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Lessons from history

Nia Williams

March 1, 2009

During a recent prime minister’s questions, Gordon Brown inadvertently let slip the ‘D’ word: Depression.

His spokespeople were quick to clarify that it was an unfortunate slip of the tongue, but the damage had already been done. TV, radio and news reporters all pounced on this Freudian slip and started comparing today’s economic problems with the great depression of the 1930s.

Such comparisons make engaging news stories but are they really valid and, perhaps more importantly, do they teach us anything useful to help lessen the impact of today’s economic slowdown?

Wall Street crash

Many historians regard the Wall Street crash, which happened on ‘Black’ Tuesday the 29th October 1929, as the start of what was eventually to become The Great Depression. During the first fateful couple of days of the crash, the Dow Jones industrial average fell by 25 per cent, with the volume of stocks being traded setting a record which would not be broken for 40 years. When stock prices eventually reached their record low in July 1932, they had lost 89 per cent of their value and did not recover to their 1929 levels until 1954.

So what happened? No one really knows precisely what acted as the trigger for the sudden selling spree of stocks on the 28th and 29th of October 1929, but history has clearly identified why the bubble in the equity and commodities markets grew and then eventually burst.

Unlike most European economies, the US economy had not been hit hard by the first world war. In the early 20s the economy started to boom, as new industries such as motor manufacturing and telecommunications started to grow. In the eight years prior to 1929, the US economy grew by 40 per cent, with consumer spending growing at an average annual rate of just under 3 per cent. The unemployment rate between 1921 and 1926 fell from 12 per cent to 2 per cent and by 1929 the government budget ended in surplus. This was the era of the roaring 20s in which consumers believed the only way the economy could go was up.

Spend, spend, spend

Consumers were not afraid to spend, spend, spend. From the turn of the century to 1925 house prices rose by 70 per cent and oil prices jumped by 380 per cent in just 5 years. Sounds familiar, doesn’t it? Spurred on by the growing mood of confidence, increasing numbers of consumers decided to buy stocks and shares in order to get rich quick. Individuals were able to buy stocks ‘on margin’, which meant they borrowed the money against their other shareholdings; a potential disaster in the making.

Interest rates in the US had also been held unusually low for several years and Congress had passed a highly protectionist tariff bill which, ironically, was one of the factors which started to spook the markets. And the final ingredient in the recipe for impending disaster was a very lax regulatory regime, which allowed insider trading to run rife and dealers to artificially inflate share prices.

House of cards

When the house of cards did eventually tumble down, the effects on the US economy were devastating. The economy shrank by a third, unemployment levels reached 25 per cent (and at that time there was no state aid to help unemployed workers) and, as a result, consumer spending collapsed. Thousands of factories were forced to close due to a lack of demand, which meant more workers losing their jobs. Again, does this sound horribly familiar?

To compound problems, the banking system then collapsed. In the period from 1930 to 1932 there were repeated bank runs and thousands of banks failed and as a result, those banks which did survive were unwilling to lend. So concerned was Roosevelt about the plight of the banks, when he was voted into power in early 1933, that he ordered the banks to close for 2 weeks while Federal inspectors examined their books. Roosevelt then instigated what was to become known as the ‘new deal’ which aimed to stop the bank runs and use government spending to stimulate economic activity. Yes, more parallels with events today.

Roosevelt was, however, eager to continue balancing the nation’s books and in order to do so he raised taxes which, in 1938, had the effect of halting the green shoots of economic recovery and sending the economy back into recession. The dark days of the great depression eventually came to an end in 1939 when the government started to ramp up defence spending. As a result, US production rose by 80 per cent in just three years and what was a government surplus became a government deficit which, for the large part, is where is has remained ever since.

Parallels

The parallels between The Great Depression of the 1930s and events of today are obvious, but that does not necessarily mean we are in for similar tough times in the years ahead. Today, most governments have recognised the need to stimulate the economy and have acted fairly quickly to prevent a catastrophic collapse of the banking sector. There will be many readers who will feel that the government today has not acted quickly enough, but they have undoubtedly been more decisive than their forefathers.

It was interesting, listening to debates taking place at the recent economic summit in Davos, to hear ministers arguing about the potential dangers of introducing protectionist economic policies and the need for all countries, no matter how hard their economies are being hit, to keep their trading links open. Although it may seem prudent to some to keep government spending under tight control and to put measures in place which favour domestic manufacturers, if there is a lesson to be learnt from history, it’s that such policies don’t work.

Lessons to be learnt

It is also unreasonable to assume that the collapse in consumer spending in the 1930s will be matched by a similar decline today. Yes, we are seeing a sharp downturn in spending but it has to be remembered that back in the 1930, when someone was thrown out of work they received no support from the state and became destitute. Today, as tough as life is for the unemployed, they do get state help and do continue to spend, albeit to a lesser extent.

However, there are lessons to be learnt. The Great Depression demonstrated the way in which a run in the financial markets and collapse in confidence in the banks could have a dramatic impact on the real economy. We have seen that happening all too graphically in recent months. The Great Depression also showed that if the right economic policies are introduced by governments that the situation can be eased, but if the wrong decisions are made – as they were by Roosevelt when he raised taxes in order to balance the nations books – then the economy can take a sudden nose-dive.

Let’s hope that the leaders of the world’s largest economies have learnt the lessons from history and that the road to recovery will be shorter and less painful than it was back in the 1930s.


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