Apparently there has been a fundamental change in criteria for judging security values. Widespread education of the public in the worth of equity securities has created a new demand.
~ The Outlook & Independent Magazine (May 15, 1929)
One of the most consistent phenomena in the world of investing is the presence of faith in the transformation of economic law after a stock market boom has been in progress for several years. Experts proclaim an advent of a new era, an era in which the old numbers and old patterns of investing have been superseded, usually by a combination of technological improvements and central bank wisdom. Investors are assured that “this time, it’s different.” This time, stocks will go up despite low dividends, interest rates will stay low despite rising government deficits, and consumers will continue to buy despite poor job prospects.
Investors who have seen their stocks rise want dearly to believe this story of a new era. Even more optimistic are employees who have seen their portfolios increase in their retirement funds. They look at the numbers, and they know that without unprecedented economic returns, they will not have sufficient capital to live comfortably on when they retire, given the low level of dividends, especially after their funds’ management expenses are deducted. They have to believe in above-average returns if they are to maintain their dreams of golden years on the golf course. Otherwise, they would have to revise their plans. They have made these plans on the assumptions that the Social Security System’s chain letter, created in 1936, is not coming to an end.
People believe what they want to believe. They resist the intrusion of evidence that points to a different, less pleasant scenario. This is always true. It will always be true.
There are always a few pessimists who look at the numbers and conclude: “This dream isn’t going to end painlessly, but it is going to end.” They are like John the Baptist, crying in the wilderness.
The worst economic crisis in American history began in October, 1929. It did not end for a decade. This is why it’s worth looking at what the experts were telling the public in 1929.
A COMMITTEE OF EXPERTS
In 1929, a committee of economists turned in a report. The committee had been assembled in 1927. As things turned out, the title of the committee was more indicative of things to come than the actual report: the Committee on Recent Economic Changes of the President’s Conference on Unemployment. The report was submitted to the President’s Conference on Unemployment in February, a few weeks before the inauguration of the newly elected President who was officially the chairman of the committee, Herbert Hoover, or as he was unofficially referred to by outgoing President Coolidge, “the wonder boy.”
The committee’s members were associated with the National Bureau of Economic Research, which had been founded in 1920 to survey the economy, gather statistics, and produce reports. The NBER over the years has become the number-one expert organization of economic boom and recession. Even today, its assessment of when a recession begins and ends is considered the final word.
In 1929, the director of the NBER’s research staff was Edwin F. Gay, professor of economic history at Harvard University. In his introduction to the two-volume report, Professor Gay hinted that the American economy had entered into a new era.
The shiftings of psychological attitude, here indicated, seem to suggest that something distinctly different from our former experience is taking place. The chief characteristics of the present economic phase, agreed upon by our numerous visitors from abroad, are, it is true, evolved logically from what has preceded, and we are still finding answers along similar lines to a similarly constructed problem. But there seem now to be differences of degree which approach differences in kind.
This no doubt sounded like great news to the newly elected President, who was about to take over from President Coolidge. But what was the basis of this new era? Technology, for one. Business ethics, for another. And this combination was creating millionaires by the score.
In this sense we may say that the unprecedented utilization of power and its wide dispersion by automobile and tractor, in which this country leads the way, is a new addition of enormous potentiality to our resources. With the general increase of wealth, the growth in the number of millionaires has been accompanied by a remarkable rise in the real wages of industrial workers, and a wide range of investments. The profession of management is clearly emerging, and there is visible an increasing professional spirit in business, which springs from and entails recognized social responsibilities.
This was all good news, especially when added to “The strength and stability of our financial structure, both governmental and commercial. . . .” (Recent Economic Changes in the United States, 1929, vol. I, p. 11)
The director of the NBER, Wesley Mitchell, concluded the two-volume study. He warned against becoming complacent. The economy was good, but not perfect.
With the significant exception of stock-market dealings and closely related processes, the latest statistics indicate that the expansion which began in January, 1928, was proceeding at a temperate pace when this report went to press in March, 1929. Of course, that is no proof that moderation will characterize the later stages of the current cycle or its successors. For we can ascribe the mildness of recent fluctuations only in part to intelligent management. Every factor which has restrained prosperity has had its share in preventing the development of an unhealthy boom, and so in guarding against a violent relapse.
Got that? There might possibly be “a violent relapse” in “the later stages of the current cycle,” but at present, any suggestion that the economy was experiencing “an unhealthy boom” was not justified by the detailed research of the committee. What would be the sign of looming problems? “If and when Europe regains its prewar level of prosperity, world prices rise, and American agriculture works out of its troubles, then our skill in controlling business cycles will be put to a severer test” (vol. 2, p. 909). That seemed a long way off. When economists gather, such unpleasant economic events are always a long way off.
The following October 24, the stock market crashed. This became known as Black Thursday. The following Tuesday, October 29, the events of the previous Thursday were dwarfed.
This came as a surprise to Professor Irving Fisher of Yale, the millionaire inventor of the Rolodex. On September 5, he had issued the following statement to the press:
There may be a recession in stock prices, but not anything in the nature of a crash. Dividend returns on stocks are moving higher. This is not due to receding prices for stocks, and will not be hastened by any anticipated crash, the possibility of which I fail to see.
The good professor understood that lots of Americans did not believe him. There was an irrational fear of stocks. These fears were unwarranted.
A few years ago people were as much afraid of common stocks as they were of a red-hot poker. In the popular mind there was a tremendous risk in common stocks. Why? Mainly because the average investor could afford to invest in only one common stock. Today he obtains wide and well managed diversification of stock holdings by purchasing shares in good investment trusts.
Investment trusts in his day were the equivalent of mutual funds today. The investor got diversification. Did he ever!
Investment TrustsSept. 5, 1929Oct. 25, 1931American International
American, British & Continental
Goldman Sachs Trading
The market went lower in 1932.
Professor Fisher lost his fortune. He did not lose his job. His theory of the quantity theory of money (MV=PT) was picked up and developed by Milton Friedman to create what today is known as monetarism.
NO PROBLEM, REALLY!
In response to that stock market crash, the experts rushed into print. Their assessments were later assembled into a little book, Oh, Yeah? (Viking Press, 1931).
John D. Rockefeller, Sr.: “Believing that fundamental conditions of the country are sound and there is nothing in the business situation to warrant the destruction of values that has taken place on the exchanges during the past week, my son and I have for some days been purchasing sound common stocks. We are continuing and will continue our purchases in substantial amounts at levels which we believe represent sound investment values.” (Oct. 30, 1929).
Henry Ford: “Things are better than they were yesterday.” (New York Evening Post, Nov. 4, 1929). “The crash was a good thing. . . . You watch” (New York Times, Oct. 3, 1930) “These really are good times but only a few know it.” (New York Times, March 15, 1931).
Roger Babson: “Sooner or later a crash is coming that will take in the leading stocks and cause a decline of from 60 to 80 points on the Dow Jones barometer.” (Sept. 5, 1929) [It dropped from 381 on Sept. 3, 1929 to 41 on July 8, 1932.] “In a big way, 1931 can be described as a year of opportunity.” (Dec. 26, 1930).
Charles M. Schwab, Chairman, Bethlehem Steel. “Never before has American business been as firmly entrenched for prosperity as it is today” (Dec. 10, 1929). [He died bankrupt in 1939.]
Robert P. Lamont, Secretary of Commerce. “As weather conditions moderate we are likely to find the country as a whole enjoying its wonted state of prosperity. Business will be back to normal in two months.” (March 3, 1930) “We have weathered the worst of the storm and signs of stability and recovery are already appearing.” (Dec. 6, 1930).
James Davis, Secretary of Labor. “The worst is over without a doubt.” (June 30, 1930). “We have hit bottom and are on the upswing.” (Sept. 12, 1930).
Herbert Hoover to the American Bankers Convention. “During the past year you have carried the credit system of the nation safely through a most difficult crisis. In this success you have demonstrated not alone the soundness of the credit system, but also the capacity of the bankers in an emergency.” (Oct. 2, 1930) [About 6,000 banks went bankrupt over the next 30 months.]
The epilogue of Oh, Yeah? ends appropriately with a quotation from former President Calvin Coolidge:
“The country is not in good condition.”
GRAMLICH, THE GRINCH
On Feb 25, Edward Gramlich, a member of the Board of Governors of the Federal Reserve System, gave a speech at the Euromoney Bond Investors Congress in London. It received little publicity in the United States. Among FED Board governors, Gramlich is the grinch.
His topic was the twin deficits: Federal and trade. He argued that they can go together, but they are not twins.
He made a major point early: a balance of payments surplus is the product of a high rate of thrift domestically.
Any saving the nation does finances either private domestic investment directly or the accumulation of claims on foreigners. This means that national saving — the sum of private and government saving — equals private domestic investment plus that period’s accumulation of claims on foreigners, or the trade surplus. The trade surplus can also be thought of as net foreign lending.
The converse is also true: any imbalance of payments is based on high rates of saving on the part of one’s trade partners.
National saving is the only way a country can have its capital and own it too. Models of the economic growth process identify national saving as one of the key policy variables in influencing a nation’s living standards in the long run.
This lack of thrift is America’s problem, as Gramlich admitted later in his presentation. But before he got there, he raised this supposedly hypothetical issue. The problem is, it describes the United States today.
Conversely, suppose that expansionary fiscal policy resulted in a rise in budget deficits. If this expansion were totally financed by borrowing from foreigners, domestic interest rates would not change much, and domestic investment and private saving might not either. In this scenario, there could be a simultaneous dollar-per-dollar change in budget and trade deficits — the classic twin-deficit scenario. Such a situation is most likely to occur in small economies fully open to international trade and capital flows, economies in which domestic interest rates are determined by world capital markets and are independent of domestic economic variables.
What we are seeing today is the world’s largest economy, which is performing exactly as he describes here. The reason is, the dollar is the world’s reserve currency and Americans are the world’s most voracious consumers. Asian central banks are cranking out fiat money by the digital carloads in order to keep the dollar from falling. They are afraid that a falling dollar will mean reduced imports by Americans — a safe bet.
We are now coming into uncharted waters. The debt/GDP ratio is soaring in the U.S.
Historically, there have not been significant instabilities in U.S. federal budget deficits. Overall deficits have averaged about 2 percent of GDP over the past four decades, but figure 1 shows that when interest is deducted, primary budget deficits have averaged close to zero, the approximate level that stabilizes the debt-to-GDP ratio. Hence, the outstanding debt, while fluctuating in the range of 25 percent to 50 percent of GDP, has actually declined slightly as a share of GDP. It was 38 percent of GDP in the mid-1960s and is now only 37 percent of GDP. The ratio did rise as high as 50 percent in the high-deficit years of the early 1990s, but it dropped sharply thereafter with the primary budget surpluses of the late 1990s.
The estimated Federal deficit for fiscal 2004 of $520 billion is in the range of 5% of GDP — over twice what he says is normal. Gramlich did hold back. He did not cite the $520 billion deficit for this fiscal year, which would reveal a large upward move in the debt/GDP ratio.
As a result of recent fiscal changes, the budget has lately fallen into primary deficit again; this primary deficit is now more than 2 percent of GDP (1.5 percent after cyclical adjustment). The deterioration reflects the much-discussed recent rapid growth in expenditures, along with significant tax cuts. Perhaps more significant, in a few years the United States will face huge looming costs for retirement and health programs. It will take extraordinary fiscal discipline just to keep the present primary deficit near its current level of 1 to 2 percent of GDP over the short, medium, and long run. And even at that level, the stability condition is violated by at least 1 percent of GDP, suggesting that the debt-to-GDP ratio is likely to climb steadily upward.
On the trade side, figure 2 shows that the trend is definitely more worrisome. While the budget debt has fluctuated between 25 percent and 50 percent of GDP over the past several decades, the net external debt has grown steadily. Until 1985, this external debt was not even positive; that is, until that time the United States had net claims on foreigners. But because the United States has run persistent and sizable primary trade deficits since 1990, the net external debt is now 25 percent of GDP and rising sharply. The primary trade deficit is now 5 percent of GDP, violating the stability condition by nearly this same amount. At this rate, the external debt ratio will climb very quickly.
Look at figure 2; it’s a chiller. Ever since 1988, net external debt has moved relentlessly upward, from 0% to 25% of GDP.
Gramlich points to the looming day of reckoning, when “the economy gets outside of the credibility range.”
With each deficit there is probably a credibility range. By that, I mean a limited range within which a country may be able to violate its stability condition and have its debt-to-GDP ratio trend upward without further economic consequences. . . .
Once the economy gets outside of the credibility range, more significant relative price adjustments become likely. On the trade side, for example, the continued accumulation of foreign claims on the U.S. economy will raise the issue of whether foreign investors will want to hold an ever-increasing share of their wealth in the form of U.S. assets. Or, as is the focus of the stability condition above, whether the U.S. economy can indefinitely pay out ever-higher shares of GDP in the form of interest and dividend payments. The conventional view is that at some point there should be a relative price adjustment — some combination of rising U.S. interest rates (to make U.S. assets more attractive), rising foreign prices (to make imports more expensive), moderating U.S. prices (to make U.S. exports more competitive), or a change in exchange rates. Each of these reactions is likely to occur naturally, and each moves in the direction of lowering the external imbalance. That is why foreign trade deficits are typically thought of as self-correcting. The main risk here is that the natural adjustments may not occur gradually, but so rapidly as to threaten various types of dislocations.
Here are the ways out, he says: (1) productivity growth (which requires more saving); (2) fiscal austerity on the part of politicians.
As mentioned above, such a fiscal austerity policy is the only known way to correct persistent budget deficits. The reduction in deficits should lower domestic interest rates and trigger changes in exchange rates that lower imports and raise exports. Hence, well-designed fiscal austerity measures could solve all the problems simultaneously. They correct budget deficits directly, they reduce trade deficits indirectly, and the implied higher level of national saving also permits more funds to flow into capital formation and long-term productivity enhancements. Fiscal austerity is the one tried and true approach to dealing with budget and trade deficits simultaneously.
What is the likelihood of belt-tightening by Congress? The odds are surely against it. So, here is how Gramlich ended his speech. Note the phrase, “dislocating changes.” This is true grinchism.
There are forces tending to increase both deficits: political and demographic for budget deficits, income elasticities for trade deficits. At some point, continued large-scale trade deficits could trigger equilibrating, and possibly dislocating, changes in prices, interest rates, and exchange rates. Continued budget deficits will steadily detract from the growth of the U.S. capital stock and may also trigger dislocating changes.
I suggest that you pay attention to Gramlich’s speech. It’s a bit technical, even in my extracted version. He was sounding the alarm in the international investment community. He was saying, as loud as any senior official has said it, that the twin deficits cannot go on.
To quote Herb Stein, Nixon’s chairman of the Council of Economic Advisors, things that cannot go on have a tendency to stop.
“The main risk here is that the natural adjustments may not occur gradually, but so rapidly as to threaten various types of dislocations.”
March 3, 2004
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