Lessons from a 1930s rebound that petered out

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Our capacity to learn from the Great Depression is limited because we do not know how economies would have evolved after 1938 if politics had not supervened.

General Electric, bellwether of corporate America, has cut its dividend – its first reduction since 1938. This year we will probably see the largest reduction in dividends since 1938. But 1938 is not generally remembered as a remarkable year in economic history. What happened?

An explanation takes us back to the history of the Great Depression, as recounted entertainingly by J.K. Galbraith and influentially by Ben Bernanke, chairman of the US Federal Reserve. The Wall Street crash of 1929 was not, initially, a dramatic event: by the standards of more recent history, the share price correction was modest. What was remarkable was that the share price decline went on and on. By 1933, US equities had lost three-quarters of their 1929 value.

There is not much dispute that government actions after 1929 made the crisis worse, even if there is still controversy about the relative contributions of restrictive fiscal policy, inept monetary policy and protectionist trade and financial strategies. When President Franklin Roosevelt took office in 1933, America’s monetary system had reached the point of collapse.

Whatever Wall Street financiers thought of Roosevelt’s New Deal, markets responded positively. Stocks doubled in value in 1933, and their ascent continued until 1936. US gross domestic product, which fell precipitously in 1929-33, made a modest recovery in Roosevelt’s first term.

As they often do, markets anticipated movements in the real economy. In 1936 the stock market stalled and fell back. From 1937 to 1938, US GDP dropped more than 3 per cent. The effect on corporate profits was particularly marked: down by 40 per cent, they led companies to reduce dividends by more than 30 per cent. Only preparation for war and involvement in hostilities from 1941 pulled America out of depression.

The European experience was more mixed and more complex. Britain never enjoyed America’s 1920s boom. Plagued by Winston Churchill’s return, as chancellor of the exchequer, to a substantially overvalued exchange rate in 1925, the British economy grew little in the years that followed. The rebound, after the Gold Standard was abandoned in 1931 and interest rates reduced, was earlier than America’s. But Britain’s recovery, too, petered out after 1936. GDP would almost certainly have fallen between 1938 and 1939 had not public expenditure risen dramatically – by about 50 per cent from 1936 to 1939. Whatever politicians said in public, economic statistics tell a story of active preparation for war.

Experience of the Great Depression reveals that economic downturns can last a long time, and that markets can rebound sharply but sometimes ephemerally. Perhaps the clearest lesson, but we hope an irrelevant one, is that war is good for output, employment and corporate profits.

Yet there is another, perhaps no less gloomy, way to draw parallels between the present crisis and the Great Depression. From this perspective, we are not at the start of the crisis but several years into it. The analogue of the 1929 Wall Street crash is not the 2007 credit crunch, but the bursting of the New Economy bubble in 2000. The follies of the 1990s resembled those of the 1920s, as Galbraith’s readers know. The underlying structural weaknesses of the world economy – US budget and trade deficits financed by Asian surpluses – re-emerged in 2000 after being disguised by the imaginary wealth of the New Economy.

The difference between the years after 1929 and the years after 2000 is that the policy mistakes were almost opposite. This time monetary and fiscal policies were strongly expansionary from the outset. These measures led to a wide boom in asset prices, extended unsustainable credit levels and induced further growth of the fundamentally flawed financial infrastructure on which the 1990s boom had been based.

In 1937-38, markets and business leaders came to doubt the durability of the business foundations on which partial recovery from the Great Depression had been built. In 2007-08, markets and business leaders came to doubt the durability of the financial foundations that had supported consumption and asset price growth after the New Economy fiasco.

Our capacity to learn from the Great Depression is limited because we do not know how economies would have evolved after 1938 if politics had not supervened. Life, said Kierkegaard, is understood backwards but must be lived forwards.

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