Something happened in 1929 that changed the world. Understanding history gives us a chance to understand the present. Whether it be levees in Louisiana or banks in New York the lesson is clear. We repeat our mistakes over and over again.

Study of the Great Depression of the 1930’s shows remarkable parallels to the current economic situation. How long will it take to recover from the 2008 credit meltdown? What risks do we face now?

Preceding the depression there was a bubble known as the Roaring 20’s. It was the post WWI, late Industrial Revolution bull market that propelled the US to world dominance.

a.       The Industrial Revolution was winding towards its conclusion with such major events as telephony, electrification and oil energy spreading rapidly across the world. Productivity was on the rise far faster than wages. Workers were having a hard time upgrading their skills as machines changed the nature of labor.  Labor organizing was in its infancy. The education system was under criticism for not properly preparing workers.

b.      WW I’s destruction of European economies increased demand for US industrial output that remained strong until the late 1920’s

c.       The Free Banking Era was coming to an end with the ascendency of centralized banking. In the US, the Federal Reserve Banking system was created in 1913 to address the banking panics of the earlier era (and fund WW I).  The Fed stimulated investment in the economy with low interest rates. Many claim central banking policies drove a credit bubble and excessive industrial (mal) investment in the 1920’s.

d.      Internationally and in the US, the Gold Standard was in full effect, governing currency relationships under the stewardship of the Bank of England.  Germany, saddled with reparations in gold had suffered hyperinflation of its currency when they dropped out of the Gold Standard in 1923. In 1919 John Maynard Keynes had written, "The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance."

e.      Alcohol prohibition was in place from 1920-1933 creating a massive underground economy and promoting organized crime.

f.        The income tax was added to the US Constitution in 1913. Initially it had seven brackets with tax ranging from 1% for most Americans (under $10,000 income) to 7% for the richest.  By 1918 the top rate was 77% for incomes over $1,000,000.

g.       In the 1920’s Republican presidents Harding, Coolidge and Hoover and their Republican Congresses cut taxes on the top earners in America from 73% to 24%.

h.      Income inequality in the 1929 US was significant. In 1929 the top 1% of Americans controlled 40% of the wealth.  (Compare to 1% controlling 36% of wealth in 2010).

i.         10% Margin investment accounts backed by banks were common. When investors went broke en masse they took the banks down with them.

j.        Illegal immigration from Mexico was such a problem that President Hoover instituted a program of forced repatriation that deported 500,000 Mexican workers between 1929 and 1937.

The crisis begins.

k.       In 1928 the Fed tightened credit by raising interest rates. This move has been widely criticized. The economy was just recovering from the mild recession of 1927 and inflation was mild. Why raise rates? They were trying to discourage speculation in equities but it seemed they waited too long and used the wrong instrument.

The bubble burst in 1929 starting in August, crashing October 29, then appeared to recover in 1930 before sinking to lows by July, 1932. Hoover’s policies made things worse. The money supply shrank by 1/3^rd in these three years.

a.       Large Public bank failures created panic and more Bank failures and credit contraction, over 40% of the nation’s 25,000 banks failed. The government stood by and let it happen. There was no “too big to fail theory.” There was no FDIC deposit insurance so when a bank failed the money was gone and deposits were lost. – as debtors defaulted this reduced money supply adding to deflation.  Herbert Hoover believed in small government and limited regulation. He espoused a theory of public-private cooperation called “voluntarism.” Regulating banks was anethma to Hoover.

b.      Credit tightening by the Fed in 1930-31 further reduced money supply.  Here are the nominal interest rates and the inflation (negative inflation is deflation) producing the real interest rate. 14%-16% is way too high for a recovery. Historians believe the Fed had two major problems during this era. First their measures of the money supply mislead them to believe the supply was greater than it actually was.  Second they underestimated the impact of deflation. There was no theory to support Quantitative Easing which may have been helpful. Hoover was a fiscal conservative who believed in balancing the budget.

1.       Year       Infl         Nom      Actual

2.       1930       -3.96      3.59        7.87

3.       1931       -10.00    2.64        14.04

4.       1932       -11.38    2.73        15.92

5.       1933       -2.96      1.73        4.54

c.       Investment Consumption dropped dramatically.

d.      Although the events of October 29, 1929 get all the press, the real damage followed. By 1932 the Dow dropped to 41 vs its peak of 381 in 1929. Even considering deflation this is a loss of 86% of its value in two years. By 1932 the GDP was down 67%

e.      Federal tariffs under the Smoot Hawley Act created Economic Isolation from Europe – reduced trade

f.        The British pound was forced off the Gold Standard in Sept, 1931 when speculators ran the Bank of England out of gold.  Attacks on the dollar followed, causing banks to feel stress from withdrawals of deposits to redeem for gold. Fed raised nominal interest rates to defend the dollar resulting in further contraction of the money supply.  A Ben Bernanke paper studies the strong correlation between leaving the gold standard and quick recovery from the Great Depression internationally. The US stayed on gold standard under Hoover until Roosevelt ended it in 1933.

g.       Unemployment crested at 25% and stayed above 15% for most of the decade

h.      Income tax rates on high earners were reinstated in 1932. The top income tax rates stayed high (above 70%) until Reagan’s presidency.

Impact of natural disasters including the 1918 Spanish Flu, the Great Flood of 1927, and the 1933 Dustbowl delayed recovery by causing reduction in population growth and relocations to cities

The turnaround began in April 1933 under Roosevelt. The effectiveness of his policies in “The New Deal” continues to be argued. Re armament of Europe for WW II and the war itself finally ended the unemployment that lingered for 10 years during the depression.

a.       Ending the gold standard in 1933 effectively devalued the dollar by 50% and ended the need to maintain interest rates to prevent international speculative runs on the currency (redemptions for gold).  Since 1971 the currency has no commodity basis. Nixon took us off the Silver standard. A so called fiat currency it has been the responsibility of the Fed to prevent hyperinflation. The Fed has been content to maintain a 3% or more inflationary trend for decades and staunchly opposes deflation.

b.      Prohibition became increasingly unpopular during the Great Depression, as the repeal movement, led by conservative Democrats and Catholics, emphasized that repeal would generate enormous sums of much needed tax revenue, and weaken the base of organized crime. In 1933 the Prohibition amendment to the Constitution was repealed, allowing the states to set their own laws. The organized Prohibition movement was dead nationwide, but survived for a while in a few southern and border states

c.       Interest rates were lowered. Modern economists would argue for more quantitative easing of the money supply through open market operations namely repurchase of Treasuries to inject more cash into the system.

d.      Roosevelt declared a bank holiday and only reopened sound banks and created FDIC deposit insurance. The Glass Steegal Act reinforced bank regulation and separated the various types of banks. Weakened in the 1990’s Glass Steegal was finally repealed by the Republican Congress in 1998. George Bush further relaxed banking regulation between 2001 and 2006. Banking deregulation and contagion between investment, commercial, and S&Ls’ is believed to have been a contributor to the credit crisis of 2008 and the S&L crisis of the 1980’s.

e.       Efforts to balance the federal budget in the 1930’s continued even while public works projects were underway. This added fiscal drag to the recovery. Modern economists would have argued for deficit spending.

f.        Unemployment dropped to 15% and was headed lower until…The recession of 1937-8 seems to have been triggered by premature fiscal and monetary tightening in an effort to be “responsible.” Deficit spending for WWII eventually ended the Depression and restored full employment.

If Keynesian economics had existed, Roosevelt might have done better — The General Theory was not published until 1936.