Boom & Bust 1929 to 2007 (Feature Article)

Economic policies, monetary policy normalisation decisions and geopolitics have been brought back into the spotlight over the last 12-18 months. From Brexit, Trump’s election, US Tax Reform, Trade Reform Retrogression and North Korea-South Korea geopolitical gyrations to name a few have kept financial markets, big industry and policy makers on their toes. This of course creates opportunities for new business ideation, innovation and disruption within our global market place.

With this in mind, this full feature article focuses on the comparison of the Great Depression of 1929 relative to the Global Financial Crisis (GFC) of 2007. Superfluous amounts of documentation, commentary and findings have arisen since the cataclysmic events of the GFC of July 2007 to June 2009. The purpose of this feature article is to truly determine how effective policy responses were during both events and determining whether the GFC was an unique event.

The periods from 1882 to 2009 are extensively reviewed, and a historical montage is formed in conveying this precise message. Substantial evidence is conveyed to ensure the reader ascertains the patterns that emerge in market-based economies.

Headlines during the Great Depression (L), and the GFC (R)

Pervasive government policies typically lead to negative and as will be exhibited have polar opposite effects from their benevolent intentions. Restoring confidence in the global financial system is of utmost importance to this expose, and therefore the policy implications to be presented are aimed toward bringing balance to market-based economies after such a tumultuous Global Financial Crisis.

“…define and deeply analyse history’s crises, through comparing and contrasting key issues and ascertaining if there indeed is a case for the GFC being unique.”

From the onset, we must define what it means for something to be unique. Oxford Dictionary defines unique as ‘Being the only one of its kind; unlike anything else’ (1). The seminal dates of the Great Crash occurred during 28th – 29th October 1929, known as Black Monday and Black Tuesday respectively. The Great Depression immediately ensued from The Great Crash through to the year 1939 (2).

Chart 1: The Dow Jones Industrial Average Index (DJIA), 1918-1940

Ref.1 DJIA 1918-1940

Chart 1 (Macrotrends 2018) (3); vertical axis indicates the $USD nominal values rebased for October 1915=100 of the DJIA stock market index between the years 1918 to 1940. The 1920’s was a period referred to as the ‘Roaring 20’s’, from the evident stock market boom at its peak of 380.33 in August 1929.

The period during 1929-1933 witnessed almost 6,000 commercial bank suspensions, and over one million dollars (USD $18.5M, 2016) in losses borne by commercial bank depositors (4). John Maynard Keynes and his contemporaries believed that the Federal Reserve did all it could through its stimulative policies to reduce the severity of such a tumultuousness event. Peter Temin concluded that before the money supply fell, prices were already falling (Kindleberger & Aliber 2011) (5). Monetarists, on the other hand, refer to Milton Friedman and Anna Schwartz, who point out that indeed the monetary authorities acted in a manner inconsistent with their purpose of injecting liquidity in the banking system in times of crisis. This, being their responsibility as per the Federal Reserve Act of 1913. Friedman continues, indicating how the US monetary authorities allowed the monetary base to shrink, leading to the quantity of money to decline by one third over 1929-1933 (Friedman 1968) (6).

Kindleberger & Aliber (2011) (5) connect the similar features between the 1882 French Bank Crisis and the Crash of 1929 with the expansion in the use of, and speculation in call money. The high leverage in margin credit meant buyers of stocks were required by brokerage firms to provide a 10 percent down with the remaining 90 percent borrowed. From end of 1926 to early October 1929 the volume of call loans had risen by 220%. The warning signs were echoed in the market when in February 1929, Paul Warburg one of the founders of the Federal Reserve Bank System, made an address saying; US stock prices were too high likening the situation to the 1907 Bankers’ Panic. Additionally, the then Chairman of the Federal Reserve Board made a similar statement (5). Their statements however, could not stop the impending Great Crash, as presented by Chart 1; stock prices continued trending upward till August 1929.

“Policy mistakes will be brought into the spotlight, addressing its effects on the US housing & equity markets. Additionally, drawing attention to the decisions of the US Federal Reserve during the period of 1988 to 2009.”

Questions begin to emerge as to how policy decisions can be implemented to bring about ideal effects on market-based economies. A policy designed to alleviate shocks, and to not allow the market to reach such lows as seen during 1929 and the Great Depression. The extend of globalisation relative to the early 20th century has brought about greater degrees of financial market integration with instantaneous transactions around payments, lending and borrowing for economic agents. Financial regulation is a fiercely contested topic and the book; Money, Information and Uncertainty, sheds light on the economic climate leading up the 1980’s. Theoretical critique for the use of regulation was commonplace, ‘… regulation distorts, misallocates, and restricts competition and raises prices to the consumer as a generality – is widely represented.’  (Goodhart 1989) (7).

A slew of key regulation was repealed and introduced during the 1980’s. Glass-Steagall Act of 1933 restricted banks from dealing with profitable activities. Eventually, in 1987 the Federal Reserve authorised one of the first subsidiaries to create a structured investment vehicle (SIV) which generated up to five percent in net earnings from its activities. The Basel Accord of 1988, and the Gramm-Leach-Bliley Act of 1999, were instrumental in allowing bank-holding companies to explore all avenues of financial activities which were not viable nor possible under an originate and hold banking model, and previous regulatory confinements.

The tectonic shift to the originate and distribute banking model, was pivotal in bringing about speculative behaviour in the US realty market (refer Chart 2) which additionally ran into equities (refer Chart 3), and the affects thereof seen at their peaks in 2006 to 2007. Banks now had less pressure to raise capital in their liabilities, as they sold their securitised loans to their special purpose entities (SPE), which in turn reduced their loan books and increased cash assets on the balance sheet. Government sponsored agencies (GSE) such as Fannie Mae and Freddie Mac were incentivised into buying mortgage backed securities, with Taylor (2008) writing that these agencies and the list of government interventions were intrinsic to, and the hallmark of the GFC.

Chart 2 – US Housing Starts per Month – (1990-2010)

Housing Starts USA 89'-2010'

Chart 2 (Macrotrends 2016) (8); brings to life the extent of housing starts per month in the US from the key period between 1988 to 2010. The peak of the housing starts boom is 2,273 in January 2006. By March of 2009, housing starts fell to 478, down by almost 80 percent.

The policies pursued provided the extra spice needed for the housing boom to continue to its peak, and cannot be any more clearly shown, than in Chart 2.

Chart 3 – S&P500 Index (1988-2010)

S&P500 - 88-10

Chart 3 (Yahoo! Finance 2016) (9); portrays the S&P500 index peaking at $1,518 in August 2000, then again at $1,550 in October 2007.

It is without doubt that the repealing and introducing of new financial reform was at the forefront of producing such amplified booms and busts, seen in Chart’s 2 and 3, during the period of 1988 to 2010. Additionally, it can be further propounded that the policy pursued by the US monetary authorities, was immensely inflationary and incorrect, given hindsight. Further, these policies left economies post-GFC with a new issue to deal with, in the form of zero lower bound and stagflation. Exploring the low climate of global interest rates is beyond the scope of this full feature article, yet addressing it is imperative to obtaining a richer understanding of the GFC. Near zero interest rates cause a liquidity trap for central banks and renders stimulative monetary policy impotent.

Chart 4 – US Fed Funds Rate Spread (1988-2010)

4. Fed Future Funds Rate Spread 90'-2010'

Chart 4 (TradingEconomics 2016) (10); illustrates how drastically loose monetary policy was after the dotcom bubble up until mid-2004. The excess liquidity can be seen inflating both the US realty market and the equities market in Chart’s 2 and 3 respectively.

Chart’s 2 and 3 vividly depict the US housing and equity markets over heating, Chart 4, shows the audience that the FED under Bernanke were in damage control. Policy makers could see that the post-dotcom bubble stimulus only added wind to the sails of the impending housing market collapse in 2007.

“…focus on how policy decisions altered economic agent behaviours, and distorted market signals in market- based economies, across the globe.”

Issues pertaining to the banking crises are the net effects of microeconomic distortions, too commonly resulting from government subsidisation of risk (Calomiris 2011) (11). What arose from 1988 to 2006 was a banking system which had reason to expand the scope of participation into risky activities. Activities, where:

  1. Banks originate assets
  2. Manage assets In SPE’s
  3. Provide underwriting of securities which were collateralised with the initial assets they had originated
  4. Service and collect fees from the originated assets

The consequent mortgage backed securities (MBS) and the collateralised debt obligations (CDO) required a favourable credit rating in order for institutional investors to purchase such securities. Credit rating agencies (CRA) rated the MBS and CDO products in a convoluted fashion, which, at heart, was flawed. The rating process involved using the historical default risk on mortgages, prior to the use of MBS and CDO products, as well as, mortgages that were a part of the old originate and hold banking model.

Chart 5 – CDO Issuance in Billions (2004-2008)

CDO Issuance $Bil

Chart 5 (Barnett-Hart 2009) (12); displays the CDO issuance boom, peaking at over $180Bil in Q1 2007, to eventually imploding by 92 percent in only 12 months. Explanations of such behaviour by banks, the shadow banking system, financial institutions and government sponsored enterprises, were under the political mantra of improving affordable housing which had tremendously negative microeconomic ramifications. (Calomiris 2011) (11) Strictly indicates the government sponsorship of mortgage risk, as the key factor in such behaviours seen in Chart 5.

Credit evaluation was an essential function under the originate and hold banking model, whereby, banks where directly responsible for the assets held in their loan books, and so therefore, would not lend to borrowers who failed their credit risk evaluation. However, under the new originate and distribute model, banks were handing out NINJA loans (No Income, No Jobs, No Assets) to borrowers. The surge in subprime lending, flowed from the demand for origination by banks, regardless of the poor-quality credit attributes of borrowers. Subprime carried heightened risk, relative to the mortgage securities prior the banking system shift in the late 1980’s. Put in plain English, there was never an easier time to obtain a home loan in the US, and, never a worse type of debt floating around in financial markets. The credit ratings by ratings agencies were severely skewed for various reasons, some of which being:

  • The combination of government sponsored risk
  • Government policy push for ‘affordable housing’
  • Extremely loose monetary policy
  • The banking model shift from; originate and hold, to an originate and distribute model

Critically, however, before the complex structured finance products such as the MBS and CDO’s could enter the market for institutional investors, the rating agencies had to assess and approve these products as triple-A. Moral hazard was intrinsic to the three main rating agencies, as they were remunerated for rating the product. If one chose not to, clients could, and did, go for a seven-and-a-half-minute walk to a competitor who would obtain their business.

Chart 6 – House Price Appreciation in 6 Countries (2002-2008)

FCIC Increased Housing Price Index 6 Countries

Chart 6 (FCIC 2011) (13); visualises the rapid increase in house prices in six countries including the US and Australia. It is quintessential to understand that the rapid movement observed in equities, realty and instruments such as CDO’s and MBS’s (having their origins in realty), model the aggregate behaviour of all economic agents within the US and indeed across the globe. What is invariably obvious given the aforementioned policies and charts, is that they became the proverbial carrot dangled before the faces of economic agents, to get involved and buy in, of which, many found irresistible.

In such an expansionary environment, investment decisions were concentrated toward high growth areas, further distorting the evaluation of risk, over-borrowing and over-investment in these high growth markets (Kregel 2008) (14). Calomiris, like Taylor, agree that loose monetary policy, in combination with global instabilities acted as the tipping point for the subprime crisis.

Securitisation, however, was not just a recent phenomenon. A high degree of securitisation occurred during the roaring 1920’s, for the funding of residential and commercial construction. The commercial backed securities market was affected prior to the stock market crash of 1929, precisely the reason for the continued surge in the US stock market, up till it’s peak in August 1929 seen in Chart 1.

“Regulatory arbitrage, implicating the banking, shadow banking and the financial system. With a spotlight on the Australian financial policy landscape.”

The insolvency of banks occurs from a drying up of credit. Consider the polar opposite, do banks that have 100 percent deposit insurance (DI), experience a lack of banking prudence, ill-discipline, biased advantage, opportunity for regulatory arbitrage? The answer is, yes! They do. Any business declares insolvency when their liabilities have exceeded their assets, and, as Goodhart (2008) (15) many people would support the unlimited shareholder liability precedent that was in action prior to regulatory interference in the late 1980’s. The key reasoning behind this stance is, that it requires no taxpayer recapitalisation.

Financial regulation has behavioural qualities that are worth discussing. Over regulating a sector, reduces profitability opportunities, thus, incumbents move their operations into un-regulated sectors. Capital requirement regulation, engenders regulatory arbitrage and spurs banking intermediaries to shift their playing field from the banking system into the shadow banking system (16). Non-regulated sectors are affected first during an economic shock, case in point with SPE’s and conduits during the GFC (17). The policy implication here is that there should be an allowance for failure in order to avoid the regulatory arbitrage that is brought about from over regulation.

Policy ramifications are not circumscribed to the US financial and banking sectors, but also ring true for the Australian economic landscape. Drawing upon the Financial System Enquiry Final Report (2014) (18) the rhetoric is consistent regarding; ineffective regulatory disclosure, removing explicit and implicit government guarantees, removal of barriers to international and domestic competition and ceasing to transfer banking risk to taxpayers by increasing capital requirements.

The policy implication in response, is that government guarantees introduce covert costs which limit efficiency and competition within the banking sector, and therefore, should be minimised in order to reinforce domestic and international confidence in Australia’s banking sector.

“…alternate perspectives are conveyed and assessed. Along with, offering a concise summary, coupled with final policy implications in response to the Global Financial Crisis…”

The likes of H. Minsky, and, A. Cukierman, agree with certain causes of the GFC explained throughout the five-part series on 1929 to 2007, however, ultimately allude to different policy solutions.

Equations.1

Government policy has outlandishly deviated over the last 23 years since (Minsky 1995) (19). Based on Minsky’s economic intuition, the policy implication here, has to be to rein in government spending through forms of austerity.

Our conclusion to (Cukierman 2011) (20) is that central banks have taken on too many responsibilities from the period of the Great Depression to the GFC date. Monetary policy is inherently a double-edged sword, where financial stability is a trade-off for price stability. Furthermore, suggesting to:

  1. Remunerate regulators on-par with the market institutions they regulate
  2. Limit remunerations within the financial sector
  3. Extend regulation and supervision to all financial institutions

Makes the case for, the overreaching and gross microeconomic distortions spoken of in (Calomiris 2011) (11).

  • Firstly, taxpayer capital would go toward removing the salary differential, which in turn, causes the labour market to bid up their wage to be compensated for avoiding regulation, thus the policy comes to no effect.
  • Secondly, capping remuneration in the financial sector only pushes workers from the regulated to the unregulated sector.
  • Thirdly and finally, extending the scope of regulation to all financial institutions is in total contradiction to the proposed policy implications written in part 4, on regulatory arbitrage, and throughout the expose.

Throughout this five-part expose, the 2007-2009 GFC was analysed with respect to the 1929 Great Crash and the ensuing Great Depression. The findings expressed in and throughout, spell out how the GFC was not an unique event relative to history. Contracting money supply by a third, spelt disaster in prolonging the Great Depression, however, extended periods of ‘loose’ monetary policy were the key protagonist for prolonging the GFC.

This expose points out that policy decisions throughout the 1980s to the 1990s, played instrumental roles in inflating equity, housing and securitised debt markets. Regulation intended to curtail certain banking behaviours indeed had detrimental opposite effects on global markets. The implication for policy in market-based economies is to eliminate the pervasive government policies spoken of throughout, in order to restore and re-balance confidence in global financial markets.

 

References:

(1) Oxford Dictionaries 2018, Oxford University Press <http://www.oxforddictionaries.com/definition/english/unique&gt;.

(2) Richardson, G., Komai, A., Gou, M., Park, D. 2013, ‘Stock Market Crash of 1929’, Federal Reserve History, <http://www.federalreservehistory.org/Events/DetailView/74&gt;.

(3) Macrotrends 2018, Dow Jones Industrial Average Index 1918-1940, <http://www.macrotrends.net/1319/dow-jones-100-year-historical-chart&gt;.

(4) Federal Deposit Insurance Corporation 2005, Federal Deposit Insurance Corporation: The First Fifty Years, <https://www.fdic.gov/bank/historical/managing/chron/pre-fdic/&gt;.

(5) Kindleberger, C. & Aliber, R. 2011, Manias, Panics & Crashes A History of Financial Crisis, 6th edn, Palgrave Macmillan, Basingstoke, Hampshire, pp. 79-89.

(6) Friedman, M. 1968, ‘The Role of Monetary Policy’, American Economic Review, vol. 58, no. 1, pp. 3.

(7) Goodhart, C. 1989, Money, Information and Uncertainty, 2nd edition, pp.195.

(8) Macrotrends 2016, US Housing Starts per Month, <http://www.macrotrends.net/1314/housing-starts-historical-chart&gt;.

(9) Yahoo! Finance 2016, ‘S&P500 Index: 1988-2010’,

(10) TradingEconomics 2016, ‘Fed Future Funds Rate: 1988-2010 <http://www.tradingeconomics.com/united-states/interest-rate&gt;.

(11) Calomiris, C. 2011, ‘Origins of the Subprime Crisis’, Columbia Business School and National Bureau of   Economic Research, pp. 73-91.

(12) Barnett-Hart, A. 2009, ‘The Story of the CDO Market Meltdown: An Empirical Analysis’, Harvard College Cambridge, p. 6.

(13) Financial Crisis Inquiry Commission 2011, ‘Financial Crisis Inquiry Report’, The Financial Crisis Inquiry Commission, Pursuant to Public  Law 111-21, p. 415.

(14) Kregel, J. 2008, ‘Using Minsky’s Cushions of Safety to Analyze the Crisis in the U.S. Subprime Mortgage Market’, International Journal of Political Economy, vol. 37, no. 1, Spring 2008, pp. 3–23.

(15) Goodhart, C. 2008, ‘The regulatory response to the financial crisis’, Journal of Financial Stability, vol. 4, pp. 351-358.

(16) Goodhart, C., Kashyap, A., Dimitrios, P., Alexandros P. 2012, ‘Financial Regulation in General Equilibrium’, AXA Working Paper Series, no. 9, pp. 1-50.

(17) Goodhart, C. 2010, ‘The Future of Finance And the theory that underpins it’, The Future of Finance: The LSE Report, p. 177.

(18) Financial System Enquiry Final Report 2014, Financial System Enquiry Final Report, November 2014, The Australian Government the Treasury.

(19) Minsky, H. 1995, ‘Financial Factors in the Economics of Capitalism’, Journal of Financial Services Research, vol. 9, no. 3-4, pp. 197-208.

(20) Cukierman, A. 2011, ‘Reflections on the crisis and on its lessons for regulatory reform and for central bank policies’, Journal of Financial Stability, vol. 7, pp. 26-37.

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