October 9, 2008

The Great Depression

Jon Galane
10 min

Dateline, October 9, 2008. One year ago today the Dow Industrial Average was 14,198. We have just experienced a 40% drop in one short year. Scarier is the 25% drop in the 200 day moving average of the Dow. The volume was the highest since September 19, 2008 when the market started its free fall. October 4, 2002 was the last support level low of 7428 and on October 28, 1997 the Dow was at 7498.

Here are some immediate observations. We have two solid support levels at 7400-7500, at two six year intervals. This is just too much of a coincidence for me. I see a low of 7400-7500 and then a chop between 7400 and 9700 for the next 6-12 months. Within two years we should see a stabilization of the banking and lending scandals.

The problem arises when we see the aftermath of this market over the next four years. This is starting to look eerily similar to 1929 through 1933.

When the market crashed it was just the beginning of the Great Depression. The following five years were the worst for the average American. I see parallel correlations between the two market cycles. First, let’s get a background on the Great Depression.

The Great Depression in the United States began on October, 29, 1929, “Black Tuesday” with the Wall Street crash which rapidly spread worldwide. The market crash marked the beginning of a decade of high unemployment, poverty, low profits, deflation and lost opportunities for economic growth and personal advancement in the United States. Although its causes are still uncertain, the basic cause was a sudden loss of confidence in the economic future.

The traditional explanation is a combination of high consumer debt, ill-regulated markets that permitted malfeasance by banks and investors, cutbacks in foreign trade, and according to some, growing wealth inequality. All interacted to create a downward economic spiral of reduced spending and production. The initial government response to the crisis exacerbated the situation; protectionist policies like the 1930 Smoot-Hawley Tariff Act, rather than helping the economy, merely strangled global trade. Industries that suffered the most included agriculture, mining and logging as well as durable goods like construction and automobiles that people postponed purchasing.

In the chart below let’s focus on Gross Domestic Product from the start of Black Tuesday in October of 1929 until the end of 1933. This is exactly what I see happening from October 2008 until the end of 2012. I see the duplicity, either real or perceived market coincidences, both in the stock market and real estate markets. Only we shall call this Black Thursday, followed by a rapid worldwide spread of banking failures, insolvent countries, high consumer debt, according to liberals of the day wealth inequality, ill-regulated markets that permitted malfeasance by banks and investors and cutbacks in foreign trade, interacting to create a downward economic spiral of reduced spending and production.

Gross domestic product as shown in the chart below was at its all time high prior to the market crash of 1929. We have just officially reported our first quarter of falling domestic product since 2002 – note the resemblance to 1921. Oil is currently falling at an incredible pace with a price of $70.00 on October 16, 2008. Housing continues to fall and foreclosures increase.


We have just witnessed the passing of what I call the RAT Act, my version of the rescue plan bill. Thus, giving the government too much power and too much money to fix a problem that was created by greed in congress, Fannie Mae and Freddie Mac, poor decision making by homeowners and then bad loans being sold to brokerage firms and banks. So even though everyone wants to blame Wall Street for this, they are really taking the fall for everyone else. It is also faithfully used by Venezuela and Cuba. Let’s examine the policies of the two presidents presiding over the Great Depression:

Herbert Hoover (1929-1933). He promoted government intervention under the rubric “economic modernization.” in the presidential election of 1928, Hoover easily won.

Hoover tried to combat the Depression with government action, none of which produced economic recovery during his term. The consensus among historians is that Hoover’s defeat in the 1932 election was caused primarily by failure to end the downward spiral into a deep Depression, compounded by popular opposition to prohibition.

Congress approved the Smoot-Hawley Tariff Act in 1930. The legislation, which raised tariffs on thousands of imported items, was signed into law by President Hoover in June of 1930. The intent of the Act was to encourage the purchase of American-made products by increasing the cost of imported goods, while raising revenue for the federal government and protecting farmers. However, economic depression now spread through much of the world, and nations outside the U.S. increased tariffs on American-made goods in retaliation, reducing international trade and worsening the Depression.

By 1932, the Great Depression had spread across the globe. In the U.S., unemployment reached 24.9%, a drought persisted in the agricultural heartland, businesses and families defaulted on a record numbers of loans, and more than 5,000 banks failed.

The final attempt of the Hoover Administration to rescue the economy was the passage of the Emergency Relief and Construction Act which included funds for public works programs and the creation of the Reconstruction Finance Corporation (RFC) in 1932. The RFC’s initial goal was to provide government-secured loans to financial institutions, railroads and farmers. The RFC had minimal impact at the time, but was adopted by Franklin D. Roosevelt and greatly expanded as part of his New Deal.

The Economy

In order to pay for these and other government programs, Hoover agreed to one of the largest tax increases in American history. The Revenue Act of 1932 raised income tax on the highest incomes from 25% to 63%. The estate tax was doubled and corporate taxes were raised by almost 15%. Also, a “check tax” was included that placed a 2-cent tax (over 30 cents in today’s dollars) on all bank checks. Economists William D. Lastrapes and George Selgin concluded that the check tax was “an important contributing factor to that period’s severe monetary contraction.” Hoover also encouraged Congress to investigate the New York Stock Exchange, and this pressure resulted in various reforms.

Franklin D. Roosevelt blasted the incumbent for spending and taxing too much, increasing national debt, raising tariffs and blocking trade, as well as placing millions on the dole of the government. Roosevelt attacked Hoover for “reckless and extravagant” spending, of thinking that “we ought to center control of everything in Washington as rapidly as possible,” and for leading “the greatest spending administration in peacetime in all of history.” These policies pale beside the more drastic steps taken later as part of FDR and the New Deal. =

Franklin D. Roosevelt (1933-1945). He caused a realignment political science called the Fifth Party System. His aggressive use of the federal government created a New Deal Coalition which dominated the Democratic Party until the late 1960s. Roosevelt introduced new taxes that affected all income groups. Conservatives ehemently fought back, but Roosevelt usually prevailed until he tried to pack the Supreme Court in 1937. He and his wife, Eleanor Roosevelt, remain touchstones for modern American liberalism.

Roosevelt’s administration redefined American liberalism and realigned the Democratic Party based on his New Deal coalition of labor unions; farmers; ethnic, religious and racial minorities; intellectuals; the South; big city machines; and poor workers on relief.

The First New Deal (1933-1934)

  • Recovery was pursued through “pump-priming” (that is, federal spending). The NIRA included $3.3 billion of spending through the Public Works Administration to stimulate the economy. Roosevelt created the largest government-owned industrial enterprise in American history, the Tennessee Valley Authority (TVA), which built dams and power stations, controlled floods, and modernized agriculture and home conditions in the poverty-stricken Tennessee Valley.
  • In a controversial move, Roosevelt gave Executive Order 6102 which made all privately held gold belonging to American citizens the property of the US Treasury. This gold confiscation by executive order was argued to be unconstitutional, but Roosevelt’s authority to do so was based on the “War Time Powers Act” of 1917. Gold bullion remained illegal for Americans to own until President Ford rescinded the order in 1974.

Economic Environment

Government spending increased from 8.0% of gross national product (GNP) in 1932 to 10.2% of the GNP in 1936. The national debt as a percentage of the GNP had doubled from 16% to 33.6% of the GNP in 1932. Roosevelt’s emergency budget was funded by debt, which increased to 40.9% in 1936.
Unemployment fell in Roosevelt’s first term, from:

  • 25% when he took office
  • 14.3% in 1937
  • 19.0% in 1938 (‘a depression within a depression’)
  • 17.2% in 1939 because of various added taxation (undistributed profits tax in March 1936, and the Social Security Payroll Tax in1937, plus the effects of the Wagner Act; the Fair Labor Standards Act and a blizzard of other federal regulations)
  • Stayed high until almost vanishing during World War II

During this time the previously unemployed were drafted into the military taking them out of the potential labor supply number.
I see two possible market scenarios that could be produced by the current market conditions. The most dangerous is high unemployment with increased taxation and deflation. These would be the triple threat that could throw us into the second great depression of American history. The second scenario and most likely is stagnation: inflation with a deflationary economy.

Deflation is the opposite of inflation. Therefore, under the usual contemporary definition of inflation, ‘deflation’ means a decrease in the general price level. Alternately, the term was used by the classical economists to refer to a decrease in the money supply.

In economic theory, deflation is a general reduction in the level of prices, or of the prices of an entire kind of asset or commodity. Deflation should not be confused with temporarily falling prices; instead, it is a sustained fall in general prices. That is, there is a fall in how much the whole economy is willing to buy and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity – contributing to the deflationary spiral.

Since this reduces capacity, investment also falls, leading to further reductions in aggregate demand. This is the deflationary spiral. The solution to falling aggregate demand is stimulus either from the central bank, expanding the money supply, or by the fiscal authority to increase demand and borrow at interest rates which are below those available to private entities. It seems that Hank Paulson and Ben Bernanke believe this is in the wings and they, as well as congress, have already spent over $3 trillion of our tax dollars this year to expand money supply and reduce interest yet again.

In more recent economic thinking, deflation is related to risk – – when the risk adjusted return of assets drops to negative, investors and buyers will hoard currency rather than invest it, even in the most solid of securities. In a closed economy, this is because charging zero interest also means having zero return on government securities, or even negative return on short maturities. In an open economy it creates a carry trade and devalues the currency producing higher prices for imports without necessarily stimulating exports to a like degree. We have also seen this scenario over the last six months.

In modern economies, as loan terms have grown in length and financing is integral to building and general business, the penalties associated with deflation have grown. Since deflation discourages investment and spending, because there is no reason to risk on future profits when the expectation of profits may be negative and the expectation of future prices is lower, it generally leads to, or is associated with a collapse in aggregate demand. Without the “hidden risk of inflation”, it may become more prudent just to hold onto money and not to spend or invest it.

Studies of the Great Depression by Ben Bernanke have indicated that, in response to decreased demand, the Federal Reserve of the time decreased the money supply, hence contributing to deflation. I believe Mr. Bernanke’s fears of this are unfounded in the current scenario. As with any theorist, he is experimenting with the American economy and the lives of all of us to see if he is right. So far I have seen little evidence that his lowering of rates to save the economy are working. I believe his fear of tightening money due to his incorrect assumptions will lead us quickly where he is afraid of going.

On Monday, October 28, 1929 the first “Black Monday”, more investors decided to get out of the market, and the slide continued with a record loss in the Dow for the day of 13%. The next day, “Black Tuesday”, October 29, 1929, about 16 million shares were traded. The volume on stocks traded on October 29, 1929 was “…a record that was not broken for nearly 40 years, in 1968.” Author Richard M. Salsman wrote that on October 29 – amid rumors that U.S. President Herbert Hoover would not veto the pending Hawley-Smoot Tariff bill – stock prices crashed even further. William C. Durant joined with members of the Rockefeller family and other financial giants to buy large quantities of stocks in order to demonstrate to the public their confidence in the market, but their efforts failed to stop the slide. The DJIA lost another 12% that day. The ticker did not stop running until about 7:45 that evening. The market lost $14 billion in value that day, bringing the loss for the week to $30 billion, ten times more than the annual budget of the federal government.

The 2008 Budget for the United States is $2.9 trillion. It has been estimated that $6 trillion or double the current budget has been lost in the market. Unemployment has risen steadily from a low a year ago of 4.7% to 6.1%.

Stagnation the second scenario is out of control inflation from artificially loosening money supply, keeping rates low devaluing the dollar. Does anyone remember 1973 through 1983? I believe this is the more likely scenario as a result of the current economic policies

Energy Crisis

Let’s look back to Jimmy Carter for insight on this scenario:

In 1973, during the Nixon Administration, the Organization of Petroleum Exporting Countries (OPEC) agreed to reduce supplies of oil available to the world market. This sparked an oil crisis and forced oil prices to rise sharply, spurring price inflation throughout the economy and slowing growth. Significant government borrowing helped keep interest rates high relative to inflation. I remember hearing a speech about six months ago that the leader of OPEC gave in which he refused to increase production and that he expected to see oil at $170 by the end of the year. I believe history will show that this speech, the devaluation of the dollar and the speech by Barnie Frank (head of the congressional banking committee) in July of 2008 singing the praises of Fannie Mae and Freddie Mac as strong, and that there was not a mortgage crisis, will mark the incompetence that will eventually throw us toward this scenario.

Carter told Americans that the energy crisis was “a clear and present danger to our nation.” In 1977, Carter had convinced the Democratic Congress to create the United States Department of Energy (DOE). Promoting the department’s recommendation to conserve energy, Carter wore cardigan sweaters, had solar hot water panels installed on the roof of the White House, had a wood stove in his living quarters, ordered the General Services Administration to turn off hot water in some federal facilities, and requested that Christmas decorations remain dark in 1979 and 1980. Nationwide controls were put on thermostats in government and commercial buildings to prevent people from raising temperatures in the winter (above 65 degrees Fahrenheit) or lowering them in the summer (below 78 degrees Fahrenheit). Polices all which led to the greatest period of stagflation our country has ever seen.

As reaction to a perceived “energy crisis” and growing concerns over air pollution, Carter also signed the National Energy Act (NEA) and the Public Utilities Regulatory Policy Act (PURPA). The purpose of these watershed laws was to encourage energy conservation and the development of national energy resources, including renewable sources such as wind and solar energy. None of which has produced any significant results as to energy conservation or reduction in oil usage, but have proven insurmountable strangleholds on the private sector from producing usable clean sources to produce energy.
Economy: stagflation and the appointment of Volcker

During Carter’s administration, the economy suffered double-digit inflation, coupled with high interest rates, oil shortages, high unemployment and slow economic growth. Productivity growth in the United States declined to an average annual rate of 1%, compared to 3.2% in the 1960s. There was also a growing federal budget deficit which increased to $66 billion dollars.

The 1970s are described as a period of stagflation, as well as higher interest rates. Price inflation (a rise in the general level of prices) soured creating uncertainty in budgeting and planning. In the wake of a cabinet shake-up in which Carter asked for the resignations of several cabinet members (see “malaise speech” below), Carter appointed G. William Miller as Secretary of the Treasury. Miller had been serving as Chairman of the Federal Reserve Board. To replace Miller and in order to calm down the market, Carter appointed Paul Volcker as Chairman of the Federal Reserve Board. Volcker pursued a tight monetary policy to bring down inflation, which he considered his mandate. The economy slowed further and unemployment rose, prior to any relief from inflation. The stock market and home ownership suffered greatly due to these policies and the short and long term outcomes. It was not until well into the first term of Ronald W. Reagan before new policies and tax relief began to reverse the severity of the Carter years.

Led by Volcker, the Federal Reserve raised the discount rate from 10% when Volcker assumed the chairmanship in August 1979 to 12% within two months. The prime rate hit 21.5% in December 1980, the highest rate in U.S. history under any President. Investments in fixed income (both bonds and pensions being paid to retired people) were becoming less valuable. The high interest rates would lead to a sharp recession in the early 1980s.

When the energy market exploded Carter was planning on delivering his fifth major speech on energy; however, the American people were no longer listening. His pollster told him that the American people simply faced a crisis of confidence. On July 15, 1979, Carter gave a nationally-televised address in which he identified what he believed to be a “crisis of confidence” among the American people. This came to be known as his “malaise” speech, although the word never appeared in it, here is an excerpt from that speech:

“…The threat is nearly invisible in ordinary ways. It is a crisis of confidence. It is a crisis that strikes at the very heart and soul and spirit of our national will. We can see this crisis in the growing doubt about the meaning of our own lives and in the loss of a unity of purpose for our nation.

In a nation that was proud of hard work, strong families, close-knit communities, and our faith in God, too many of us now tend to worship self-indulgence and consumption. Human identity is no longer defined by what one does, but by what one owns. But we’ve discovered that owning things and consuming things does not satisfy our longing for meaning.
I’m asking you for your good and for your nation’s security to take no unnecessary trips, to use carpools or public transportation whenever you can, to park your car one extra day per week, to obey the speed limit, and to set your thermostats to save fuel… I have seen the strength of America in the inexhaustible resources of our people. In the days to come, let us renew that strength in the struggle for an energy-secure nation…”

It seems no matter what pundit is speaking the only disagreement seems to will we be in a deep recession or a depression? Although my thoughts lead toward the deep recession with stagnation, neither situation is particularly tasteful medicine. I believe the stock market will not recover from its almost 50% loss for at least ten years. That would be a 10% average annual rate of return on stock investments from the low of about 8,000 on the Dow Jones Industrial Average.

I believe that bonds have yet to see the worst point and that bond prices could feasibly fall between 50% to 90% in the next 24 months depending on who is president. Bonds are not a safe haven under either of the two economic scenarios I posed. Real estate, however, has in the past kept pace with inflation. Under the recessionary scenario, this means if we end up with interest rates of 10% or higher, real estate would see a 100% growth rate in ten years. In a depression scenario, the growth rate could be quite a bit higher as people would need lower rents and not have the ability to buy real estate. This could lead to tremendous opportunities in the next two years as the economy deflates. The rebound will create the need to purchases homes, driving prices up to pre 2006 levels in a matter of the next five years. This is a possible rate of return in excess of 20% a year or 200% over the next decade.

It is important to note that we are at the beginning of a very difficult period and that nothing will happen quickly. Those who are patient and willing to be a contrarian, that is, when there is fear buy, and greed sell, will reap the rewards of past successful investors during both the depression and stagflation economies.

At least in the white house, I suspect spending will come to a halt thus increasing the likelihood of a longer recession, but create greater growth as the economy recovers. Interest rates will find a reasonable median point, housing and the markets will return to pre-crisis levels sooner and future growth will be sustained over a much longer period of time. Ownership of Department of Treasury securities around the world and especially by China will go down significantly creating a stronger dollar and higher degree of national security.

For more information on the economic conditions we currently face, or the ways in which you can take the greatest advantage of self-directing your IRA or 401(k) into real estate related investment and the advantage of hard assets over paper assets please contact: Mountain West IRA, 866-377-3311.

Jon A. Galane was a Vice President and Sales Manager of the Morgan Stanley Las Vegas complex. Jon is now principal and CEO of Mountain West IRA. Mountain West IRA has offices in Salt Lake City, Utah and Boise, Idaho.

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