dangerous history lessons: 1929 and analogies with the great

8/14/2019 Dangerous History Lessons: 1929 and Analogies With the Great

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Dangerous history lessons: 1929and analogies with the Great

Recession of 2008

Hans-Joachim Voth


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Key points

Important similarities between 2008 and

the Great Depression Like generals fighting the last war, policy

makers (especially in the US) are treatingthe current crisis as a rerun of 1929

As the biggest economic policy experimentin our lifetime unfolds, we learn about thepast and economics in general andmaybe, we got the history wrong.

If 1929 and 2008 are balance sheetrecessions (like Japan 1989+), currentpolicy probably misguided


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Output, then vs. now


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The effect of banking crises


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The sudden return of history - 2

Recovery because of

End to deflation good side of leavinggold, competitive devaluations

Fiscal stimulus (All those autobahns +rearmament)

Bank stability (nationalizations; bankholidays)


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Early abandonment of gold spurredrecovery


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Central banks then: Villains of thepiece

Monetary policy was tight after1929

Weak LOL policies wide-spread

bank collapse Policy today (Bernanke, Romer):

Rerun of 29-32, with different policy

response


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The sudden return of history

Ben Bernankes

apology:

I would like to say toMilton and Anna:Regarding the Great

Depression. You'reright, we did it. We'revery sorry. But thanksto you, we won't do itagain

What we used to think:Great depression greatbecause of Collapse in money

(Friedman-Schwarz):"the contraction is in facta tragic testimonial to theimportance of monetary

forces." Collapsing banks

(Bernanke) Autonomous declines in

consumption (Romer-Temin)

Bug**r-thy-neighbor(protectionism,competitive devaluations)


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Government deficits are muchbigger


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Interest rates are much lower


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Money supply is way up


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Trade and the GD what do wereally know?


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Maybe its not over yet


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Alternative view (Mellon view)Liquidate labor, liquidate stocks, liquidate the farmers,liquidate real estate it will purge the rottenness out of

the system Values will be adjusted, and enterprisingpeople will pick up the wrecks from less competentpeople.

nominal factor and asset price adjustment inevitableworldwide, synchronized balance sheet recessions are less

susceptible to aggressive monetary and fiscal responses Continue until balance sheets (of surviving) firms,

households strengthened A bit of inflation may help, but the basic dynamics of flows

doing the adjustment to a shock in levels remain If this is so, key question is how do you avoid the

buildup of bubbles and balance sheet fragility in the firstplace?


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Speculative Bubbles and CentralBank Policy

Reasons for a central bank to worry about

bubbles: misallocation of capital during the bubble period

wealth effects during the period of increasing

asset prices may cause overheating in theeconomy, inflationary pressures

sudden collapse of asset prices may amplifyrecession. Asset used as collateral for lending;

process of credit intermediation unravels(Bernanke-Gertler; Miskhin etc.)


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Speculative Bubbles and CentralBank Policy - 2

Reasons not to intervene

difficulty of telling the difference betweenbubbles and asset price increases justified byproductivity gains (Krugman 1999)

generally higher interest rates put a brake oninvestment, consumer spending in the economyat large

simulation studies show that volatility of interest

rates, output, inflation may actually increase ifthe central bank raises targets asset prices(Bernanke and Gertler 1999)


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What to do?

Policy Options for Central Banks

general credit restriction, raising interest rates(historical examples: US 1929, Japan 1989) open mouth operations (Greenspan 1996) surgical strike attempt to limit lending to

stockmarket alone, higher lombard rates, punishment

of banks that fail to curtail lending to thestockmarket, impose higher margin requirements etc.(US 1929, Germany 1927)

Strategies Simulations

Estimating monetary policy rules, weight of assetprices in central bank policy rule

Case studies


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What not to do

German central

bank intervenes inMay 1927

Puts pressure onbanks

Black Friday 13.5.1927

Price collapse by

12%; 25% byyear-end

400

600

800

1000

1200

1400

1600 3

4

5

6

78

1925 1926 1927 1928 1929

Intervention

Dividend Yield

Stock Price Index

Dividend Yield and Stock Prices in Germany, 1925-30


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Central bank analysis

speculation is primarily responsible for the extraordinaryexcesses in terms of equity valuations. There are people who

claim that, at a time when the money market rate is at 5%, a valueof 300 for a share paying a 15% dividend is not too muchI wouldnot like to enter into a theoretical argument, but would like to pointout what the situation in 1913 was like. The yield of fixed securitiesquoted on the Berlin stock exchange was 4.5%. The [dividend] yieldof shares was somewhat lower, 3.97%, since shares offer aspeculative upside. The difference in yield between bonds andshares was a mere 0.5%. Today, we see bonds offering a yield of7.12%, while shares (even if we look at the latest dividend figures)yield 3.44%. That not only means that todays [dividend] yield islower than in 1913, when we [the German people] were richer, butit also means that the difference in yields is more than 3.5%nowThis proves how unhealthy current conditions are;

everybody is buying shares because they think there w ill befuture capital gains - Report of Reichsbank President Hjalmar Schacht to the German

cabinet, May 1927


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Implied rates of dividend growthValuation Measures

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

1926 1927 1928

ImpliedRateofDividendGro

wth

8%

real return on shares, 1870-1913

real return on gold-backed

mortgage bonds + 3%

actual rate of dividend growth, 1870-1913

actual rate of dividend growth, 1925-30


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Fallout

-2

-1

0

1

2

-3

-2

-1

0

1

2

80 85 90 95 00 05 10 15 20 25 30

Reichsbank

intervention

real

stockmarketindex

new shareissues

New share issuance and real stock market index


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Fallout - 2

In 1926, 30% of capitalformation finances via equity

issuance [i]ndustrial leaders declare

that the restriction of bankcredits not only will affectshare prices adversely butalso will handicap theindustrial life of the country.It is pointed out that thereorganisation of Germanysindustries has not beenfinished and can be carriedout successfully only if theBourse is able to absorb the

new shares which Germanysindustries will be obliged tomarket. AP correspondent,May 1927

US slump starts with adownturn of consumption

German slump starts earlier(1927/28) with a fall ininvestment

Weak balance sheets in theGreat Depression Banks very weak due to

equity losses additionalaccelerator effect (historicalcost accounting hides muchof this)

Firm balance sheets weaker less good a risk for loans,etc.


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Where do all the bubbles comefrom?

Keynes (1936)

It might have been supposed thatcompetition between expertprofessionals, possessing judgmentand knowledge beyond that of theaverage private investor, would

correct the vagaries of the ignorantindividual left to himself.


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Where do all the bubbles comefrom?

0.00

0.20

0.40

0.60

0.80

Mar-98 Jun-98 Sep-98 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99 Mar-00 Jun-00 Sep-00 Dec-00

Proportion inves ted in NASDAQ high P/S stocks

Zw eig-DiMenna

Soros

Husic

Marke t Portfolio

OmegaTiger


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Two assets:

t = 0 1

Safe asset: 1 1.5

(variable supply)

Risky asset 1 unit 6 w. pr. 0.25

(fixed supply) costs P 1 0.75

ER = 2.25All investors are risk neutral


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The fundamental

Investors have wealth 1 and invest own money

Equating marginal returns

2.25 = 1.5PF 1

PF = 2.25 = 1.5

1.5


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Intermediated case

Investors have no wealth of their own

They can borrow 1 at date 0 and repay 1.33at date 1 if they can

Lenders cant observe how loans areinvested


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Can P = 1.5 be equilibrium price?

Borrow 1 and invest in safe asset

RSafe = 1.5 1.33 = 0.17

Borrow 1 to buy 1/1.5 units of risky asset

RRisky = 0.25( 1 x 61.33) + 0.75x0 = 0.67 > 0.17

1.5


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What is the equilibrium P?

Since risky asset is in fixed supply, P will be bid up

until returns are equated

0.25( 1 x 6 1.33) + 0.75 x 0 = 1.5 1.33

P

P = 3

Theres a bubble since P = 3 > PF = 1.5


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Implications

Monetary policy a poor tool in

Preventing crises

Dealing with crises

If 1929 and 2008 are balance sheetrecessions

There is very little we can do today,beyond pumping up confidence

The key is avoiding similar imbalances inthe future


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Implications

Avoiding future imbalances

Reduce the strength of the link assetprices confidence (less houseownership, less funded pensions, etc.)

Reduce incentives for bubbles Limit lending, lower L/V

Reign in pay + bonuses

Strengthen short selling, guarantee crediblyopportunities to go short


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Sic transit...

We turn to history when theory fails

Two golden moments for monetary policymakers: 1920s and 1990s/2000s

GD and GR demonstrate how marginal the

fine-tuning of the economic cycle is,compared to the risk of major disruptions

Monetary policy either weak or the wrong

tool altogether (avoidance/dealing with thefallout)

dangerous history lessons: 1929 and analogies with the great

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