Depressing

An overleveraged, overpriced market brutally declines by about half, only to be followed by a rebound of about 50% that is almost as swift as the decline. A description of 2008 to 2010, or of 1929 to 1930? The answer is both. So what happens next? From mid-1930 to 1932 the market declined an additional 86%. Could we see a repeat of this, and the Great Depression that accompanied it?

The short answer is yes, but only if governments around the world repeat the mistakes of the 1930’s. And that would not be easy for governments to do. First of all, several of the missteps of the early 1930’s have already been avoided. With no FDIC or emergency Fed funding, millions lost their savings as over 5,000 banks closed in 1929-1932. This also resulted in a massive contraction in the money supply, contributing to deflation. There was no unemployment insurance to support the spending of millions of unemployed workers as the unemployment rate climbed to almost 25% in 1933, further driving down demand and fueling deflation. Likewise, farmers had no assistance as drought and the dust bowl ravaged the plains beginning in 1930. So in all of these ways, this time truly is different. Programs already in place (the FDIC, unemployment insurance) and actions taken since the current crisis began (emergency Fed funding, Fed securities purchases, TARP, stimulus spending) have supported both demand and the money supply and prevented (thus far) the devastating deflationary spiral that defined the Great Depression of the 1930’s.

That is not to say that we are out of the woods. Governments around the world could still take ill-advised actions that could at a minimum drive us back into a severe recession. By 1937 there had been a substantial recovery in the economy and the stock market that was driven (at least in part) by the 1930’s version of the stimulus package (the multitude of New Deal programs). But in that year a conservative coalition in Congress that decried the resulting government spending and deficits as ruinously large and threatening inflation successfully pushed through a roll-back of much of the New Deal spending in an effort to balance the budget. Sound familiar? The result was another plunge in both the markets and the economy that lasted until World War 2.

As in the United States of the late 1920’s and Japan of the early 1990’s, the U.S. today is still over-leveraged. Sooner or later all of that excess leverage has to unwind. It may happen gradually (as it did over more than a decade in Japan) or quickly and severely (as it did in the early 1930’s). At this point in our nascent economic recovery, the more governments here and abroad try to raise taxes, reduce spending and balance budgets, the more likely we are to de-lever quickly and painfully, and with some risk of a deflationary spiral like that of the 1930’s. This seems to be our present course, with the fiscal stimulus money, TARP, and the Bush tax cuts all about to come to an end (and worse yet, many pushing to cut spending even further). On the other hand, an extension of the Bush tax cuts and/or stimulus spending would help the economy, and likely give the stock market a huge boost in the short run. But even in that case we will still need to de-lever, leaving Japan’s “lost decade” (which really lasted even longer), during which banks, individuals and companies slowly paid down their debts while the economy more-or-less flat-lined, as an example of the best we can hope for.