The U.S. stock market and economy are in much the same place now as they were in 1930.
The U.S. stock market and economy are in much the same place now as they were in 1930.
Seventy-nine years ago, unemployment stood at about 10%, even though the stock market was 40% above its low set in the crash a year earlier. As the calendar moved into 1931, the bottom fell out. Unemployment ultimately hit 25%, while the stock market lost 84% of its value.
Recovery stalled in 1930 due to several ill-advised moves on the part of the Federal Reserve and the Hoover administration. The Fed drained liquidity from the system and raised interest rates, while the president — albeit reluctantly — signed protectionist trade laws and hiked taxes. Those combined actions choked off any possible rebound and led to eight years of Depression.
If policymakers continue along their recent paths, investors should beware that history may repeat itself. Stocks may resume the free-fall they started in September 2008 and housing prices may crumble even more as job losses mount and credit markets seize. The value of the U.S. dollar will plummet, along with stocks, because our low interest rates will induce investors to seek higher-yielding currencies elsewhere. The only safe haven will be Treasury notes and bonds, but only for a short time. Sheer supply coupled with a weak currency will force these credits down, as well.
PROSPECTS ARE GRIM
Recent Fed data suggest that our prospects of avoiding this dire scenario are not good. Growth in bank loans, free reserves and money stock is slowing, which is evidence that the Fed has already begun to remove its stimulus.
The late Nobel laureate Milton Friedman would be concerned with such a policy because he believed that money growth is the key to a strong economy. Opponents of his views argue that the Fed's vigorous expansion of the money supply in the wake of the credit crisis risks hyperinflation. Although that indeed is a possibility, the gap between the level of expansion necessary to create hyperinflation and today's contracting money supply is so large that it would take years to fill.
On another policy matter, Fed Chairman Ben Bernanke believes that healthy banks mean a healthy economy. Mr. Friedman would have maintained that the health of the banking system is no more important than the health of any other sector of the economy.
True to form, Mr. Bernanke's “quantitative easing” policy is aimed at helping banks. It has entailed the purchase of more than $1 trillion of Treasury and agency fixed-income securities earmarked for bank balance sheets, greatly expanding the nation's monetary base. The idea behind this policy is that the fixed-income securities will shore up the banks' capital and that the banks, in turn, will lend that capital. So far, quantitative easing has not worked be-cause banks are not lending.
This is nothing new; the same thing happened during the Great Depression. The Fed bought bonds and posted them to bank balance sheets, yet the banks did not lend.
To get the economy moving, Milton Friedman's advice would have been to inject money directly into the system to boost consumer confidence and encourage spending. Unfortunately, that is the opposite of what is happening now. Consumers are hoarding cash. The velocity of money — or the frequency with which a unit of money is spent in a specific period of time — is currently less than 1, which means that consumers are stuffing dollars into mattresses rather than spending it.
To increase velocity, Mr. Friedman would again have recommended increasing the money supply. Currently, however, the rate of money supply growth is the second lowest of the last four recessions. During the slowdown that followed 9/11 and during the recession of 1980-81, money supply grew at higher rates.
Meanwhile, the Obama administration's policies are compounding the problem. Its stimulus package clearly has protectionist leanings. Organized labor and small U.S. manufacturers won an amendment to the stimulus bill requiring that materials used on construction and infrastructure projects be made in the United States. Further, banks bailed out by the Troubled Asset Relief Program are discouraged from hiring immigrants.
In addition, the administration wants to raise taxes on the rich. The money would be used to pay for the health care plan and to reduce deficits. Proponents of the measure argue that tax hikes will not hurt the economy, because the nation's highest-wage earners have excess discretionary income. But that is precisely the point. The high level of discretionary income among the wealthy supports spending on travel, leisure, private schools, household goods, new cars and real estate. If the tax hikes take hold, there will be less spending. Jobs will be lost and the economy will come under further pressure.
The same can be said for reducing deficits. Although paying down debt sounds prudent, doing so actually forces the economy to contract. At reasonable cost, debt is a vital force in economic growth. At today's 0% Fed interest rate policy, the cost of government debt is at its lowest in history. The government should lock in current interest rates for as far out as possible. When the economy rebounds in the future, the nation will be able to meet the debt load easily and use any additional funds to pay down the deficit at a time when the economy can endure it.
INFLECTION POINT
Just as in 1930, our economy is clearly at an inflection point, and it will not take much to tip the scales. Even Congress has taken note. The Congressional Oversight Panel recently warned that banks still hold many risky loans of uncertain value. If unemployment rises sharply or if the commercial real estate market collapses — as many economists fear is possible — the banking system could again lose its footing, the report said.
The bottom line is that risk still runs rampant. For the equity markets to remain strong, stocks need sustainable earnings, not technical bounces. To achieve that, as well as to employ people and engender confidence, the economy needs whatever stimulus it can get.
Ben Bernanke is focused on the health of banks. President Obama is focused on taxes. While healthy banks and sound tax policy are important, they are micro issues in the midst of a macro problem. Our leaders need to focus on expanding the economy through whatever means are necessary.
Raising taxes, shrinking the money supply and reining in the deficit will not spur growth. In fact, they will damage the nation's ability to create jobs, ease the real estate crisis and put the stock market on a firm foundation.
Today's policies must be put aside for now. Once the economy stabilizes, we will be in a better position to revisit them. But for now, we are far from recovery, and getting further every day.
Jay R. Feuerstein is chief executive and chief investment officer of 2100 Xenon Group LLC, a commodity-trading adviser that provides alternative investment strategies to institutional and retail investors.
