What caused the 1929 crash? (The 1930 slump, pt. 1 of 4)
I don’t really know what caused the crash, but I think I have as good an explanation as anyone. For those who don’t know, I am taking a two month break from blogging in order to finish revising my manuscript. During that time I will post material from chapters 4, 5, and 6. Today I have the first 9 pages from chapter 4, and I will do 3 more posts from that chapter over the next week or two. Chapter 4 covers the first year of the Depression.
Believe me, I’d rather be blogging. Just yesterday I saw the following two stories juxtaposed:
1. Stocks fall and the dollar rises on Bernanke warnings
2. Obama pushes new jobs bill
Policy coordination just doesn’t get any more uncoordinated than that. But I held back.
The following excerpt does not include graphs, as I haven’t figured out how to post graphs from my Word files. But you’ll get the general idea. The next post will provide a narrative of how the stock market responded to policy news in 1928-29. The third post will look at the events of 1930, and the last one will provide my take on the first year of the Depression. In subsequent weeks we will look at chapters that cover 1931 and 1932; much more interesting years than 1929-30. Don’t worry if you don’t find my arguments totally convincing–I don’t either. Consider these ideas to be seeds that will bear fruit in later chapters. And I don’t think we’ll ever fully understand the stock crash, my goal is to partly understand it. (Footnotes are handled oddly, you’ll need to get used to it.)
Chapter 4: From the Wall Street Crash to the First Banking Panic
“Partly, no doubt, the stock market crash was a symptom of the underlying forces making for a severe contraction in economic activity. But partly also, its occurrence must have helped to deepen the contraction.“ (Friedman and Schwartz, 1963, p. 306.)
In mid-1929 the macroeconomic performance of the U.S. economy seemed close to ideal. There was strong growth in output, stable prices, low unemployment, a federal budget surplus, a trade surplus, and a booming stock market.[1] Then after September 1929, both prices and output began a precipitous decline that would continue for nearly 3 years. There is now widespread agreement that the 1929-32 contraction was caused by a decline in aggregate demand, which may have been triggered by tight money or by an autonomous drop in private spending. But no one has yet explained why demand fell so sharply in the year after the crash.
Over the next 9 chapters we will be looking at the response of financial markets, and especially the U.S. stock market, to economic policy-related news. An obvious place to begin this narrative is with famous stock market crash of 1929, which might have been linked to the subsequent Depression in one of two ways. Most historical accounts have assumed that the crash helped trigger the Depression. Alternatively, the stock market crash could have been caused by (expectations of) an oncoming Depression. This is the interpretation most compatible with the efficient markets hypothesis.
It will be useful to begin by briefly comparing the 1929 crash with a strikingly similar decline that occurred in 1987. In 1929, the Dow peaked in early September, fell at an increasing rate during late September and early October, and finally plunged 23 percent on October 28 and 29. The total eight-week decline was 39.7 percent. In 1987, the Dow peaked in late August, fell at an increasing rate during September and early October, and then plunged 22.6 percent[2] on
[1] Of course it is natural to compare the U.S. economy of the late 1920s with the late 1990s, which featured many of the same characteristics. But even with that comparison the 1920s would probably come out ahead. In retrospect, it is obvious that in the late 1990s there was over-investment in IT and telecommunications, even assuming there had been no recession in 2001. Although over-investment may have occurred in the 1920s as well, it is not at all obvious that booming industries such as automobiles would have been overextended had the U.S. economy continued to grow at a healthy rate during the early 1930s.
[2] This was by far the largest single day decline in U.S. stock market history.
October 19th. The total eight-week decline was 36.1 percent. And both occurred after the U.S. economy had experienced a sustained period of economic growth under conservative Republican tax-cutting administrations. One difference is that further sharp declines occurred over the weeks following ‘Black Tuesday’ and thus the total market decline in 1929 was nearly 48 percent. The more important differences, however, relate to macroeconomic events that occurred after each crash.
The 1987 stock market crash was followed by three more years of strong economic growth and healthy corporate profits. Because of the lack of obvious ‘news’ surrounding the 1987 crash it was widely viewed as an example of investor irrationality, an interpretation that is incompatible with efficient markets theory. Popular historical accounts also tend to portray the 1929 crash as an episode in mass hysteria, which is odd given that the 1929 crash was followed by the most severe depression in U.S. history. The 1929 crash might just as well be viewed as a striking confirmation of the extraordinary sophistication of market expectations””as investors were able to perceive the onset of a depression, even as many so-called experts remained optimistic about the economy. Before considering evidence for this hypothesis we need to take a closer look at the relationship between the stock market and the business cycle.
Schwert (1990, p. 1237) showed that between 1889 and 1988 “future [industrial] production growth rates explain a large fraction of the variation in stock returns.” Dwyer and Robotti (2004, p. 11) observed that the “stock market does not necessarily decline before a recession, but the onset of a recession is invariably associated with a substantial decline in stock prices.” And McQueen and Roley (1993, p. 705) noted that “news of higher-than-expected real activity when the economy is already strong results in lower stock prices, whereas the same surprise in a weak economy is associated with higher stock prices,” a result of particular relevance to this study. In the following narrative I will show that during the Depression stock prices responded positively to news of policy initiatives that were expected to boost output, and vice versa.
It seems unlikely that the stock market crash and the Great Depression were entirely unrelated. But is it plausible that the 1929 crash could have been triggered by policy-related news? The crash might have merely been a reaction to signs that the economy was slowing in the autumn of 1929; industrial production had already peaked in late summer. Yet why would a relatively modest decline in production over a period of just a few weeks reduce equity values by 48 percent? On the other hand if bad policy was the cause, then what were those policies?
If the Depression did cause the stock market crash then the very scale of the crash suggests that any plausible explanation must involve a forward-looking mechanism whereby investors foresaw at least a part of the economic calamity to come. Did the stock market receive such bearish information in October 1929? It is unlikely that we will ever find an answer that is completely consistent with the efficient market hypothesis. But if the scale of the 1929 crash is destined to remain something of a mystery, we will at least find some tantalizing hints that can be developed much further in subsequent chapters.
This chapter focuses on two key questions: Did an increase in the world gold reserve ratio begin reducing aggregate demand in late 1929? And if so, did it also contribute to the 1929 stock market crash? Before applying the gold market approach to the onset of the Depression, however, it will be useful to first review some previous studies of the 1929 crash.
4.a Previous Explanations of the 1929 Stock Market Crash
The monetarist view of the Depression generally begins with the Fed’s move toward a tighter monetary policy in mid-1928, a policy switch that also shows up clearly in the U.S. gold reserve ratio, but not in the world gold reserve ratio.[1] Despite the quotation that opens this chapter, in Friedman and Schwartz’s account “the underlying forces” behind the October 1929 stock market crash are never really explained. Instead, they basically treat the crash as an aggravating factor that depressed velocity. The problem is that the monetarists’ “long and variable lags” might explain why the Depression began more then a year after the Fed adopted a tight money policy, but it cannot account for the strong performance of U.S. equity markets during the intervening period. Although monetarists tend to believe in market efficiency, their policy narratives often overlook market responses to monetary policy actions, or even imply highly irrational behavior by investors. Nor are they alone in this regard.
In the Austrian view, inflationary monetary policies during the 1920s led to an unsustainable investment boom. Both the stock market crash and the ensuing Depression were a consequence of those policy errors.[2] The assumption of market inefficiency is even more central to the Austrian view; as rational investors presumably would not have bid prices up to such lofty levels in mid-1929 if they understood that Fed policy would inevitably produce a bust. And whereas monetarists can at least point to the fact that monetary tightening has often been followed by economic downturns, the Austrian view is hard to reconcile with post-war U.S. monetary policy. Several post-war decades saw far more inflationary booms than the 1920s, and stock market booms of a nearly comparable magnitude. Yet none were followed by major depressions. Thus modern Austrians often distinguish between the initial shock, and what’s called a “secondary depression.”
[1] Friedman and Schwartz focus more on the forces that worsened the slump after the onset of the banking panics, but Schwartz (1981) clearly attributes the initial downturn to a tight money policy adopted in 1928.
[2]See Rothbard (1963) and Palyi (1972.)
As with the monetarists, Keynesians viewed the 1929 crash as both an exogenous event and a causal factor in the ensuing contraction. Indeed, because the initial stages of the Depression are difficult to explain within an IS-LM framework, the importance of the crash is typically even greater than in monetarist accounts of the Depression. And Keynesians are even more likely to view the spectacular 1928-29 bull market as a “bubble”, the bursting of which depressed aggregate demand. For instance, Romer (1990) argued that 1929 stock market crash sharply reduced consumer confidence, and that this was a major factor depressing aggregate demand.[1] But the quite similar stock market crash in 1987 seemed to have no impact at all on economic growth, suggesting that the impact of stock prices on real output is almost certainly very small.[2] If Friedman and Schwartz had written their Monetary History 25 years later, they probably wouldn’t have even mentioned the crash as a causal factor.
Romer suggested that the 1929 crash may have had a greater impact on consumer confidence than the 1987 crash because the earlier crash was followed by a higher level of stock market instability, but this hypothesis has two serious flaws. First, the fact that the stock market was modestly more unstable in 1930 than 1988 could explain a small difference in economic growth, but it can hardly explain the difference between a severe recession in 1930, and an economic boom in 1988. And even worse, the extra market volatility didn’t begin until mid-April 1930, by which time the economy was already deep in recession. Indeed, the Dow actually performed much better in the six months after the 1929 crash than during the six months following the 1987 crash. Of course the striking lack of impact from the 1987 crash might be an anomaly. But several recent studies looking at both time series and cross sectional data, found little or no evidence of a significant wealth effect from changes in stock prices.[3]
[1]Temin (1976) also argued that the first year of the Depression could be explained by an autonomous drop in consumption, but was uncertain as to what caused consumption to fall.
[2] It might be argued that the Fed eased policy much more aggressively after the 1987 crash, and that otherwise that crash would also have been followed by a depression. Even if one accepts this argument (and recall that the Fed also cut rates after the 1929 crash) it seems more of an argument for the importance of monetary policy as a determinant of business cycles, rather than stock prices.
[3]Case, Quigley and Shiller (2005, p. 26) find “at best weak evidence of a stock market wealth effect.” Dwyer and Robotti (2004) also find little evidence of a “wealth effect”. And note that measured correlations probably overstate the impact of stocks on consumption, as both variables will, at least to some extent, respond to (unobservable) changes in expectations of future economic conditions.
In fairness, even most Keynesians don’t see the crash as “the cause” of the Great Depression, but rather as simply one of many unfortunate events that contributed to the disaster.[1]
What evidence do we have that stocks were overpriced in the late 1920s? Some finance models suggest that stocks were grossly undervalued throughout most of the 20th century.[2] If the investment community expected economic growth to continue right on into the 1930s, then would investor expectations really have been so irrational? Perhaps, economists are split on this issue.[3] But Field (2003) showed that the 1930s were “the most technologically progressive decade of the twentieth century”, so there really were a lot of new developments for investors to get excited about. Before we throw up our hands and accept the “bubble” explanation, we should first see whether there is an alternative explanation that allows for sensible investors to have been highly optimistic in September 1929 and much more pessimistic in November 1929.
4.b Gold Market Indicators at the Onset of the Depression
It is not surprising that many observers would blame the stock market crash for the sharp decline in aggregate demand after October 1929; there were no other obvious culprits. For instance, there was no dramatic break in the growth rate of U.S. monetary aggregates in the year following the crash. But as we saw in the previous chapter, domestic monetary aggregates may not be a reliable indicator of monetary policy under an international gold standard. Rather it is the world gold reserve ratio that is the theoretically appropriate indicator of policy.
To see whether the gold market approach can help us understand the collapse in aggregate demand after September 1929, it will be helpful to take a closer look at the data in table 3.4 (at bottom of post.) If we focus on the gold reserve ratio, there are two statistics that really stand out. The first was the French gold reserve ratio, which between December 1926[4] and December 1932 increased by enough to reduce the entire world price level by 17.3 percent! And as noted earlier, there was a 9.6 percent increase in the world gold reserve ratio during the 12 months after October 1929 stock crash. If the gold reserve ratio is a useful policy indicator, then we ought to be able to see links between changes in the ratio and policy actions by major central banks.
[1]Temin (1989, p. 44) argues that the crash was not a major independent shock, and also cites the 1987 crash.
[2] During the 20th century, long term rates of return on U.S. stocks have been much higher than on risk-free Treasury securities. The undervaluation hypothesis is based on the view that this differential is much too large to be explained by any plausible risk premium on equity investments
[3]During the Great Depression Irving Fisher was widely ridiculed for having called the stock market undervalued in October 1929. And studies by DeLong and Shleifer (1991) and Rappoport and White (1993) provide indirect evidence of bubble-like behavior. But McGrattan and Prescott (2004) suggest that “Irving Fisher was right” about stocks being undervalued in 1929 if one accounts for the value of intangible corporate assets.
[4] Although the French franc was fixed to gold in December 1926, France did not officially return to the gold standard until June 1928.
The data certainly supports studies by Johnson and Eichengreen that showed the deflationary impact of French policy.[1] Eichengreen (1986) cites France’s Monetary Law, which prohibited purchases of foreign exchange, as an important constraint on the Bank of France. This law mandated 100 percent gold backing for any increase in the currency stock. Contemporaneous observers noted that almost all of the increased circulation was occurring in the larger denomination notes, and attributed this increase to widespread currency hoarding by French peasants.[2] But the French gold reserve ratio increased at a fairly steady rate, at least until uncertainty surrounding the devaluation of the British pound in September 1931 led France to sharply accelerate the rate at which it was replacing foreign exchange reserves with gold. Thus although French policy may well have contributed to the worldwide deflation that occurred between 1926 and 1932, it doesn’t tell us anything about why the U.S. price level was stable in the late 1920s, and then suddenly began a sharp decline after October 1929.
Table 4.1 is identical to 3.1, except that the percentage changes for each sub-period have been annualized to make it easier to identify policy changes. If we look at the worldgold reserve ratio, we can see that what had been a mildly contractionary policy between 1926 and 1929 (with a world gold reserve ratio rising at roughly 2.5% per annum) turn sharply contractionary after October 1929.
This policy shift is particularly interesting when contrasted with Friedman and Schwartz’s data on U.S. monetary aggregates. They had difficulty identifying any significant policy shift in the fall of 1929, but found strong evidence of a highly contractionary U.S. policy after banking panics began in late 1930. If the gold market approach is to provide a superior explanation for the onset of the Depression, and by implication, the stock market crash, it will almost certainly involve the sharp increase in the world gold reserve ratio during 1929-30. Any gold-based explanation must be able to explain why this policy shock occurred in late 1929.
[1]By 1932 France held almost twice as large a proportion of the world’s monetary gold stock as during 1914. This led Nurske (1944), Hawtrey (1948), and Cassel (1936) to assert that French policies resulted in a “maldistribution” of gold stocks which contributed to the 1929-32 deflation.
[2] See the Commercial and Financial Chronicle (May 3, 1930, p. 3089).
TABLE 4.1. The impact of changes in the world gold-reserve ratio, real demand for currency, real demand for gold, and monetary gold stock, on the world price level, 1926-1932.
Time period
Dec 1926 Jun 1928 Oct 1929 Oct 1930 Aug 1931 Dec 1926
To to to to to to
Jun 1928 Oct 1929 Oct 1930 Aug 1931 Dec 1932 Dec 1932
D(ln 1/r) -2.65 -2.38 -9.62 +1.86 -4.35 -3.64
D(ln 1/md) -2.70 -2.21 -4.97 -19.42 -10.17 -6.80
D(ln 1/g) -5.35 -4.59 -14.59 -17.56 -14.52 -10.44
D(ln G) +3.88 +4.06 +5.25 +4.72 +3.88 +4.27
D(ln P) -1.47 -0.53 -9.34 -12.84 -10.64 -6.18
D(ln 1/r) = change in the log of (the inverse of) the gold reserve ratio
D(ln 1/md) = change in the log of (the inverse of) real money demand
D(ln g) = change in the log of (the inverse of) the real demand for monetary gold
D(ln G) = change in the log of the world monetary gold stock
D(ln P) = change in the log of the world price level
(The percentage changes now represent annualized first differences of logs.)
________________________________________________________________
Notes: Outside the U.S., the currency stock was used as a proxy for the monetary base. The change in the real demand for monetary gold is equal to the sum of the changes in the gold reserve ratio and the real demand for currency. The change in P reflects changes in the monetary gold stock and the (inverse of the) real demand for monetary gold. The changes are not seasonally adjusted.
Although French policy was undoubtedly important throughout the entire period of 1926-32, if one looks at smaller time periods then shifts in U.S. and British policies take on greater significance.[1] Table 3.4 shows that between December 1926 and June 1928 expansionary monetary policy in the U.S. helped offset the contractionary effects of French policy. Note that the terms ‘expansionary’ and ‘contractionary’ refer to the gold reserve ratio, not the (endogenous) money supply. The U.S. currency stock actually declined slightly over this period. The expansionary policy reflected the (activist) views of New York Fed Governor Benjamin Strong, who was supporting his friend Norman Montegu Montagu Norman at the Bank of England during this period. Because England had returned to gold at the pre-war parity, which overvalued its currency, whereas France had sharply depreciated its currency, England had the more difficult time in readjusting to the gold standard.[2] Strong’s decision to adopt an expansionary policy during 1927 allowed Britain to attract gold without being forced to adopt deflationary policies.
Governor Strong’s policy was criticized at the time for being highly “inflationary.” This characterization may seem puzzling given that the U.S. currency stock, and price level, actually declined during this period. Yet the decrease in the gold reserve ratio confirms the expansionary nature of the policy. By mid-1928 the U.S. had exported almost $500 million in gold and there was a growing perception of excessive speculation in the stock market. During mid-1928 the Fed switched to a contractionary policy aimed at restraining Wall Street’s “irrational exuberance”.
This shift in U.S. policy was partially offset by a move towards a more expansionary policy in England. After the death of Governor Strong, the Bank of England was the only major central bank that saw the need for international cooperation to maintain price stability. However England’s resources were severely limited. Between July 1928 and October 1929, their monetary gold stock fell by nearly a fourth. By the summer of 1929 England’s gold stock had fallen below the £150 million level recommended in the Cunliffe Committee report and thus, on September 26th the Bank of England was forced to raise its discount rate. By late October the pound had risen to the gold import point and England’s gold reserve ratio began to increase rapidly.
[1] Of course the concept of causation is difficult to define when the actions of several countries are independently affecting the world price level. For instance, if policies in England, France, and the U.S. each tend to reduce the world price level by 2 percent, and if the monetary gold stock rises by 4 percent, then the price level will decrease 2 percent. In this case each of the three countries independently, or all three jointly, could be said to have ’caused’ the 2 percent deflation.
[2]The fact that the French franc was undervalued does not explain the huge inflows of gold into France. Hawtrey noted that France’s creditor position and favorable balance of payments could only affect her demand for gold by affecting the demand for currency notes. Instead, the undervaluation of the franc explains why in returning to the gold standard France did not have to deflate its price level by as much as England.
In retrospect, the period from October 1929 to October 1930 was decisive. U.S. monetary policy became even more restrictive than during the previous 16 months. Well into 1930 many Fed officials continued to emphasize the need to liquidate the excessive debts accumulated during the previous boom. Proposals that monetary policy be eased were rejected on the grounds that such a policy would simply repeat the mistakes that resulted in the crash.[1] At the same time France continued to increase the gold backing of its currency. The simultaneous adoption of tight money policies in the U.S., France and Britain made worldwide deflation almost inevitable. The world gold reserve ratio, which had increased at an annual rate of 2.53 percent from December 1926 to October 1929, soared by 9.62 over the next 12 months. Despite a slight acceleration in the growth rate of the monetary gold stock, the price level fell almost as sharply.
The sudden upward surge in the world gold reserve ratio after October 1929 calls into to question the Keynesian view that monetary policy is unable to explain the first year of the Depression. Even previous researchers who focused on the contractionary role of the gold standard, such as Temin and Eichengreen, were not able to find the sort of dramatic shift in world monetary policy that could have plausibly caused both stocks and output to fall sharply in the fall of 1929. The next step is to see what specific policy actions might have contributed to the increase in central bank gold reserve ratios, and how markets reacted to those policy shifts. As we do so, we need to continually think about investor perceptions of monetary policy from a “what did they know, and when did they know it” perspective.
[1] See Nelson (1991.)
TABLE 3.4. The impact of changes in the gold-reserve ratio, the real demand for currency, the real demand for gold, and the total monetary gold stock, on the world price level, 1926-1932.
Time Dec 1926 Jun 1928 Oct 1929 Oct 1930 Aug 1931 Dec 1926
Period to to to to to to
Jun 1928 Oct 1929 Oct 1930 Aug 1931 Dec 1932 Dec 1932
U.S. 1. r +1.24 -2.59 -4.69 +1.55 +9.46 +5.15
2. m +1.55 -0.58 -0.46 -9.85 -9.66 -19.01
3. g +2.79 -3.17 -5.15 -8.30 -0.20 -13.86
England
4. r -1.07 +1.52 -1.38 +1.05 -1.37* -1.19
5. m -0.13 +0.30 -0.55 -0.59 +1.19 +0.29
6. g -1.20 +1.82 -1.93 +0.46 -0.18 -0.90
France
7. r -3.23 -2.73 -2.49 -1.80 -6.53 -17.27
8. m -1.47 -1.68 -3.08 -3.02 -5.17 -13.99
9. g -4.70 -4.41 -5.57 -4.82 -11.70 -31.26
ROW
10. r -0.92 +0.62 -1.06 +0.75 -7.36 -8.55
11. m -4.01 -0.98 -0.89 -2.73 +0.08 -8.09
12. g -4.93 -0.36 -1.95 -1.98 -7.28 -16.64
World
13. r -3.98 -3.18 -9.62 +1.55 -5.80 -21.86
14. m -4.05 -2.94 -4.97 -16.18 -13.56 -40.80
15. g -8.03 -6.12 -14.59 -14.63 -19.36 -62.66
16. G +5.82 +5.42 +5.25 +3.93 +5.18 +25.61
17. P -2.21 -0.70 -9.34 -10.70 -14.18 -37.06
r = direct impact of changes in gold-reserve ratio on price level
m = direct impact of changes in real currency demand on price level
g = direct impact of changes in real demand for gold on price level
G = change in the total world monetary gold stock
P = change in the world price level
_______________________________________________________________________________
Note: All numbers represent the first difference in the log of P (times 100); the numbers are not annualized. The sum of the impact of changes in r and m, should equal the impact of changes in g. For the world as a whole, the change in P reflects changes in G and g. For more information on rest of world (ROW), see appendix.
*The decomposition of the British demand for gold has little significance after Britain left the gold standard in September 1931.
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11. February 2010 at 21:44
That is certainly a strong international story. (And there is a lot of fun to be had in blaming the French.) Since Australia was a highly indebted primary products exporter with its pound pegged to the British pound with significant institutionalised inflexibility, I can see how we would have such a big downturn.
I would just like to recommend Tooze’s Wages of Destruction again, since he discusses the period you are discussing here in some detail.
11. February 2010 at 23:54
Ugh. Do you have to mention the Austrians? Scott, I think you need to face facts: you’re not an expert on the Austrians. You haven’t even read most of the primary sources thereof. I think you’d better to leave well enough alone.
1) Mises uses the term inflation, not to refer to the price-level, but to the expansion of bank-credit.
2) Mises is concerned about the market-rate relative to a sociological natural-rate.
3) #1, #2 combine in a transmission mechanism that has bankers shifting the credit supply (#1) such that the market-rate falls below the natural-rate (#2)
4) The Austrian view does not contradict EMH. Again, Mises is clear on this point even in the TOMC, he talks about ambiguity in the causes of the expansion of bank-credit. I.e., market participants are not certain whether the expansion is ‘natural’ or ‘artificial’, and furthermore that the normal mechanism of ‘market-calculation’–prices is precisely what is incapable of discerning the difference between these two events. For circularity reasons, its not clear that the bankers can even be sure themselves. Regardless, the market would eventual drop once the truth becomes clear, e.g., when rising inflation causes a yield-curve inversion or a run on convertibility.
5) “Thus modern Austrians often distinguish between the initial shock, and what’s called a “secondary depression.” I think the history there is really wrong. That idea has been around for nearly 100 years.
12. February 2010 at 05:02
Scott,
I love you and appreciate your work, but what I’m going to write here is not going to be very kind. Please take it in good spirits; I’m only doing it so you don’t embarrass yourself by writing this stuff in the book!
“I don’t really know what caused the crash, but I think I have as good an explanation as anyone.”
This sentence is a contradiction. If you have an explanation, then you know what caused the crash. If you don’t know what caused the crash, then you don’t have an explanation. Having read your “explanation” I can say that the first part of this sentence is correct: you do not know what caused the crash.
I’m not an Austrian economist, but I’m always shocked at how wrong your treatment of their ideas is. It’s remarkably shoddy. You do not have an explanation for the 1929 crash, and yet you dismiss the Austrian explanation with the shoddiest of reasoning.
Scott, you do not understand anything about Austrian economics or economists. You have never read anything about Austrian business cycle theory. You stubbornly refuse to read anything by Hayek, Mises or Rothbard. You had no idea about Hayek’s work on the business cycle, and you didn’t even know he won the Nobel Prize for it. If you’re going to try to write this wrong explanation of yours, don’t make it worse by distorting ideas you do not understand.
“the Austrian view is hard to reconcile with post-war U.S. monetary policy.”
This is silly. In spite of your complete ignorance of Austrian theory, you feel entitled to pronounce what the implications of this theory are for the post-war decades. And you then conclude that since your mistaken interpretation of Austrian theory doesn’t fit with the postwar era, then the Austrian theory is wrong. YOUR understanding of Austrian theory is wrong; not the theory. What you are doing is intellectually dishonest. Read the bloody thing before passing judgment on it!
How could you justify to yourself and your readers writing this sentence when you have not read anything by an Austrian on the postwar period? Can you name one thing you’ve read about this?
I would recommend that you read Hayek’s Denationalization of Money. Or that you read the different intros to the different editions of Rothbard’s America’s Great Depression. With every new edition, Rothbard would use the introduction to show how Austrian theory explains the latest rounds of monetary disasters. Heck, why don’t you read anything by an Austrian anywhere anytime?
12. February 2010 at 05:09
Jon:
Nothing Sumner said is inconsistent with your claims.
Scott:
Investors wouldn’t have bid up _what_ prices to such lofty heights? Stock prices, right? I guess you need to specify that.
12. February 2010 at 05:35
“Most historical accounts have assumed that the crash helped trigger the Depression. Alternatively, the stock market crash could have been caused by (expectations of) an oncoming Depression. This is the interpretation most compatible with the efficient markets hypothesis.”
That is not a problem, but it is important to point that this definition of eficient market is not consistent with the definition you normaly use on this blog.
Here you normaly state the EMH as “you can’t beat the market”, what means that the market stays on points that are optimum for the individuals participating on it (Nash equilibium? Probably with some pertubations, like incomplete information).On the above fragment, you state that an eficient market wouldn’t help causing the Depression, so EMH here means that the market stays on points that are socialy optimum.
12. February 2010 at 05:42
Lorenzo, Thanks. Later I argue that the problem wasn’t any one single country, but rather the system itself, which didn’t have any well-accepted rules. Nevertheless, the French accumulation of gold did cause problems. As I recall in “Lords of Finance” there was something about payback–they had been angered by UK actions when they were struggling, and weren’t anxious to help out the Brits.
I’ll check out the Tooze book.
Jon, I’ll replace “modern Austrians” with “Austrians.”
I don’t find any of your others arguments convincing. The Austrians claimed monetary policy was too expansionary in the 1920s. How can they know that if (as you claim) it is not possible for investors (and presumably Austrian economists) to even tell whether monetary policy is too expansionary? I must be missing something, as that makes no sense to me.
Other than the “modern” adjective, I don’t believe I mischaracterized Austrian views in any way. If I did, please tell me where.
saifedean, You said;
“I would recommend that you read Hayek’s Denationalization of Money. Or that you read the different intros to the different editions of Rothbard’s America’s Great Depression.”
I’ve read both books.
Like Jon, you seem remarkably sure I am wrong about the Austrians, but are unable to find any mistakes. The purpose of the comment section is to explain where I went wrong. If the Austrians didn’t claim monetary policy was too inflationary in the 1920s, show me where Rothbard says it was just right, or too contractionary.
On the crash, I do intend to explain part of the crash, in the segment I post in a few days. I meant I cannot explain the severity of the crash. I’ve never even seen an Austrian ATTEMPT to explain why a crash occurred in October 1929, rather than some other month.
Bill, Thanks, I will add that.
12. February 2010 at 05:46
Marcos, I am not arguing that a crash couldn’t make the Depression worse on theoretical grounds, or on EMH grounds. That argument was based on empirical facts, such as 1987. Rather the EMH says that crashes can’t be considered exogenous events, that just hit the economy for no reason, and then cause damage. The EMH says there must be a reason for the crash. Given the timing, the Great Depression itself is by far the most plausible reason.
12. February 2010 at 06:48
Glad to see a second rec for ‘Wages of Destruction.’ Tooze, writing from the German economies perspective, puts a great deal of importance on the fragility of the international balance of payments system in the 20’s, with the circular flow of reparations, allied war debt and US credit to Germany. Along with this he mentions the growing international distrust and trade imbalances.
Post-crash Schacht’s machinations to nominally keep the gold standard in place without deflation are truely impressive in their ingenuity and perversity. But, since you’re going to read it, I suppose I should quit typing and just let you read that yourself.
In any case, I can’t say I find your theory of the crash persuasive becuase it doesn’t take into account private credit growth at all. The two peaks in US debt to GDP were 1929 and 2008. I realize the number rose as GDP plummeted in the 1930-1932 period, but that’s because delevelering is hard (paradox of thrift and all).
And, of course, I’ll point back to my favorite economic paper, “Credit Booms Gone Bust,” pointing that credit booms are the best (though not infallible) predictor of financial crisis. High chlosterol and high blood pressure do not predict every heart attack, but I wouldn’t let my father go to a doctor that didn’t realize they were risk factors.
http://www.econ.ucdavis.edu/faculty/amtaylor/papers/w15512.pdf
12. February 2010 at 08:58
“Governor Benjamin Strong, who was supporting his friend Norman Montegu.”
The latter’s correct name is Montegu Norman, not the reverse.
12. February 2010 at 09:22
OGT, Thanks for the tips. As you know I am not into forecasting, so I haven’t spent much time looking at papers that claim to predict recessions. It is possible that high debt levels contribute to bad monetary policy, perhaps by making velocity (or the natural rate of interest) more unstable. It’s just not an issue I have examined closely.
Macgill. Ouch! I must be suffering dyslexia. And I just read Lords of Finance and saw his name mentioned 100 times. I just added that last night, and forgot to proofread.
12. February 2010 at 09:46
Scott:
Clearly that’s a matter of hindsight. The Austrians were big on the idea that it was the price system that conveys information. The boom is eventually discovered once price-inflation accelerates for instance; however baring that or some other information that may not be immediately available, no one can discern (for sure, they can suspect) whether a decrease in the cost of money (i) reflects only credit expansion or a substantive change in the natural-rate (r).
Market prices include uncertainty. e.g., surely the market does not expect “a” single future EPS. No the market price can be decomposed into some probability profile of different EPSs which in turn give the expected value. But that value can and does shift.
12. February 2010 at 09:53
“Policy coordination just doesn’t get any more uncoordinated than that. But I held back.”
Depends what you mean by coordinated. If the Fed were acting in a way that maximized the exchange-valued wealth of dollar holders (on the world economy), and the Fiscal Authority were doing the minimum possible to satiate the political rage of the masses (while duping them into thinking that a strong dollar is good), I would say it’s extremely well coordinated.
The strong dollar fanatic pseudo-austrians are doing their best to bring back fascism by collapsing the current social contract. And yet, _they_ like to talk about unintended consequences.
12. February 2010 at 10:26
ssumner –
[3]Case, Quigley and Shiller (2005, p. 26) find “at best weak evidence of a stock market wealth effect.” Dwyer and Robotti (2004) also find little evidence of a “wealth effect”. And note that measured correlations probably overstate the impact of stocks on consumption, as both variables will, at least to some extent, respond to (unobservable) changes in expectations of future economic conditions.
First, wealth (or expected wealth) is hugely important in consumption decisions, which we know from endless micro studies. Note that all of these studies would really underestimate the wealth effect for the same reasons they discuss – correlation. Consumers react to wealth based on expectations of wealth, so the issue is not merely that the stock market declined, but rather than the decline was EXPECTED TO BE PERMANENT. Why was it expected to be permanent? Because of a range of policy decisions and circumstances that were confirmed in various places, including the press. While somewhat a self-confirming loop, a “small” exogenous factor feeding into the loop (like gold reserves) can be magnified many times over.
So these studies don’t say that wealth is important, but rather that the “stock market as wealth” is inseparable from “stock market as expected wealth” which is inseparable from “stock market as a measure of future profit streams” which is inseparable from “stock market as indicator of future expectations of the economy”. There’s not a statistical model that could separate these reliably without a lot of data, and certainly not based on one historical episode.
In 87, the stock market crash was not perceived to be permanent by consumers, and hence wealth loss was not perceived to be permanent, etc… If consumers _had_ expected the wealth shock to be permanent, they would have cut consumption, but they clearly did not. One thus has a stronger argument that ’87 represented a deviation between consumer predictions and finance predictions (a short term failure of EMH), or a correct based on prior deviations, or both – possibly related to computer trading. Within 2 years, the market regained all it’s lost ground.
Anyway, you might want to push the comparison between ’87 and ’29 a little further. I think it’s very productive ground. Maybe you’ll get to this when you start talking about the huge dead-cat bounce that followed, which policymakers in ’30 used as an excuse to keep money tight, while policymakers in ’88 proved more accommodating.
But I don’t know that I’d hang my hat too much on the brilliance of the markets (why fight unrelated battles that don’t need to be fought?). If the market brilliantly predicted the elongated bust, how come the (dead cat bounce) mispredicted a recovery? How many participants were wiped out by repeated policy head fakes? You’re just asking for someone to take issue with a side point, and lose the main thrust of your argument.
Fun read.
12. February 2010 at 12:02
OGT:
I like reading your comments, but this one just baffles me:
“The two peaks in US debt to GDP were 1929 and 2008. I realize the number rose as GDP plummeted in the 1930-1932 period, but that’s because delevelering is hard (paradox of thrift and all).”
The first sentence contradicts the second. Did you mean the peak in total US debt was in 1929? And that Debt/GDP only continued rising because GDP plummeted faster than Debt? Because I think that’s what the data says…
Again… http://www.marktaw.com/culture_and_media/politics/USA_debt_2009.html
In terms of absolute debt, doesn’t your “peak” depend on whether you are using real or nominal measurement?
Finally, let me offer you a competing narrative – the decline in debt/GDP ratio (aka, real debt) which finally started to occur in 1933 was brought about by monetary policy change – and by this I include banking policy which limited credit even as successive devaluations vs gold added currency to the economy. One can also make a “memory” argument, that the recent bad monetary shock limited extension of bad credit even as money supply reflated.
12. February 2010 at 13:55
“I’ve never even seen an Austrian ATTEMPT to explain why a crash occurred in October 1929, rather than some other month.”
It would really impress me if you could explain why a crash started on October 28th, 1929, and not, say, October 21st, 1929.
While I applaud any attempt to understand the 1929 crash, I think the best answer to its cause will always be a hearty “I don’t know”. In other words, rational ignorance is better than a maybe-yes-maybe-no theory. To understand why so many people sold, you have to look into their heads for their motives, and those people are all dead.
12. February 2010 at 14:06
WRT the stock crash, a lot of public corps at the time were involved in exports of consumer goods. The crash is a likely a forward looking EMH response to the tariffs that were being proposed in congress. Also, at the same time as there was a liquidity crisis in the farm banks as happened every year around october. The two combined to make a rather nasty crash.
12. February 2010 at 14:10
“Clearly that’s a matter of hindsight.”
That’s pretty much what distinguishes science from religion.
😉
12. February 2010 at 14:14
“I’ve never even seen an Austrian ATTEMPT to explain why a crash occurred in October 1929, rather than some other month.”
Um, iirc Hayek did.
Anyway that was the traditional time for panics in the banking system of the time, due to the way the banking laws worked to make paper money supply increases difficult, combined with the cyclicality of seasonal paper money demand.
Also, look at the legislative schedule at the time, and how support for the tariffs grew and fell. I can’t remember the researcher who did this, but iirc Russ Roberts interviewed him. He showed a link between government support for new tariffs and the stock market price near the crash.
12. February 2010 at 17:02
Bt traditional, time, I mean traditional time of year. late October, early november.
12. February 2010 at 17:56
Statsguy- “Did you mean the peak in total US debt was in 1929? And that Debt/GDP only continued rising because GDP plummeted faster than Debt? Because I think that’s what the data says…”
That’s precisely what I mean. Credit creation in the twenties far outstripped both real GDP and NGDP. If we are talking about the causes of the crash and subsequent slump, I don’t find it contradictory to say that credit policy in the twenties was too loose and monetary policy in the crash era was too tight. For a cataclysm of the magnitude of the GD, it seems likely that a multitude of causes were necessary.
By the way, over at the Economist I noticed this blurb on Richard Koo’s book on Japan’s (1st) Lost Decade, which seems relevant:
I read The Holy Grail of Macroeconomics: Lessons From Japan’s Great Recession by Richard Koo. This very convincing book argues that Japanese economic policy over the last 20 years has been maligned. He says that the problem was a balance sheet recession in which, thanks to the popping of the asset bubble, the Japanese corporate sector’s liabilities were much bigger than its debts. As a result, monetary policy did not work. The problem was not a lack of lending power, but a lack of willing borrowers. Japanese companies were repaying debt at zero interest rates, contrary to all economic theory. (Koo’s thesis is well backed up by data.)
Now I have to add that one to the reading list too, so take your time Scott.
12. February 2010 at 17:57
Sorry, link to the above quote:
http://www.economist.com/blogs/buttonwood/2010/02/deficits_crucical_argument
12. February 2010 at 19:31
Scott,
Stocks are valued by discounting expected cash flows back to the present, so a key variable is interest rates. In the ’87 crash, interest rates had risen to around 8% (the 30-year bond) and were too high given the level of stock prices.
In his book on monetary theory, David Glasner put it nicely by saying that investors had a one-time bearish change in their expectations of stock prices, and marked them down accordingly. I assume something like this happened in the ’29 crash, although that crash as a % of the decline in equities’ market value was considerably smaller.
So investors shifted their expectations to lower cash flows and therefore lower stock prices. The valuation mechanism
they use is discount rates, which change in tandem with interest rates. The two Penn State professors who run the valuepro.net investing site wrote a book about stock valuation going into all this, but the title escapes me and I can’t put my hands on my copy.
12. February 2010 at 20:06
Scott-
I’m shocked that you write a long piece on the causes of the stock crash without even talking about credit expansion and stocks bought on margin.
As Garet Garrett wrote in 1931: “In two years [before the crash] brokers’ loans on the New York Stock Exchange alone increased five billions of dollars. That was credit borrowed by brokers on behalf of speculators, and it was used to inflate the daily Stock Exchange quotations for those bits of printed paper representing fragments and fictions of title to things both real and unreal”
If you pump 6 billion dollars into the market, by definition, the price of stocks will rise. If that source of credit dries up for any reason, simply the absence of continual new money will cause the market to fall back to its original level. Of course, since so many people are buying on margin based on the new higher prices, the event in a fall of prices causes people to have to sell off to meet margin calls. This causes the price to fall far below the original level (undershooting). Failures to meet margin calls means loans go bad, and then given an overall unstable banking system, the whole system can tip into a Fisher debt deflation.
I also recommend “Reminisces of a Stock Operator” if you want to understand stock booms and crashes in the early-1900’s. Jesse Livermore made off with millions in both the 1907 and 1929 crashes. Wikipedia summarizes his thinking: “Livermore first became famous after the Panic of 1907, when he sold the market short as it crashed. He noticed conditions where a lack of capital existed to buy stock. Accordingly, he predicted that there would be a sharp drop in prices when many speculators were simultaneously forced to sell by margin calls and a lack of credit. With the lack of capital, there would be no buyers in sight to absorb the sold stock, further driving down prices. After the crash and its aftermath, he was worth $3 million … In 1929, he noticed market conditions similar to that of the 1907 market. He began shorting various stocks and adding to his positions and they kept declining in price. When just about everyone in the markets lost money in the Wall Street crash of 1929, Livermore was worth $100 million after his short-selling profits.”
I do not buy the theory that the stock market crashed because people believed that corporate earnings were likely to fall over the next few years. First, look at a graph of P/E ratios over time. It’s utterly insane. P/E ratios went from 20 in late 1928, to 30 in 1928, then down to 5.5 in 1932, then up to 11 in 1933, then up to 22 in 1937, then down to 12 in 1938, etc. There is no rhyme or reason. In fact, P/E ratios are generally highest right before earnings are about to fall. If stocks were actually based as anticipated cash flows you would expect exactly the opposite. Second, if you actually ask people why they buy and sell you’ll see that it’s extremely irrational. Having just lived through the crash of 2008, it is obvious that people do not sell because they worry about a drop in future cash flows, people sell because of a) a need to make margin calls or cash flow needs or b) panic.
12. February 2010 at 21:10
Scott,
I want to remind you that the decline in 1929 equity wealth was similar to (in terms of GDP) the more recent wealth decline. Other than that I have no great disagreement. At this point in your story you obviously have more disagreement with the Austrians than me. Tell me more.
13. February 2010 at 06:42
How do high debt ratios cause recessions? How does “overleverage” cause recession?
The story appears to be that those who are overleveraged spend less and instead pay down debts. Less spending results in less sales. Less sales results in less production.
Only when debts are paid down, will funds be available for new spending. Then sales can recover and production will expand.
This approach fails because of the fallacy of composition. While an individual may pay down debts by reducing expenditure, when debts are paid down, those receiving the funds now have can now spend more. There are more sales of whatever it is those receiving the debt repayments choose to buy. Sales do not decrease on net (though there may be a shift in the composition of demand.) The production of goods doesn’t shift (though there may be a change in the composition of output and perhaps capacity is less suitable to the new composition of demand.)
Of course, it is possible that those receiving repaid debts simply hold the funds received-that the demand for money rises.
But if the quantity of money adjusts to meet the demand for money, then debts can be reduced without any decrease in nominal or real expenditures.
13. February 2010 at 07:21
Jon, You said;
“Clearly that’s a matter of hindsight. The Austrians were big on the idea that it was the price system that conveys information. The boom is eventually discovered once price-inflation accelerates for instance; however baring that or some other information that may not be immediately available, no one can discern (for sure, they can suspect) whether a decrease in the cost of money (i) reflects only credit expansion or a substantive change in the natural-rate (r).”
This still makes no sense to me. Either the information was obvious at the time, or we still don’t have any information that supports the Austrian view. I’ll ask you one more time. Tell me very specifically what economic data told the Austrians that the monetary policy was overly expansionary in the 1920s. You can’t have it both ways, arguing the investors didn’t know what was going on, but the Austrian economists did. Data may come out with a one or two month lag, but not a 10 year lag.
Statsguy, Except the Fed isn’t even helping dollar wealthholders, they only think they are. Total dollar wealth has plummeted since 2008, mostly because of tight money.
But I agree with you about how they are misguided in thinking tight money is good for us.
Statsguy, I don’t follow your argument. They find that changes in stock market wealth don’t have much effect on consumption. As far as I know, they don’t explain why it has little impact. Any of your reasons might be correct, and that still wouldn’t undercut the study.
I don’t agree that changes in the stock market aren’t viewed as permanent—it tends to roughly follow a random walk. In any case, whatever the reason for 1987 having little impact on consumption, rational or irrational, presumably the same applies to 1929. That was my point.
JP Koning. And I am convinced that even if we could ask the individuals involved, they wouldn’t know. At the time the press didn’t know, and they could ask traders. I see the market as like a brain, and traders as like individual brain cells. No individual cell in your brain knows much of anything. Just a little part of the big picture.
Doc, My next narrative will discuss the tariff, actually the next two. “It’s complicated” to quote a movie title.
Doc Merlin. The prospects of passing S-H were getting LOWER during the October crash, not higher.
Regarding Hayek, why not October 1928, or 1930?
OGT, I’d put 95% weight on tight money, and 5% on too much debt.
OGT, Just reading that description, it doesn’t really seem that Koo understands that monetary policy can raise NGDP even if the private sector isn’t borrowing.
Bill Stepp, The problem with that view is it assumes investors are irrational. They knew all that even before stocks crashed 23% on October 19. So why did they fall so far that day?
Devin, You said;
“If you pump 6 billion dollars into the market, by definition, the price of stocks will rise.”
No, money doesn’t get “pumped into” markets, money is merely a medium of exchange. If more money is used for transactions, stocks can either fall or rise. Some of the busiest days on Wall Street are when stocks crash, not rise. So money being pumped into the market doesn’t raise prices at all. For every purchase, there is a sale. Money is simply a medium of exchange.
I think your P/E numbers may be wrong. I seem to recall the P/E ratio hit infinity around 1932 or 1933.
Mark, And similar to 1987, which had zero effect on the economy. BTW, total wealth fell far more this time, as housing also crashed (unlike 1987)
I say some nicer things about the Austrians at the end of my chapter, which I’ll post in a couple weeks.
Bill Woolsey, I agree. Here’s my take on why people mix the two up. There are occasions where debt crises correlate with monetary policy failure. Why? Perhaps because after a major debt crisis, borrowing falls sharply and this reduces the natural rate of interest. If the Fed keeps targeting nominal interest rates, then monetary policy unintentionally becomes more contractionary. I think that happened in both late 1929, and late 2008.
13. February 2010 at 07:34
@Bill Woolsey
I agree that the approach, that paying down debts is bad for the economy, fails.
I take a very different stance:
The economy being highly over-leveraged increases risk of default and bankruptcy. It makes the economy brittle so a small shock can have disproportionately large effect. So, when savings is so much lower than debt (or alternatively MB so much lower than debt) the system becomes fragile to shocks.
13. February 2010 at 08:36
Scott:
I think the last sentence deserves to be the title or at least the subtitle of the chapter:
“What did they (investors) know and when did they know it?”
This captures your unique perspective on macroeconomic issues: markets are efficient and the choices by forward looking investors and business managers determine the near term paths of nominal variables.
Lead with your punchline!
Carl
13. February 2010 at 10:03
Scott-
The P/E data, it comes from Robert Schiller, on this page: http://www.econ.yale.edu/~shiller/data.htm.
As for my comment about “pumping money” into the stock market, let me clarify a bit.
Imagine at time A people allocate 5% of their income to buying stocks. Meanwhile holders of stock sell their stock at a rate of 2% of their shares a year. Now at time B there is more general exuberance. People start buying on margin with only 10% down. The man on the street starts dabbling in stocks. The formerly conservative investor puts his life savings into stocks. At time B, 7.5% of national income is now spent buying stocks. All things being equal, the price of stocks will rise 50%. This is by definition the average stock price for a period will be is the total amount of shares divided by the amount of money spent on stocks.
Stocks are not priced like most other goods. With most goods, if people start spending more on it, the price will rise dampening demand. For instance, a person might have $10,000 to spend on a car. If the price rises to $13,000, they will not buy. But stocks are different. People say, “I want to buy $10K of stocks”, not “I want to buy a certain portion of the company”. If the price rises, people actually get more excited about buying stocks. Conversely, a rising price does not increase the supply of shares being sold. Sure there are some short sellers like Jesse Livermore who can sense when stocks are over-priced, but a lot of people will hold their shares as they watch it rise.
The end result is that if some exogenous factor – credit expansion or “irrational exuberance” – – causes more money to enter the market on the buy side during a given period, then the average share price will rise.
At some point people are so leveraged that credit can expand no further. The Fed may even intervene to constrain credit to keep the bubble from going out of control. At this point the stock market is balanced on the head of the pin. Any sort of shock can send it downwards. As it moves downwards, people who bought on margin need to sell, driving the price down even further, creating a downward cycle. The man on the street is scared and stops buying any more stock, and perhaps panics and races to sell what is left. Stock prices plummet.
13. February 2010 at 10:38
Scott,
You wrote:
“And similar to 1987, which had zero effect on the economy. BTW, total wealth fell far more this time, as housing also crashed (unlike 1987)”
Well, to nitpick, the total value of corporate equities was actually much higher relative to GDP in 1929 than in 1987. The 40% decline in the stock market in 1929 reduced net wealth by an amount equal to about 70% of GDP, almost exactly the same as the aggregate decline in net wealth from 2006 to 2Q 2008. In comparison the 36% decline in the stock market in 1987 reduced net wealth by a much more modest 10% of GDP, and that was more than overcome by increases in other forms of wealth.
On the other hand, as I mentioned in another post, the wealth effect of corporate equities (about 2%) is much lower than for real estate (about 8%). Thus the 1929 crash could only have explained a decline in aggregate spending of about 1.4% of GDP. This is of course dwarfed by what subsequently happened. As you say, this was just one one event that contributed to the disaster, not its cause.
So you’re right, but the analogy with 1987 isn’t really perfect, due to the very different scales of the corporate equities markets.
Also, it’s interesting to note that nominal housing prices started to decline in 1926. By 1929 they were about 8% below their peak level in 1925. (They would eventually fall about a third from their peak by 1933.) This represented a decline in net wealth equal to about 10% of GDP. Thus the wealth effect of declining real estate values was only perhaps 0.8% of GDP in 1929. Even lumping the two wealth effects together is insufficient to explain the Great Depression.
And despite the similar scale of the wealth declines in 1929 and 2006-2Q 2008, I would argue that the wealth effect this time was much greater (about 3.6% of GDP as of 2Q 2008) since about 60% of the decline in net wealth was in real estate (corporate equities represented only about a quarter of the decline). However, as you no doubt agree, better monetary policy could still have averted a Great Recession.
13. February 2010 at 13:05
Scott,
You wrote:
“They find that changes in stock market wealth don’t have much effect on consumption. As far as I know, they don’t explain why it has little impact.”
I’ve read at least a couple of explanations of the different effects of changes in corporate equity wealth versus real estate (at the moment I can’t remember where) that are relevant to your statement. It boils down to this:
Wealth effects function like an impulse in that they increase rapidly at first and then level off. The rate at which wealth effects reach their maximum effect is proportional to the degree of volatility in the value of the particular asset class. Since housing values are far less volatile than corporate equities the rate at which a change in housing prices leads to a change in consumption is much faster than for corporate equities. Since almost all estimates of wealth effects involve point estimates that fail to take into account this effect, the estimated wealth effect of corporate equities is much smaller than for real estate.
Hypothetically, in the long run, the wealth effect of all asset classes is the same. Since we don’t live in a hypothetical world, the reality is that changes in the value of corporate equities don’t have much of an effect on consumption.
13. February 2010 at 15:01
Mark-
The 40% decline in the stock market in 1929 reduced net wealth by an amount equal to about 70% of GDP,
Where are you getting that number from?
13. February 2010 at 16:31
David,
You would ask that wouldn’t you?
I had to scramble through my collection of digital research papers to recollect how I came up with that figure. It was an estimate that I came up with by referring to the following paper:
http://www.cfr.org/content/thinktank/Depression/Fisher_McGrattenPrescott.pdf
FRB flow of funds reports obviously don’t go back that far so this is probably the best source of information. McGratten and Prescott estimated that total market value was between 124% and 167% of GDP on August 30, 1929 (Table 1). I used the upper range of that estimate (actually 40% of 167% is of course about 67% of GDP), so if truth be told I’m guilty of slightly exaggerating. If one uses the middle of that range then the loss of corporate equity wealth in the 1929 crash was probably about 60% of GDP.
It was probably the greatest loss of corporate equity wealth as a percent of GDP (especially given the time span) in U.S. history. Nevertheless, the wealth effect of corporate equities is neglible, so its effect was probably too small to be labeled the “cause” of the Great Depression.
13. February 2010 at 16:33
Devin,
I apologize for calling you “David.”
14. February 2010 at 06:10
Bill Stepp, The problem with that view is it assumes investors are irrational. They knew all that even before stocks crashed 23% on October 19. So why did they fall so far that day?
Scott,
My view doesn’t assume irationality on the part of investors. (For the record, I think there’s no such thing as “irrationality.” All action is rational in the sense Mises used it, meaning goal-directed. This says nothing about the concrete content of anyone’s goal(s).
I have no idea what you mean when you write: “They knew all even before stocks crashed 23% on October 19.” They certainly didn’t know all, whatever “all” is. Is “all” perfect information? Of what? Next year’s earnings of each of their stocks? To the penny? Are you serious?
The ’87 crash certainly gave the lie to the Fama view of the world.
As to why they fell so far that day, no one knows exactly why. Do you know why a stock rises or falls by the amount that it does on a particular day? Taleb and Mandelbrot have shown that “fat-tailed” outliers happen a lot; some events are fatter than others, and rarer; but they still happen a lot more than would be expected if stock price changes followed a normal distribution. There is no explanation for why a market changes by x.3% as opposed to y.7% on a given day. But we do know that some day, some market will have a huge rise or a huge fall, just as an individual security will on almost any day. (Just check the list of biggest gainers and losers every day.)
14. February 2010 at 06:53
“This approach fails because of the fallacy of composition. While an individual may pay down debts by reducing expenditure, when debts are paid down, those receiving the funds now have can now spend more.”
Corporation A owes one billion dollars to be paid in five years.
Probably even before the debt is due, corporation A will start to save something to be sure it will be able to service this debt (principal and interest). The same applies to individuals (consumers).
So paying down the debt is not the only problem. You have to consider the saving that comes before the debt is due.
And you have also to consider that as the stock of securitized debt grows in relation to GDP so probably does the amount of debt securities put on sale everyday – thus making interest rates spreads tend to rise.
Yes, you may keep things going without inflation or income redistribution for some time with more liquidity from the FED, but you will just postpone and worsen the crash dead ahead.
However, if the FED starts buying assets and printing money causing sufficient inflation – or targeting some inflation – then maybe the real value of the debt stock may fall in relation to GDP and disposable income, allowing the cycle to continue indefinitelly
But such approach if taken isolatedly – as Scott seems to suggest – may be extremely dangerous because speculators may anticipate inflationary expectations and make asset prices skyrocket and grow much faster than consumer income, leading to staginflation.
The approach would tend to be more successfull if at the same time ideology was put aside and higher income and net worth had higher taxes – one should remember: the counterpart of a debt is almost always someone else’s asset – and deficit spending with low income people was allowed, at least for a certain period.
The Fed would simply proceed with the monetary expansion buy increasing the purchase of government debt instruments
(The Fed is already allowing short term government securities to be sold at very low interest but at same time this short-term-only compromise turns the administration hostage of future FED moves…)
I am not proposing socialism here. I am just trying to save capitalism from itself.
14. February 2010 at 08:27
Doc, You may be right about excess debt, it might make the economy more susceptible to bad monetary policy.
Carl, Thanks, I’ll see what the editor thinks.
Devin, Corporate profits were negative in the early 1930s. How do you get a P/E ratio with negative earnings? Shiller probably took a 10 year average, or something like that.
You said;
“At time B, 7.5% of national income is now spent buying stocks. All things being equal, the price of stocks will rise 50%. This is by definition the average stock price for a period will be is the total amount of shares divided by the amount of money spent on stocks.”
This seems to confuse stocks and flows, unless I misunderstand you. The flow of money spent buying stocks has no impact on prices. During the stock market crash of 1987 Americans spent an all time record share of their incomes buying stocks. Yet prices fell.
If you are referring to net purchases, not gross purchases, it is always zero.
You said;
“Stocks are not priced like most other goods. With most goods, if people start spending more on it, the price will rise dampening demand.”
First of all, price rises don’t affect demand for any good. You are confusing demand with quantity demanded. If the demand rises, the subsequent price increase doesn’t cause demand to fall. And I think stocks are exactly like other goods, the demand curve is downward sloping. That’s why stock prices are so stable. That’s why only once in the last 100 years have stocks moved by more that 15% in a day. If prices rises led to expectations of more price rises you’d often see the market zoom up by 100% in a day, once upward price momentum got going.
Mark, I am going to need a source for that assertion. You implicitly claim that when the Dow was at 380 in 1929 it was more than 6 times as large as when at 2700 in 1987, as a share of GDP? Maybe, but I’d like to see data on total market caps at each date. If that were true, why was the market considered overvalued in 1987? Surely no one considers the Dow 6 times overvalued in 1929?
Mark#2, You may be right about the slow response of consumption to stock price changes. All I would add is that if you are right it supports my skepticism about the 1929 crash being the cause the the Depression.
Devin#2, Thanks for asking. I checked the Figure 2 of the paper Mark refers to, and he is flat out wrong. It looks like stock values as a share of GDP were only about 20% below 1929 levels, not 1/6th.
Bill Stepp, By “know all” I meant the specific causes of the crash you mentioned, like the 8% interest rates.
I don’t claim to understand the 1987 crash.
Cucaracha, None of the problems you mention will develop if the Fed keeps NGDP growing at 5% per year. We won’t get high inflation, and we won’t get a deep recession.
14. February 2010 at 09:33
@ Bill Woolsey on debt:
Compare a situation where everyone has modest savings (#1) with one in which some have vast savings and others are in debt (#2)–total net savings being the same in the two situations. If there is some sort of shock that lowers everyone’s expectations of future income, in which situation will there be a greater curtailment of consumption? Answer: in situation #2. Everyone in #1 will cut consumption somewhat, the amount being cushioned by his ability to draw on savings. In #2 the wealthy will again cut consumption somewhat, not quite as much as did the people in #1 because their greater savings provide even more of a cushion. But in #2 the indebted people will slash consumption quite drastically; their indebtedness will magnify their response to the negative shock, by more than the extra wealth of those with savings will dampen *their* response.
This is not yet to explain why #2 might go through a more severe depression than #1–or, indeed, why either situation might involve a depression–but it does point out that the two situations are economically different–that debt does matter.
On another matter: it’s ‘Montagu’, not ‘Montegu’.
14. February 2010 at 10:52
Scott
“You can’t have it both ways, arguing the investors didn’t know what was going on, but the Austrian economists did.”
This is a false dichotomy because of the way that monetary expansion acts as a tax on savings which creates a PD type scenario. As there is no difference between the portion of the MS that the Fed just created and the savings that were held by average citizens before hand there is no way for investors to simply select for “real” money verses “created” money and as such they can only select to borrow or to not borrow.
Not borrowing.
If I choose not to borrow and no one else chooses to borrow (or the amount of borrowing is the same as would have been without the creation) then nothing changes.
If I choose not to borrow and borrowing exceeds to a moderate amount what would be expected without expansion then any savings I hold lose value while I gain nothing from the new reserves.
If I choose not to borrow and borrowing is very excessive and a bubble forms then my savings could be wiped out entirely (either by collapse and bank runs or hyperinflation) and I gain nothing during the run up.
If I borrow and no one else borrows then I gain from the cheap credit at the expense of savers.
If I borrow and there is some moderate borrowing in excess then my gains are smaller but help to offset losses in my savings.
If I borrow and so does everyone else and economic collapse ensues- then I am in the same boat as everyone else.
Even if you stipulate that all investors and businessmen had the same understanding as the Austrians claimed to have one would still expect some “frothy” behavior as each actor tried to gain at the others expense- one might model this and find that the bubble bursts earlier and has less of an impact but even in a world with high knowledge one would still expect the early stages of bubbling to happen.
This brings us to how markets usually work. Competitors set up shop and the ones who make the best decisions make the most money and plow that money back into the same decision making framework which leads to their framework being represented at larger and larger shares of the economy. By creating money and taxing savers the Fed circumvents this mechanism if saving over period X would have been the better policy. The tax transfers wealth to the borrowers at the expense of the savers and the longer and larger the tax is the worse off savers are. The other option is to go short the market once the bubble has formed- this strategy is very risky and requires that one loses money early on due to the taxing of savings.
If this explanation is close to correct the natural play for market participants who understand this is to participate in the bubble as it grows and to hedge their positions with leverage so when the bubble does go they hold onto as much of their gains as possible (in the US system there is another good play- become an intermediary between the fed and the borrowers and take a % off the top).
This summary fits extremely well with what the absolute top players in the game spent the past decade doing. Large investment banks make a killing trading the bubble on the way up while also developing cheaper and more elaborate ways to hedge their risk (the explosion in the CDS markets) while also paying out huge portions of their gains in salaries, bonuses and dividends which essentially locked in a good chunk of their gains.
14. February 2010 at 13:52
Scott,
Most of what follows is nitpicking because I agree with your central point that the Crash was not the cause of the GD. But this exchange might help you in your writing and it is certainly helping me establish the correct figures on total market value.
You wrote:
“Mark, I am going to need a source for that assertion. You implicitly claim that when the Dow was at 380 in 1929 it was more than 6 times as large as when at 2700 in 1987, as a share of GDP? Maybe, but I’d like to see data on total market caps at each date. If that were true, why was the market considered overvalued in 1987? Surely no one considers the Dow 6 times overvalued in 1929?”
It’s possible to estimate the relative difference in total corporate equity value by looking at the Dow Index but I think you’re somewhat oversimplifying here. I haven’t studied whether the market was overvalued in 1987 so I have no opinion. The paper by McGratten and Prescott that I linked to explicitly argues that the 1929 stock market was correctly valued (I suspect it supports your case).
You wrote:
“Mark#2, You may be right about the slow response of consumption to stock price changes. All I would add is that if you are right it supports my skepticism about the 1929 crash being the cause the the Depression.”
Indeed, I’d like to see this conjecture tested more but I acknowledge this would be very difficult. But at least it makes sense from a theoretical perspective. And yes, it does support your skepticism about the 1929 crash being the cause of the GD. That’s one reason why I mentioned it.
You wrote:
“Devin#2, Thanks for asking. I checked the Figure 2 of the paper Mark refers to, and he is flat out wrong. It looks like stock values as a share of GDP were only about 20% below 1929 levels, not 1/6th.”
Figure 2 needs to be looked at with care. The dashed line represents an estimate of the total value of US corporate equities at year’s end. The solid line represents the sum of total corporate equity and net corporate debt at year’s end. The dashed line thus is much more relevant to our discussion.
Since both lines represent value at year’s end they fail to capture the market’s peak in both 1929 and 1987. The decline in total corporate equity between peak and year’s end was however similar in both cases.
The dashed line was estimated from the total market value of the NYSE. It was the lowest of the various estimates of total market value in 1929 (1.24 times GNP on August 30, 1929). The highest estimate was 1.67 times GNP. The estimate that Mcgratten and Prescott have the most faith in was by Sloan (1.54 times GNP).
My previous estimate of total corporate equity value in 1987 was indeed wrong for the following reason: I was only considering the household and non-profit sector. At year’s end total corporate equity value was $2522.4 billion according to the FRB flow of funds historical records (Table L.213, line 21). Since GDP was $4736.4 billion in 1987 that means that total coporate equity was about 53.3% of 1987 GDP at year’s end.
Using the S&P index I estimate that total corporate equity declined by about 27% between peak and year’s end. Thus at market peak in 1987 total corporate equity was probably about 73% of GDP. This is substantially more than I had calculated previously (I was only looking at the household sector). However this is still less than half the relative value of corporate equity at market peak in 1929.
This also means my estimates for wealth effect in 1987 and 2008 are greater than I had calculated previously. However since the wealth effect of corporate equities is small this should not change things very much.
In your case I still suggest that you qualify your analogy between the 1929 and 1987 crashes by noting the still substantial difference in the size of the corporate equity markets with respect to GDP/GNP. The analogy is not perfect.
14. February 2010 at 14:16
Scott,
Are the ideas of Bernanke/Gertler important for your understanding of the Great Depression?
“Some evidence suggests that the influence of monetary policy on real variables is greater than can be explained by the traditional “cost-of-capital” channel, which holds that monetary policy affects borrowing, investment, and spending decisions solely through its effect on the level of market interest rates. This finding has led researchers to look for supplementary channels through which monetary policy may affect the economy. One such supplementary channel, the so-called credit channel, holds that monetary policy has additional effects because interest-rate decisions affect the cost and availability of credit by more than would be implied by the associated movement in risk-free interest rates, such as Treasury rates. The credit channel, in turn, has traditionally been broken down into two components or channels of policy influence: the balance-sheet channel and the bank-lending channel (Bernanke and Gertler, 1995). ”
Do you think that 1929 crash has de facto tightened the monetary policy as credit channel has weakened as a result of stockmarket and margin debt losses?
I see some important differences between 1929 and 1987. In 1929 market participants have underestimated the volatility of the market and the level of margin debt was excessive and unsustainable. In 1987 market participants have also underestimated the volatility of the market, but this time it was reflected not in the excess levels of margin debt but in the unsustainable portfolio allocation decisions of unlevered investors who have used the so called portfolio insurance strategy. So 1987 crash had smaller effect on the credit channel of monetary policy. This smaller effect was completely neutralized by extraodinary actions of Greenspan.
15. February 2010 at 09:11
Philo, Thanks, I corrected it.
baconbacon; You said;
“This summary fits extremely well with what the absolute top players in the game spent the past decade doing. Large investment banks make a killing trading the bubble on the way up while also developing cheaper and more elaborate ways to hedge their risk (the explosion in the CDS markets) while also paying out huge portions of their gains in salaries, bonuses and dividends which essentially locked in a good chunk of their gains.”
I find this completely implausible. Most of the large investment banks went bankrupt or were taken over because they faced bankruptcy. If they knew what was going to happen they would have behaved very differently. I still think the Austrians are claiming that investors are less rational than the Austrian economists themselves. That is certainly the view of many Austrians who post here, who claim that it was “obvious” by 2006 that a big crash was coming. Obvious to them maybe, but not to Wall Street.
Mark, With all due respect it seems to me like you are wasting a lot of effort defending doubtful stock/GDP estimates. I was looking at the dotted line. And the year end data doesn’t skew things much because if you overlay 1929 and 1987 stock graphs they are almost identical. Both peaked in late summer and fell about 40%. So I still think your 70%/10% distinction is way off, the market caps over GDP weren’t that different at the peak, or at yearend. Certainly not 6 times different.
123, I think other channels are important, but I don’t think the credit channel was important in late 1929. Late 2008 and 1931 are a different story.
The other channels I think are important are asset prices and real wages.
You said:
“I see some important differences between 1929 and 1987. In 1929 market participants have underestimated the volatility of the market and the level of margin debt was excessive and unsustainable. In 1987 market participants have also underestimated the volatility of the market, but this time it was reflected not in the excess levels of margin debt but in the unsustainable portfolio allocation decisions of unlevered investors who have used the so called portfolio insurance strategy. So 1987 crash had smaller effect on the credit channel of monetary policy. This smaller effect was completely neutralized by extraordinary actions of Greenspan.”
I don’t think the credit channel was important here. The banking system was in fine shape. I doubt margin debt played an important role in the economy. The fall in NGDP was the problem. And I don’t think Greenspan took any extraordinary actions in 1987, rather he kept monetary policy on target, with small cuts in nominal rates. Nominal rates were also cut after the 1929 crash, so I don’t see much difference in that conventional measure of monetary policy. The difference is that in late 1929 market participants correctly realized that the cuts in nominal rates would be too small to prevent the gold reserve ratio from rising, and NGDP from falling sharply.
15. February 2010 at 10:02
If you are talking about French mad thirst for gold, German reparations and Poincaré devaluation may be mentionned. This story leads to the following sequence of events:
_France initially hoped that it could go back on gold standard and pay its war debts painlessy by using German money.
_Germany committed monetary suicide (a.k.a hyperinflation of 1923) to prove that reparations were too high (Young’s plan adopted in 1929: Germany should pay until 1988), which probably fueled unreasonnable fear of accomodative monetary policies.
_Reparations and war debts embittered relations between countries (France occupation of the Ruhr, american unwilling to alleviate its former allies debt …) and I presume that it did not help financial cooperation.
_Poincaré devaluation ruined (more exactly made clear that they were ruined) pre-war renters but Poincaré was widely credited for a deflation which avoided a stronger depreciation. This devaluation was supposed to be the last one and it is part of the reason why France accumulated so much reserves and wait until 1936 to devaluate again.
15. February 2010 at 10:03
Scott,
You wrote:
“So I still think your 70%/10% distinction is way off, the market caps over GDP weren’t that different at the peak, or at yearend. Certainly not 6 times different.”
If you read my last comment more closely you’ll realize my current estimate of total corporate equity as a percent of GNP/GDP is about 154% of GNP at peak in 1929 (Sloan), and about 73% of GDP at peak in 1987 (details above). Thus the decline in corporate equity from was 40%x154%=61.6% of GNP in the 1929 Crash and 36%x73%=26.3% of GDP in 1987 Crash. This is certainly not 7:1 but more like 12:5, nevertheless still significantly different.
The NYSE based estimate of corporate equity greatly understates corporate equity in 1929 and significantly overstates it in 1987. The more credible Sloan estimate of 1929 corporate equity places much higher. The NYSE estimate of corporate equity overstates corporate equity in 1987 mainly because from the mid-1970s through the mid-1990s net corporate debt was a significant portion of corporate value (up to 30% in the mid-1980s). The value of net corporate debt was largely unaffected by the 1987 crash so it must be excluded. So we have a better estimate for total corporate equity in 1929 (Sloan) and we have the actual end of year value for total corporate equity in 1987 (FRB flow of funds). That’s why Figure 2 from the McGratten and Prescott paper is not very useful in comparing the value of corporate equity in 1929 to 1987. You’re attaching far too much importance to it.
Corporate equity as a percent of GDP varies significantly over time due to many factors (interest rates being one) and this means your analogy between 1929 and 1987 is not perfect even if they were both market peaks. You can’t just wave your hands and ignore that fact.
16. February 2010 at 07:55
jean, Those are all good points. I discuss reparations quite a bit in Chapter 5 (on 1931)
Mark, Even if it is 12/5, that changes everything. There is still no explanation of the fact that the 1987 crash had zero impact on consumption. In theory, the effect should ahve been 5/12ths as large as in 1929, which the Keynesians seem to think was important. Second, I still don’t buy your numbers. If you think figure two is wrong, that’s fine, but then the honest answer is that we have no idea what the correct numbers are.
16. February 2010 at 08:18
Scott,
You wrote:
“Mark, Even if it is 12/5, that changes everything. There is still no explanation of the fact that the 1987 crash had zero impact on consumption. In theory, the effect should ahve been 5/12ths as large as in 1929, which the Keynesians seem to think was important.”
Well, of course, the explanation is that the wealth effect stemming from changes in the value of corporate equities is very small. On that point I think we are in general agreement.
You also wrote:
“Second, I still don’t buy your numbers. If you think figure two is wrong, that’s fine, but then the honest answer is that we have no idea what the correct numbers are.”
The point of Figure 2 was simply to demonstrate that the NYSE based estimate tracked total corporate “value” in the post WW II period fairly well: no more, no less. We have better estimates of total corporate “equity” at peak in 1929 and 1987 than that. I encourage you to read McGratten and Prescott more closely.
16. February 2010 at 10:03
“I find this completely implausible. Most of the large investment banks went bankrupt or were taken over because they faced bankruptcy.”
I think you misunderstand the point of my post. The first portion is to briefly describe how the rules of a monetary system can be set up to mimic a prisoner’s dilemma, and the issue with a prisoner’s dilemma is that even with perfect knowledge for each individual participant the worst outcome for all participants is guaranteed. The application of that idea to the recent crisis is to show how the behavior of doesn’t preclude the fact that they may have had knowledge that they were investing (or speculating) in a bubble that must eventually burst, but wasn’t meant to be even remotely close to the whole story. Another substantial portion of that story relates to
“If they knew what was going to happen they would have behaved very differently. I still think the Austrians are claiming that investors are less rational than the Austrian economists themselves.”
The second part of the story is that knowledge is highly dispersed. Warren Buffet is famous for denigrating his own macro economic projections and yet he still has made a killing as an investor, it is not at all contradictory to say that I think I understand macro economics better than Warren Buffet and to also think that he understands the other aspects of investing more(^10) than I do. While some proponents of Austrian economics may very well believe themselves to be smarter than the average trader at Bear Stearns or Lehman Brothers that attitude doesn’t reflect anything inherently wrong with the Austrian analysis, just their own egos.
If we combine the aspects of the PD with the dispersal of knowledge we can describe a system in which the best outcomes are achieved by the smartest (or those whose overlapping areas of knowledge happen to be particularly salient at the time- ie luck + smarts) players who manage to make money on both the up and the downside (hi there Goldman Sacs) while making (seemingly) contradictory bets (build models that don’t price in any likelihood of housing price declines while making large leveraged bets that essentially relied on housing prices declining) while leaving plenty of room for
1. Banks and investors who make a killing on the way up but got busted in the bust (Lehman)
2. Banks and investors who stayed out of the boom as much as they could and made alternate choices in investing and made substantial money largely thanks to the bust (Beal bank and goldbugs in general)
3. People who went short the market to early and got eaten alive (I’m sure there are tons of examples of these but they aren’t really the type to make headlines)
“That is certainly the view of many Austrians who post here, who claim that it was “obvious” by 2006 that a big crash was coming. Obvious to them maybe, but not to Wall Street.”
Had I spent my time studying trading, modeling, complex mathematics and whatever else it took to become part of the investment community that split billions in bonus money I could have made far, far more than I made when I switched nearly 100% of my portfolio to a shiny metal a couple of years ago that I decided to do after spending 2-3 years studying macro economics in my free time (for fun). Had I managed to do both you would probably see me on TV launching my new hedge fund or I’d be posting this from my own private tropical island. I don’t think that my one good individual investment decision makes me smarter or superior to Wall Street in any way.
16. February 2010 at 18:22
Corporate profits were negative in the early 1930s. How do you get a P/E ratio with negative earnings? Shiller probably took a 10 year average, or something like that.
Yes, I believe that’s what he did, but my point still stands.
You can also look at the forward 10-years P/E ratio – ie, the P/E ratio with 20/20 hindsight. Divide the stock price at a given point by the average earnings over the next ten years. If your thesis is correct, and stock prices are fairly accurate predictors of future earnings, you would expect the 10-year forwards P/E to fluctuate within a narrow band. Expectations of lower earnings would lower the current stock price, keeping the P/E ratio at the same level. Instead, the forward looking P/E ratio goes:
25 in April of 28
35 in December of 28
55 in September of 1929
35 in December of 1929
40 in September of 1930
20 in June of 1931
7 in June of 1932
19 in July of 1933
15 in July of 1934
25 in Feb of 1937
6 in May of 1941
Again, this is ridiculously erratic. Clearly, stock prices do not accurately predict future earnings. Nor do I see how they could. Virtually no one in 1929 expected a Great Depression and the depth and the extent of the various ups and downs was unpredictable to most mortals.
“This seems to confuse stocks and flows, unless I misunderstand you. The flow of money spent buying stocks has no impact on prices. During the stock market crash of 1987 Americans spent an all time record share of their incomes buying stocks. Yet prices fell. … If you are referring to net purchases, not gross purchases, it is always zero.”
Let me use a simplified model to explain. Imagine there are two types of players in the market: workers and retirees. Retirees own half the stocks in the market, 50 trillion shares total. Every year, workers spend 2% of their income buying stocks. Being good believers in dollar cost averaging, workers will buy the same quantity of stocks no matter the price. Total yearly income is $10 trillion, so they spend $200 billion a year buying stocks. Each retiree expects to live for ten years. Thus every year, each retiree sells 10% of his shares. The retiree will sell the same quantity of shares regardless of the price.
The average stock price during that year – by definition – will be 5 trillion / $200 billion = $25. That’s just the total shares the “retirees” were selling divided by the total amount of money the workers were spending.
Now let’s say that stocks become hot for some reason. News reports start pumping up how well stocks are doing. Workers then increase the portion of income buying stocks to 3%. All things being equal, the price of stocks will rise 50% to $37.
Or let’s say banks start introduce accounts to buy on margin. When these accounts are first introduced, workers will use the loans to buy up stocks. Stock purchases by workers as a portion of income might rise from 2 to 2.5%. But then their credit lines will all be tapped out. Purchases as a percent of income drops back to the original 2%. This might trigger a bunch of workers to sell, preventing any losses. Now workers are only on net spending 1.5% of income on stocks. The stock market has just crashed by 40% off of its high.
This model is very simplified, but I think it captures the underlying dynamics of how stock booms and crashes happen in the real world.
First of all, price rises don’t affect demand for any good. You are confusing demand with quantity demanded. If the demand rises, the subsequent price increase doesn’t cause demand to fall. And I think stocks are exactly like other goods, the demand curve is downward sloping. That’s why stock prices are so stable. That’s why only once in the last 100 years have stocks moved by more that 15% in a day. If prices rises led to expectations of more price rises you’d often see the market zoom up by 100% in a day, once upward price momentum got going.
Stock prices are stable? Based on what criteria? Stocks prices not stable with regards to extrapolating past earnings nor with regards to actual future earnings. Look at Schiller’s graph.
I don’t think the demand curve is purely upward sloping, it’s just upward sloping for some people. Nor is the effect immediate. Stocks rise for a given period, the man on the street envies those making the money, and starts putting his money in stocks. Of course the man on the street is just one player in the market. Vulture buyers have a very different demand curve. Altogether the demand curve is just erratic. Most of the time it’s vertical, but it can slope up during times of exuberance and down during times of panic (and the curve is different for different players in the market). It’s based on a lot of complex herd behavior.
17. February 2010 at 08:07
Mark, Ok, I’ll drop my objections, I concede you have read it more closely than me. And we seem to agree on consumption, which is the key point.
baconbacon, I think acedemics look at these issues differently than investors. I still don’t see how the Austrians can claim they have a model that is consistent with Ratex and the EMH. I also don’t see any prisoner dilemma problems here.
The Austrians seem to claim that a low interest rate policy by the Fed pushed asset values above their fundamental values in 2006. At least I think that is the claim. And that claim is inconsistent with the EMH.
Devin, I certainly don’t think stock prices are “fairly accurate predictors of future earnings.” In 1929 no one knew we were about to enter a Great Depression, which would devastate earnings. By 1933 many people thought we’d never get out of the Depression (as say Argentina never really recovered from the Depression.) Of course the price fluctuated wildly relative to future earnings. The future is extremely unpredictable, that’s why stocks fluctuate so much.
I don’t understand your example where workers spend 2% of income on stocks. Who do they buy from? And at what price? They could spend this much and buy a few shares at a high price, or spend the same amount and buy lots of shares at a low price. Spending on stocks has no impact on price.
17. February 2010 at 11:53
“The Austrians seem to claim that a low interest rate policy by the Fed pushed asset values above their fundamental values in 2006. At least I think that is the claim. And that claim is inconsistent with the EMH.”
They Austrians don’t believe in “fundamental values.” So what you say isn’t quite right. What they believe is that the “low interest rate policy by the Fed” pushed asset values temporarily higher than they would have been without the low interest rate policy. When the policy changed, the values declined. This is compatible with EMH and ratex as interest rate policy by the fed is an exogenous, non-market decision by the small number of people; It isn’t actually a market decision.
A better way of putting it, “markets are rational and efficient,” central planners are neither. Since the interest rate is set by central planners, it is exogenous to EMH and ratex models.
While not all Austrians believe in EMH, the Austrian macro story of this recession is not incompatible with it.
17. February 2010 at 21:03
Doc Merlin – I don’t understand on what basis Austrian economists can say “… that the “low interest rate policy by the Fed” pushed asset values temporarily higher than they would have been without the low interest rate policy.” How can they know what asset values would have been without Fed policy? Since they’re supposed to be pure methodological individualists and not to believe in any possibility of economic prediction, how can they know what would have happened if policy had been different?
18. February 2010 at 07:31
“I don’t think the credit channel was important here. The banking system was in fine shape. I doubt margin debt played an important role in the economy. The fall in NGDP was the problem. And I don’t think Greenspan took any extraordinary actions in 1987, rather he kept monetary policy on target, with small cuts in nominal rates. Nominal rates were also cut after the 1929 crash, so I don’t see much difference in that conventional measure of monetary policy. The difference is that in late 1929 market participants correctly realized that the cuts in nominal rates would be too small to prevent the gold reserve ratio from rising, and NGDP from falling sharply.”
Some accounts of 1929 say that banks were in bad shape after the crash – off-balance sheet Goldman Sachs entity called “Goldman Sachs Trading Corp.” failed in 1930.
Greenspan’s actions in 1987 were extraordinary – like JP Morgan in 1907 he made sure that the asset price crash does not cause runs on the banking system.
18. February 2010 at 10:53
Doc Merlin, That shocks me. Are you saying that the Austrians don’t believe there was a housing bubble, don’t believe houses were overvalued in 2006? You might be right, but I have a hard time figuring out what they do believe.
123, I don’t see much evidence the commercial banking system was in trouble after the 1929 crash, or even in mid-1930.
What extraordinary action did Greenspan take in 1987? Why would the stock crash of 1987 have caused a run on commercial banks? I don’t understand.
18. February 2010 at 19:38
“baconbacon, I think acedemics look at these issues differently than investors. I still don’t see how the Austrians can claim they have a model that is consistent with Ratex and the EMH. I also don’t see any prisoner dilemma problems here.”
Question: If you bought the Austrian story that the Fed lowering rates would cause a bubble how would you exploit that knowledge to make money when the fed started lowering rates? If you pile in on the bubble you are doing (pretty much by definition a bubble) what everyone else is doing- ie you are not generating any excess returns (the market loves to pop when the Fed lowers rates). If you say you are going to short the crash you weren’t alone as by the time the crash rolls around the bubble had been identified by dozens of investors and pundits. Knowing that a crash will *eventually* happen if the lowers rates enough for a long enough time period doesn’t give you a big edge since the blowing of the bubble sends out plenty of information to the investing community.
18. February 2010 at 19:59
“Doc Merlin, That shocks me. Are you saying that the Austrians don’t believe there was a housing bubble, don’t believe houses were overvalued in 2006? You might be right, but I have a hard time figuring out what they do believe. ”
I think part of the problem is that Austrians and the rest of economics have a slightly different vocabulary. You have to go to back to the old-school explanation of value (utility). For Austrians this is perfectly individual and subjective and ordinal. The idea of “fundamental value” requires utility of some objects to be cardinal and non subjective.
Austrians do believe in value as separate from price. (This is a separate topic that takes a lot of explaining, and this forces them to reject strong EMH if not weak EMH.) What they don’t believe is “fundamental value” as separate from individual subjective valuation. This is why they used to be called the “psychological school.” The reason I put quotes around “fundamental values” is the theory with “fundamental values” claims that values are not completely subjective and individual.
They do believe that houses were overvalued and in a bubble Scott. They just define “overvalued” and “bubble” differently from those who believe in “fundamental values.” They define “overvalued” as price too high to sustain for very long, and “bubble” as “the price that will come crashing down suddenly.” It really hard to see these “bubbles” except in retrospect. This isn’t to say that austrians won’t try to predict them (as everyone in the market should and does try to predict prices within a market framework), just that they don’t think a non-market individual should have the power to try to “pop” them.
In the case of the housing crisis, the utility people thought they would get from houses was based partially on an erroneous assumption: that they would be able to sell the house at a higher price in the future. When people realized they were wrong (prices started leveling out due to an interest rate shock by the fed) they adjusted their utility estimates to account for the new information. This made the prices houses were selling for fall even lower than just the adverse interest rate shock did. This account is consistent with EMH and with Austrian theory.
19. February 2010 at 08:46
baconbacon, If you thought it was a bubble you would have been nuts to own stock in banks and homebuilders during 2006. But lots of very smart people did. I conclude that it wasn’t obvious that it was a bubble. If I was an Austrian, and knew the bubble was going to burst, I would have invested in government bonds in 2006, then snapped up stocks after the stock market crashed.
Doc Merlin, You said;
“They do believe that houses were overvalued and in a bubble Scott. They just define “overvalued” and “bubble” differently from those who believe in “fundamental values.” ”
Well then we’ve just wasted a lot of time arguing about nothing. When I said fundamental price, you should have simply said “they don’t call the correct price the fundamental price, rather they call it the XXXX price” where you fill in the blank. I don’t care what Austrians call it, if they think prices were too high then they must have thought the correct price was lower than the market price.
And if you can only see bubbles in retrospect, then how is it a bubble? The mere fact that a price falls sharply doesn’t mean the preceding price was inflated, perhaps new information arrived on the scene.
19. February 2010 at 11:49
” If I was an Austrian, and knew the bubble was going to burst, I would have invested in government bonds in 2006, then snapped up stocks after the stock market crashed.”
I am very surprised at this reply given the way you usually try to approach an argument from what I have read on your blog.
You have made a huge leap from
A. Identifying the bubble
to
B. Assuming you therefor know when the bubble is going to burst.
What did you do in 2005? There is a bubble, might it now burst? 2004, there is a bubble, might it now burst?
You have argued on this blog (many times) that the Federal reserve has essentially no theoretical limits in pushing the NGDP in the direction it wants. To claim that you would have simply sold out of banks and builders and bought bonds only works because you know what the Federal Reserve’s actual response was, but it does not even remotely cover all of the possible actions. What if Helicopter Ben had proposed a 1 trillion dollar bailout for homeowners instead of banks? That every home owner that currently owned but wasn’t in foreclosure 6 months from now would get a check for a % of the purchase price of their house- to be financed directly by the Federal reserve printing dollars. Your plan of holding US bonds would have been a HUGE loser under this and many other possible scenarios, in which the Federal Reserve did exactly as Bernanke had promised to do over and over again in the face of another Great Depression
“The U.S. government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at no cost.”
B.S.B
If you knew in 2006 what you know in 2010 you would have non public, material information at your disposal and that doesn’t at all violate the EMH, neither weak nor strong.
“baconbacon, If you thought it was a bubble you would have been nuts to own stock in banks and homebuilders during 2006. But lots of very smart people did. I conclude that it wasn’t obvious that it was a bubble.”
You have made the same mistake that dozens exploring the EMH have made before you, having an edge in macro understanding doesn’t automatically translate into an investing edge since there are many factors at work in markets which make the eventual path that is taken very hard to predict. If you want to stipulate that your hypothetical Austrian economist is also a very adept trader with an excellent understanding of the housing market, how derivatives were being used, who was holding which ends of them as well as a great understanding of the Federal Reserve’s options once the bubble burst (or threatened to) and a good understanding of the probabilities of each as well as their effects- then yes, you have someone who will beat the market significantly. But his existence does not violate the EMH any more than Warren Buffett’s existence does because you have included into your mix access to mental gifts that far outstrip normal market participants and are applying those to the same information. You have to explain how knowledge of the Austrian theory in the hands of a person of normal capabilities would be used to generate excess market returns- and even then you have only refuted the strong EMH, you have to go a lot further than that to refute the weak EMH.
19. February 2010 at 12:19
Scott,
To put it another way you have forgotten that Mr. Market took down the bubble, it was Mr. Market that took down (or threatened to take down) Lehman and Bear and AIG before their bankruptcy was apparent to all. To claim that the Austrian Business Cycle Theory would give you a material advantage you have to show how it would have helped you to time and predict these attacks- otherwise you were just like every other market participant waiting for the news to see if this bubble was bursting or growing larger.
19. February 2010 at 12:59
@Scott:
“And if you can only see bubbles in retrospect, then how is it a bubble? The mere fact that a price falls sharply doesn’t mean the preceding price was inflated, perhaps new information arrived on the scene. ”
If your old price didn’t take into account the possibility for the new information then wasn’t it inflated? Bah! I think this goes back to your earlier post of how “bubble” isn’t well defined.
@baconbacon
I agree, that is one of my main complaints about ABCT. It seems to get the story right, but its useless for timing.
20. February 2010 at 06:21
baconbacon, You may be right, but the Austrian theory you present is very different from what I usually get from commenters. They usually say it was obvious prices were too high in 2006, and were bound to fall. Maybe it wasn’t clear exactly when, but surely withing 5 or 10 years. I respond that the Fed could have kept NGDP rising at 5% a year forever, and they say that won’t work, a crash is inevitable.
Now you seem to agree with me that the Fed can keep NGDP growing indefinitely. If so, we agree. I was attacking a different theory from your version of Austrian econ.
Also note that my hypothetical did not require any sophisticated understanding of derivatives, but simply suggested switching money between stock funds and government bond funds. I still think most Austrian types believe their theory has implications for how you should invest, at least in terms of asset allocation.
Doc Merlin; You said;
“If your old price didn’t take into account the possibility for the new information then wasn’t it inflated? Bah! I think this goes back to your earlier post of how “bubble” isn’t well defined.”
This is flat out wrong. If the old price priced in a 30% probability of bubble collapse, and the bubble collapses, the price will fall sharply. The mere fact that the price fell sharply does not mean the possibility of new information was not incorporated into asset prices, merely that the market didn’t know precisely what was going to happen.
20. February 2010 at 06:26
“I don’t see much evidence the commercial banking system was in trouble after the 1929 crash, or even in mid-1930.”
Ted spread was very useful in monitoring the state of the commercial banking system during the latest crisis, and it started showing problems in mid-2007. Is there a similar data in the 1929-1931 – I find your account more persuasive than those that are talking about credit problems in 1929, but hard data would be helpful.
“What extraordinary action did Greenspan take in 1987? Why would the stock crash of 1987 have caused a run on commercial banks? I don’t understand.”
This is a good example of “If Mr. X had prevented September 11, would someone notice it?”. But there were serious fears of a run on some banks, and this is what prevented it:
——————-
http://www.washingtonpost.com/ac2/wp-dyn/A1742-2000Nov11?language=printer
“A key question was whether there was a major hole in the system. Was some firm in trouble and maybe insolvent? In the short run, Corrigan argued, there was no way to tell the difference between short-term liquidity problems and outright insolvency.
They finally agreed on a one-sentence statement. Greenspan issued it in his name at 8:41 a.m. on Tuesday, Oct. 20, before the markets opened:
“The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”
“Alan,” Corrigan said in a personal follow-up call to Greenspan, “we’re going to have to back this up. I just want you to know that I’m going to start making calls.” His phones were still going crazy. He had to talk to the heads of the banks and brokerage houses.
What are you going to say? Greenspan asked.
Corrigan said that he was going to have to talk very tough, and he was going to have to talk in code. He couldn’t give them orders, and he couldn’t beg.
Greenspan wanted the exact words. They couldn’t tell banks to lend to bankrupt institutions; they could be sued for huge amounts of money if bank shareholders could show that the Fed, a key regulatory agency for banks, had improperly directed unsound loans. How would it work?
Corrigan offered a hypothetical call to the head of a big bank. He would say: “You’ve got to make your own business and credit decisions. . . . But there is this bigger picture out there. If the system becomes unglued, you won’t be insulated. . . . If for God’s sake there’s anything I should know, let me know.” In other words, let him know if you’re not going to make your payments or aren’t getting payments from others, or if you’re in trouble. Corrigan needed immediate, high-quality information if he was to discover a hole that might collapse the system. They couldn’t plug a hole they didn’t know about, so they would have to address everybody.
Greenspan preferred a more subtle approach. The argument should be more calibrated, assuring the banks that the Fed was not trying to force them to lend on an irrational basis or to take extreme risks. The argument should be: Remember that these people who want money have long memories. If you shut off credit to a customer who has been a good customer for a number of years because you’re a little nervous, the customer will remember that. Think of the longer-term interests and the customer relationships. Corrigan should clarify to the banks where their self-interest lay.
Corrigan understood, but he would have to speak in his own voice – and his style was loud and clear. He knew he would have to make sure the payments and credit extensions were voluntary. At the same time, it would be his job to make certain they happened.”
—————————–
21. February 2010 at 07:57
123, I don’t see that as any sort of extraordinary measure. They reiterated what is already in their charter—they are the lender of last resort. the fed did the same sorts of things in 1929. The persuasion doesn’t work, unless backed up with NGDP targeting. In 1929 they let NGDP fall, and no amount of persuasion could help. In 1987 they kept targeting NGDP, and the persuasion was completely unnecessary. There was no reason for bank lending to slow, of for NGDP to fall, so it didn’t.
21. February 2010 at 13:26
But Greenspan was ready in 1987 to lend money to institutions that could be insolvent. In 1930-31 Greenspanesque LOLR would have softened the blow. In September 2008 mismanagement of LOLR function has depressed NGDP expectations, and Fed was flying blind for many months after that.
22. February 2010 at 07:29
123, I think we both basically agree about what sorts of monetary policy are good and bad, rather which just differ slightly on which aspects of policy we emphasize.
I agree that Greenspan policies would have been better in 1930-31, but mostly because like Governor Strong he was more activist than the actual Fed leadership in 1930. And by activist I don’t so much mean doing different things, but rather doing the same thing (something close to NGDP targeting) more aggresively.
22. February 2010 at 08:24
I’ve studied the issue of “causation” with two of the best philosophers of science writing on this topic. I can tell you that every “explication” of this notion bows before counter-examples derived from out background understanding, a Wittgensteinian / real life / actual science approach crushed a “philosophic” or inductivie or statistical approach to “causation” every time. Larry White is very good on this topic — White studied with Salmon and Hanson, and participated in some of the key debates.
22. February 2010 at 08:29
Tip — drop identifying economists by ideology.
Almost every economist is an economist first and foremost — it’s deeply insulting to suggest otherwise.
And your labels tell a lie — economist who advocate classic liberalism are not “conservatives” and they oppose most of what that implies.
23. February 2010 at 06:03
Greg, OK, I agree I should drop conservative. But what about contrasting Keynesian and monetarist views of the Depression, can’t those labels be useful in a rough sort of way? After all Keynesian theory is a product of the Depression. On the other hand there are more than one type of Keynesian. And Friedman and Schwartz were very influential.
I’d be very interested in your thoughts on my 1930 post (part 4) that I put up recently. Especially the part where I list 5 counterfactual policies and how they relate to causality, if you don’t have time to read the whole thing.
24. July 2010 at 00:11
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