There are certain stages in our nation’s history that we thought would never be repeated. In fact they should never be repeated. Those that have not learned the lessons from the past are doomed to repeat them. We have learned these lessons, or at the very least should have. For those that have not learned them, there are others that have if we will but listen. Sometimes it becomes a matter of knowing who to listen to. In this world of spin and revisionist historians, it is easy to become confused. Here then is my contribution to the economic world of wonder we are facing.
The current financial crisis we are facing has often been compared to the Great Depression. There may be some similarities and that is disturbing as this need never have happened, but with the passage of the “stimulus bill” it most certainly will turn into another great depression.
First a quick word about the economy and economic cycles. Booms and Busts. They have been with us since the beginning of commerce and will continue to be a major part of any world that consists of trade. The market psychology that comes with it is also nothing new. People get overly exuberant and overly pessimistic at the worst times and that drives the demand side of the supply vs. demand equation to unrealistic levels. Once it gets too far one way or the other, it usually returns to a more normal state but at a pace that catches most people unprepared. When this is done on a large scale it is called a bubble. It is called a bubble because prices grow rapidly and, much like a bubble, from the insertion of air…much of it hot. When a bubble can take no more air yet more is introduced, the bubble pops and everything comes tumbling back to normal waiting for someone to stick their ring in a can of solution, blow real hard and start to create the next new bubble.
We have all experienced bubbles before and sometimes not even realized it. The recent increase and then decrease in the price of oil and gasoline is a great example. The tech stock market that took dot.coms to the stratosphere and then tanked in 2000 is another. The bubble that is getting us today is housing. In order to put this into perspective and compare it to the Great Depression, let us go back to that time and see what was happening.
Most will say that the stock market crash of 1929 triggered the Great Depression while others are looking at other factors such as the governments reactions (actions taken after the fact) as the major cause of the Great Depression. From what I have seen and read, I tend to fall in the later camp.
The stock market crash of 1929 had several factors that came into play but one of the key elements was that fact that you could buy stocks on margin. In other words, you could use debt, or borrow 90% of the price of a stock to purchase it. This is known as using leverage in the investing world. It works great as long as prices are going up. It can kill you when prices go down. Here is how it works.
You buy $100 dollars in stock but you only have to come up with $10 and your broker came up with the other $90. The price of your stock goes to $110 and you sell it. You pay back the broker his $90 plus some interest for borrowing his money, say $1. That leaves you with the remaining $9 as profit and since you only put up $10 of your own money you just made a 90% return on your investment. Pretty sweet deal and way better than the piddley amount you would earn in interest from the bank.
The boom market in stocks that started in the mid 1920’s was making many people very rich, and just like the gold rush it attracted many newcomers, some that knew what they were doing and many that didn’t. It seemed that anybody could invest and make big money, and many did. And when you saw your neighbor making easy money it was natural for you to want to do the same. Pretty soon everyone was trying to jump on the band wagon and make their fortune. Eventually, prices rose to a point that was ridiculous and unsustainable and they started to decline.
When prices decline, those that have leveraged are the ones that are hurt. When the $100 stock goes to $90, and you bought it on margin, you still owe your broker $90. If you sell the stock now and pay off the broker, (and don’t forget you owe him $91 to cover the cost of borrowing) you are left with nothing. Well you don’t want that to happen so you hold on thinking this is a temporary down turn and prices will be heading up again very soon. After all you made this investment to become rich like your neighbor, and everybody is doing it. Pretty soon however the price is $80 and your broker gives you a call and says he needs some money to cover the shortfall. You don’t have any money because you spent your last $10 buying this stock that was going to make you rich. The broker sells your stock and you owe him the difference.
As the broker sells your stock it puts more pressure on the prices and they continue to go down creating a spiral effect. Individuals have to pull money from the bank to pay off their debts. If the stock they bought is used as collateral for other purchases and the value of that collateral declines the other loans are in danger of going into default. As the defaults start in one area they can quickly expand, moving from one area to another by hitting one account and then another. As people scrambled to cover their newly acquired debt and save their personal finances from collapsing, it began to impact other people and business portfolios. They in turn had to struggle to save their finances from collapsing. One person’s pain began to be felt by all.
Now remember that this was nothing new and in reality it was quite common for markets to experience booms and bust. In fact, some areas of some markets have had greater price movements both up and down. Investors have made their millions and lost everything on many occasions and in many different markets even before there was a stock market. You can find books that will describe other markets such as the great tulip market of the 1600’s that went through these outlandish pricing periods. In fact there have been many markets in our lifetime that have experienced extreme boom and bust conditions. Our awareness of them is only brought about by our personal participation or the participation of someone we know. The really big ones are only well known because they impacted a large percentage of the population. Where was the media when you lost all that money on your cabbage patch doll and beanie baby collection?
As a result of the magnitude of the stock market price decline, the impacts spilled out into all aspects of the economy from banks to business to government. The madness of men and markets drove a typical price correction into a recession of large magnitude and that should have been the end of it but then it turned into a depression as a result of the actions taken by the government to correct the problem.
Now before you get me wrong, note that they did do some things right. The margin rates were cut so that investors were no longer able to buy stocks with 10% down. The current rate is 50% which some might think is still high but 2 for 1 is a lot less than 10 for 1. They also strengthened the banking system and regulations for oversight and increased the use of insurance for depositors to restore faith in the banking system.
Unfortunately, the Great Depression also allowed the government to introduce the New Deal. This was one of those giant knee-jerk reactions from government to fix the wrongs of man. What it did was introduce many of the Socialist policies and programs that we face today. It also launched a large “stimulus” package that tried to spend our way back to prosperity. Many would say that it extended the length of the depression many years past its natural length. I would have to agree. Much of the spending went into make work projects where efficiencies and effectiveness were not considered let alone any outcomes beyond the creation of jobs as the objective. We also created the world’s largest legal Ponzi scheme ever known to man…Social Security.
This government driven economy is the very idea we used to find so abhorrent in communist nations and would speak openly against. We used to think that nationalizing any industry was something that only happened in backward third world countries and if anyone even suggested such a thing people would start looking for a hanging rope. Laissez faire has oft been the slogan of a free nation.
Click here to continue to the new Great Depression Pt. 2. or Part 3.
This is Ed Nef with a view from the Farr West.
No comments:
Post a Comment