been increasingly reluctant to approve new free trade deals and included "Buy American" provisions in the recently approved $787 billion stimulus package.
2017 view: The greatest risk currently facing the global economy today and is now rapidly unfolding. Policy makers had years, YEARS, to prevent this protectionist fervor from taking hold, but monetary policy makers repeatedly overdid it while fiscal policy makers dithered. And thus we find ourselves today with a dramatic political transformation taking place across the globe. The fallout effects on the global economy and its financial system remains to be seen.
- Global Credit - Following World War I, the United States was the main creditor to Europe. Once the flow of capital to Europe began to slow following the onset of the Great Depression, many European economies came under additional stress. Today, Asian economies including China are major creditors to the United States. If the flow of capital from China to the United States were to abate or reverse, our ability to adequately finance our own recovery efforts may come under significant strain.
2017 view: Arguably an even greater risk than protectionism. China (NYSEARCA:GXC) remains one of our two largest creditors along with Japan (NYSEARCA:EWJ). And whether U.S. investors even want to begin to recognize it or not, China's (NYSEARCA:FXI) position in this regard provides them with an influential tool that could easily rattle our stock and bond markets. Remember the so called "taper tantrum" from April to June 2013? Remember the supposed rotation out of bonds by retail and institutional following the election last November? The "taper tantrum" had little to nothing to do with the fact that Ben Bernanke started talking about scaling back QE3. And the bond sell off was taking place for months before the election. The real cause for each? Because China (NYSEARCA:ASHR) was liquidating their Treasuries to address domestic problems they were facing. Looking ahead, if either, or worse yet both, of these countries were confronted with circumstances where they either needed or wanted to liquidate, it has the potential to inflict massive pain on the U.S. financial system and place our own still fragile recovery efforts under significant strain.
So What Have We Learned?
So what have we learned from the mistakes of the past during the Great Depression? Not a whole lot apparently. Yes, the Fed opted for injecting liquidity incredibly aggressively instead of draining liquidity like they did during the Great Depression. But outside of artificially inflating the U.S. stock market and its underlying earnings beyond all recognition, this hardly warrants the "Mission Accomplished" banner as the underlying U.S. economy was largely left behind in the process.
As for the rest, we are seeing the problems that plagued the global economy in the years following the 1930 to 1932 all the way through to the late 1930s and into the 1940s increasingly manifesting themselves once again today. This includes the rapid rise in protectionism and a U.S. economy and financial system that remains unwittingly at the mercy of its global creditors whether we realize it or not.
Essentially, all that has been fixed is the stock market that has tripled in value from its lows. And whether this is truly fixed remains to be seen once the Fed finally sends the tide rushing back out after so many years assuming (and this remains a big IF) it follows through with the interest rate hikes the market is now expecting.
Everything else remains in an ongoing state of repair. And, unfortunately, this slow repair process is coming under increasing risk given the forces of the past bringing themselves to bear once again as I write this article today. For those that think these forces do not present a meaningful downside risk to capital markets in general and the U.S. stock market (NYSEARCA:DIA) in particular going forward, they are ignoring the lessons of history. These are not risks that are necessarily going to play out tomorrow - it has taken us eight years to get to this point - but they are increasingly likely to eventually lead to growing consequences for the markets at some point in the future.
In short, don't react to it all, but don't ignore it either. Because it is all likely to matter in a big way someday, potentially soon.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long selected individual stocks as part of a broadly diversified asset allocation strategy.