Latribune.fr has a very interesting post about the differences and similarities between the economic situation leading up to the stock market crashes of 1929 and 1987, and the current economic environment. Since it’s written in French, I’ve taken the liberty to translate it and make it available to my readers. I’ve tweaked it a bit and sprinkled a few clarifications here and there, but as a whole it’s fairly faithful to the original. Enjoy!

From their extensive studying of stock market crashes, economists Robert Shiller and Charles Kindleberger have concluded that said crashes result from a combination of two factors: 1) investors being nervous because of a grim economic outlook and a 2) significant drop in indexes during the week before the crash. Both crashes (1929 and 1987) happened after a weekend, when investors realized the gravity of the situation after a week of high volatility. In other words, black Mondays (October 28^th 1929 and October 19^th 1987) are merely an amplified repetition of the previous week’s events like the Black Thursday (October 24^th 1929) and the 10% drop of the market between Wednesday October 14^th and Friday October 16^th 1987.

Even though comparisons between different eras are not always relevant, looking back on economic history is always an instructive exercise.

The current volatile economic climate is fueling the fear that we might plunge into another Great Depression (that fear was also prevalent in 1987). But analysts and experts refer to the singularity of each of those economic contexts to try and prove that what happened then can’t happen now, because the present is radically different from the past. It is true that the situations are anything but similar. In 1929, the economy was in deflation, money supply was tight, and the Fed wasn’t injecting billions of dollars to prevent banks’ bankruptcies, which happened at a record pace (averaging 600 a year over the 20′s decade). Today’s situation is quite different: we’re facing rising inflation, money supply is abundant, and central banks are reacting in unison to preserve the financial system.

In the 1929 crisis, the government doesn’t really intervene until 1932, when then-president Hoover introduces the Revenue Act of 1932 (increasing taxes in an attempt to balance the federal budget), followed shortly by Franklin D. Roosevelt’s New Deal. Today’s governments have reacted swiftly with, for example, the tax cuts here in the United States or the nationalization of Northern Rock bank in the United Kingdom. It has to be pointed out that the Smoot-Hawley Tariff Act was passed in 1930 in reaction to the crash, but it is considered as not only largely ineffective, but more like a knee-jerk reaction than an actual remedial policy.

However, those difference can’t (and shouldn’t) mask the numerous similarities.

Why did the great depression of 1929 occur?

High levels of debt. In 1929, Americans were borrowing money to invest in the stock market. Stock prices had risen more than fourfold from the low in 1921 to the peak in 1929. By August 1929, brokers were routinely lending small investors more than 2/3 (two thirds) of the face value of the stocks they were buying. Over $8.5 billion was out on loan, more than the entire amount of currency circulating in the U.S. The rising share prices encouraged more people to invest, assuming that share prices would rise further. By the fall of 1929, U.S. stock prices had reached levels that could not be justified by reasonable anticipations of future earnings. As a result, gradual price declines in October 1929 led investors to lose confidence and the stock market bubble burst. Today’s Americans owe 130% of their annual income, with much of that debt being tied to illiquid real estate.

Excessive securitization. This is the second similarity. In 1929 crash of the stock market, it was the call loans (bank loans to customers buying stocks, using the purchased stocks as collateral). Today, it’s the securitization of credit. Securitization is the creation and issuance of debt securities, or bonds, whose payments of principal and interest derive from cash flows generated by separate pools of assets. Financial institutions and businesses of all kinds use securitization to immediately realize the value of a cash-producing asset (like a mortgage). These are typically financial assets such as loans, but can also be trade receivables or leases. In most cases, the originator (owner) of the asset anticipates a regular stream of payments. By pooling the assets together, the payment streams can be used to support interest and principal payments on debt securities. When assets are securitized, the originator receives the payment stream as a lump sum rather than spread out over time. As a result, banks have been more risk-prone, granting loans and turning around and “selling” them. Securitization has grown from a non-existent industry in 1970 to $6.6 trillion as of the second quarter of 2003.

Easy access to credit thanks to low interest rates. Interest rates have been hovering around 3% from 1923 to 1927, and lower than 2% from 2002 to 2005 in the U.S. This has fueled a rise in speculative buying: asset prices were rising because were being bought at breakneck pace since credit was so readily available. Said rise fueled even more buying, and so on.

Other similarities

The fourth similarity is that both financial crises are coupled with (and amplified by) a crash in the real estate market, as it happened in 1925 and 2005. Finally, in both situations, the economy was buoyed by significant productivity gains. In 1929 the underlying reason for those gains was the industrial revolution, whereas today it’s outsourcing (exporting jobs overseas).

~

Will we fall into a 30’s style depression? There’s no definitive answer. Theories of economic cycles (economic booms and recessions happening alternately) suggest recessions are only natural. Today many economists believe that the combination of the social safety net and a much better understanding of macroeconomics makes another Great Depression highly unlikely. Others believe that with growing US deficits, increasing bankruptcies, the attainment of peak oil, plus other factors, the US is in the early stages of the next great depression. Only time will tell.

Stock Market Crashes of 1929 and 1987.

Technorati Tags: crash, depression, recession, stock market, stocks

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