What The 1920s Tell Us About Unintended Consequences

by: Cashflow Capitalist

There are always economic trade-offs and unintended effects of fiscal and monetary policy.

The Fed's accommodative interest rate policy of the 1920s spurred speculative excesses and induced consumers to live well beyond their means.

Will we heed the lessons of the past?

Everyone learns Newton's Third Law in high school physics: "For every action, there is an equal and opposite reaction." It's an elegantly simple statute of the universe, and we see it play out in life all the time, whether we realize it or not.

When it comes to fiscal and monetary policy, a similar axiom holds true: "There are always economic trade-offs." No policy produces only one result. There will be unintended consequences along with the intended. Even if the intended consequence is attained, it must be weighed against the unintended consequences.

This has been one of my primary takeaways from comparing the 1920s to the 2010s, two decades separated by almost a century and yet similar in many respects. A previous article examined seven of these respects, though others could have been included.

It might have been a question in some readers' minds as to why I'm pointing out these similarities. It may be obvious, but I never spelled it out. The reason, of course, is that the 1920s preceded a devastating stock market crash and subsequently the Great Depression. If our own decade is in the process of "rhyming" with the Roaring Twenties in this respect, whether the results are milder or even more devastating, investors ought to be aware of it and prepare accordingly.

Let me summarize my thesis, and, in the process, tie in the axiom that there are always economic trade-offs. My own feeble rendition would not be adequate, however, so let me borrow the explanatory powers of (1) Nathan Lewis of New World Economics along with (2) Barry Eichengreen and Kris Mitchener, writing for the Bank of International Settlements in 2003 paper titled, "The Great Depression as a credit boom gone wrong."

First, Mr. Lewis:

The Fed was intended to be dormant most of the time, springing into action only during the occasional 1907-style liquidity shortage crisis, when the rate on [market] overnight loans rose to unusually high levels, typically above 10%. However, during WWI, the Fed had already been pressured into acting on a daily basis by the Treasury, to cap interest rates and thus allow the Federal government to issue debt to fund the war at attractive levels. This resulted in excessive Fed money creation and a deviation of the dollar’s value from its gold parity. . . .

This is referring to the years during and immediately after WWI. As discussed in my previous article, the Fed recognized that their accommodative policy and the government's deficit spending had produced a nasty inflation that needed to be subdued. Their mechanism of achieving this was higher interest rates, pushing the discount rate from 4.5% to 7%. This accomplished the intended effect of mopping up inflation, but it also produced the unintended effect of high unemployment and a wrenching bout of deflation.

In 1921, at the urging of newly minted Treasury secretary Andrew Mellon (and, interestingly, against the opinion of NY Fed Governor Benjamin Strong), interest rates were eased back down, settling around 4% by mid-1922. (See James Grant's The Forgotten Depression, p. 143.)

Here is where Eichengreen and Mitchener come in:

For a combination of domestic and international reasons [such as helping Great Britain return to the gold standard in 1924-25], the Fed maintained a relatively accommodating stance for much of the 1920s. With inflation stabilization, other countries found themselves on the receiving end of capital inflows. Financial innovation magnified the impact of these accommodating credit conditions, and central banks did little to preempt their effects. The consequences . . . included property booms, increasing consumer debt, surging investment and rising securities prices, particularly those of high-tech firms. They included growing worries about the stability of financial institutions and markets. They culminated in the collapse of financial markets and institutions and the gravest macroeconomic crisis the modern world has ever seen. [p. 52]

But wait. How exactly did these conditions culminate in the stock market crash and a macroeconomic crisis? Well, at some point in the second half of the decade,

the Fed and other central banks grew increasingly restive over what they perceived as speculative excesses in financial markets and with a growing incidence of malfeasance and graft. . . . This concern with the effects of asset-price inflation on the economy led them finally to tighten. Banks passed along the higher cost of additional reserves to their borrowers, and, in the U.S. case, they further felt direct pressure to limit their lending to securities market participants. By this time, positions — stock market positions in particular — were highly leveraged; as a result, borrowers experienced severe financial strain when credit tightened, leading them to compress their spending, and consumption and investment turned down. Ultimately, the resulting deflation became sufficiently severe to threaten the stability of the financial system and the economy more generally. [p. 3-4]

One unnamed essayist described the debt cycle breakdown thusly:

The market crashes undermined . . . confidence. The rich stopped spending on luxury items, and slowed investments. The middle-class and poor stopped buying things with installment credit for fear of losing their jobs, and not being able to pay the interest. As a result, industrial production fell by more than 9% between the market crashes in October and December 1929. As a result, jobs were lost, and soon people started defaulting on their interest payments. Radios and cars bought with installment credit had to be returned. All of a sudden, warehouses were piling up with inventory. The thriving industries that had been connected with the automobile and radio industries started falling apart.

For too long, interest rates had not been determined by supply and demand. Rather, artificially high supply via the Fed's accommodative monetary policy had stimulated an artificially high demand for debt. The Fed's action had spurred a corollary reaction in the markets. Easy money policies instituted to finance an expensive overseas war and later help our English-speaking friends across the pond get back onto the gold standard had produced unintended effects.

Could the above scenario happen in the twilight years of our own decade? Sure it could. The S&P 500 (SPY) is currently trading at roughly the same cyclically adjusted price to earnings ratio as it was at the stock market peak of 1929. And as I've demonstrated in these other articles, many other conditions in place today are similar to those of the 1920s, including asset inflation, wealth inequality, consumer credit, and artificially low interest rates.

A stock market crash followed by many painful years is far from certain. But it isn't terribly far-fetched either.

Then again, any potential crash would be sure to play out differently than in 1929-30. With a lower-for-longer interest rate scenario seemingly unfolding before our very eyes, it doesn't seem as if rising rates will seize up credit markets and prick the bubble as in the past. But if not, then what is the way forward for heavily indebted governments, business sectors, and consumers? What will prompt deleveraging and a lasting change in spending behaviors? I have yet to hear a satisfactory answer from central bank apologists.

In any case, there are always economic trade-offs. There will be unintended consequences of artificially low interest rates in the 2010s, even if they aren't exactly the same as those endured in the 1930s. It would be pollyannaish to assume all the unintended consequences will be benign.

Perhaps, now that the Fed and other central banks are near the end of their rope, we will be granted a historically rare opportunity to weigh both the intended and unintended effects of their policy decisions.

One can certainly hope.

In the economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects. Of these effects, the first only is immediate; it manifests itself simultaneously with its cause — it is seen. The others unfold in succession — they are not seen; it is well for us if they are foreseen.

—Frederic Bastiat, "That Which is Seen, and That Which Is Not Seen," 1850

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.