By Stephen FoleyFriday, 10 October 2008
Contributed by Nadia
The late John Kenneth Galbraith attributed the longevity of his book The Great Crash 1929 – published in 1955 and never since out of print – to the tendency of history to threaten a repeat. “Each time it has been about to pass from bookstores,” he wrote in a later foreword, “another speculative episode – another bubble or the ensuing misfortune – has stirred interest in the history of this, the great modern case of boom and collapse, which led on to an unforgiving depression.”
So here we are again. The financial crisis that has engulfed credit markets over the past year has finally crashed into the public consciousness, and the question of whether the US is headed for a second Great Depression is now a staple of bar-room debate. Little wonder, this has pushed the old Keynesian economist’s book back into the Amazon charts.
Almost 80 years ago, a financial crisis led directly to an economic catastrophe. The Great Crash 1929 sets out the five routes by which one became the other. Not all have direct parallels today, but some do. All these years later, Galbraith’s book is still essential reading.
The bad distribution of income
The most extreme point for income inequality in the US in the 20th century was 1928, thanks to a financial boom that had handed great wealth to the rich with the funds to play the stock market. Worryingly, we were back at just such an extreme in 2006.
In 1928, the richest 5 per cent of the population took in more than a third of all personal income. They averaged less than a quarter for most of the post-war period, but inequality began to rise sharply from the Eighties. In the past two or three years, the top 5 per cent have again made up to 38 per cent of all personal income, according to US data compiled by Emmanuel Saez, economist at the University of California.
Galbraith argued that an economy that relies on the spending of so few people is less stable, more prone to big swings, than one made up of a broader range of people of more modest means. The rich use their money on consumer luxuries or business investment, which can dry up if they lose a lot of money. The 1929 crash hit the rich hardest; the question today is whether they have shared the same amount of the financial pain from the credit crisis, the plunging stock market and the convulsions in the hedge fund industry.
The bad corporate structure
Galbraith calls it “devastation by reverse leverage”. He describes a corporate pyramid, with vast holding companies controlling large segments of the utility, railroad and entertainment business. Because dividends from subsidiaries were passed up to corporate holding companies, which relied on them to pay the interest on giant debts, an interruption in those dividends would threaten bankruptcy. To avoid that, holding company executives demanded a lock-down on investment throughout the whole structure, exacerbating the depression.
Today, public companies outside the financial sector have generally been less highly leveraged and have enjoyed a long period of strong cash generation, and conglomerates have been out of stock market fashion for a generation. The same cannot be said of the private sector, newly swollen by the private equity boom and a slew of multi-billion dollar buy-outs. The question will be, if there is an economic downturn, how will private equity owners respond to the demands of bondholders in their highly leveraged companies, and whether they have the wherewithal to keep their companies’ investment taps on.
The bad banking structure
“Since the early Thirties, a generation of Americans has been told, sometimes with amusement, sometimes with indignation, often with outrage, of the banking practices of the late Twenties,” Galbraith notes, but surprisingly he absolves most bankers of blame. Many lending practices only looked profligate or foolish when the unprecedented severity of the depression became clear. Rather, the economist blames panicking depositors, who saw the life savings of their neighbours wiped out when one bank collapsed and didn’t wait around to see the same thing happen to them. In the first six months of 1929, 346 US banks collapsed, and that was just the beginning of a series of bank runs.
It was precisely this that led to the creation of a federal deposit insurance scheme in 1933, guaranteeing most people’s savings – a scheme which has so far prevented further banking runs in the US and even managed to oversee the biggest-ever US banking collapse (of Washington Mutual, last month, whose customers were turned over to JPMorgan Chase) without anyone feeling their money was in danger.
So the banking system now is very different, then, to the 1929 era. Whether this time out, Galbraith would so absolve the bankers is unclear. The financial sector had its own version of the corporate pyramid he railed against, and “devastation by reverse leverage” is an apt summation. The sudden reversal of the US housing market and the rising number of mortgage defaults has cascaded up through the financial system, where trillions of dollars of bonds and other derivatives have relied on that underlying income stream for their value. Now we have the lock-down on bank lending, as financial institutions struggle to assess the damage.
The dubious state of the foreign balance
Since the First World War, the US had been a creditor nation, with a trade surplus that it invested by lending to governments abroad. Many of those loans – some of which were long-standing war debts, others of which were simply corrupt loans to cronies – went into default, exacerbating a budget crisis. Today, the US is in the opposite position as a debtor nation.
Poor state of economic intelligence
“To regard the people of any time as particularly obtuse seems vaguely improper,” Galbraith says, “yet it seems certain that those who offered economic counsel in the late Twenties and early Thirties were almost uniquely perverse.”
It was the Depression that gave rise to Galbraith’s beloved Keynesian economics, which argues governments must stimulate demand in response to an economic downturn, not scale back their activities – a response that made matters worse.
The balanced budget was bipartisan doctrine in this Depression era, taxes were raised and spending cut, and the result was that the government helped shrink the economy when it should have been doing the opposite. Republicans pay lip-service to the balanced budget ideal today, and John McCain promised to freeze all government spending in response to the current financial crisis, but he is proposing tax cuts. On the other side, Barack Obama will raise the tax burden on the economy, but has also promised Keynesian-style spending on infrastructure building projects to keep people in work.
The monetary authorities are also much more savvy in the US today. Whereas Galbraith berates the Federal Reserve of the Twenties and Thirties for keeping interest rates high to keep the dollar on the gold standard, as a way of keeping inflation under control, today’s Fed, under Ben Bernanke – a respected scholar and author on the Great Depression himself – has been spraying money into the financial system and cut interest rates repeatedly. Until Wednesday’s co-ordinated cuts, the European Central Bank, with its inflation-only mandate, might have been open to Galbraith’s criticism of inflation hawks of the Depression (“They were serving only as the custodians of bad memories”). Not today. For all the parallels, it is different this time.