Why This Won’t Be Like 1929

March 8, 2009 by Joe Ponzio

Let me continue this economic discussion, though I also have to get back to a few other topics as well. There is a lot of chatter as to whether we are in a recession or depression. Since November of 2007, Wall Street has been calling bottoms to this market, first setting their sights on Dow 13,000, and then incrementally lowering their targets by 1,000 points as time marched on.

Optimism and pessimism have no place in investing. Let’s look at the economy from a realistic perspective to see why this recession will be nothing like the Great Depression.

The Consumer Who Spent Too Much

Let’s face it: The United States has a consumer-driven economy. Some will have you believe that this is exactly why we are headed for a depression. “You can’t rely on the consumer! It’s fake growth! You have to manufacture! You have to produce!”

In theory, that makes a lot of sense. How long can an economy prosper, if at all, if it primarily relies on consumers and consumer spending?

If we are to believe that an economy can’t rely primarily on consumers and consumer spending, the entire US economy’s growth has been a sham. Not just recent growth, but the majority of growth for the past seventy years.

See, since 1929 (the earliest GDP data available at the BEA), consumer spending has made up 65.8% of GDP, on average. That is, we have always been a consumer-driven economy.

Over the past two decades, the problem with the US consumer is that (s)he started spending a bit too much. Ours is not a country of debt-laden, useless, broke slobs. In fact, by merely saving an extra 8% to 10% of her paycheck, Jane American can be financially stronger than she’s ever been in the past (save the 1940s World War II era).

Her portfolio may be in shambles. Still, no matter how bad things seem, it’s never too late to make some intelligent decisions and get back on track.

In doing so, Jane is not “destroying” America or putting the economy into a downward spiral. (Think of how the media rejoiced yesterday when the consumer surprised the market with spending.)

“Impossible!” naysayers scream. “Unemployment is 8.1% and rising!”

Right, which means that employment is 91.9% which means that 91.9% of our consumer-driven economy can start saving more. And if unemployment rises to 15%, then 85% of Americans can focus on spending a little less and saving a little more.

It’s Happening Now

In the fourth quarter of 2008, personal saving exploded – from 0.4% a year earlier to 3.2%, a hell of a jump in just one year. In fact, at no other point in the past fifty years have Americans increased their savings as a percentage of disposable income as quickly as they have in the past year.

In addition, nonmortgage interest payments started plummeting, down 13% from a year earlier. In the past fifty years, the amount of nonmortgage interest paid by consumers has never dropped so quickly. In fact, from 1948 to 1987 – pretty damn good years in this country- this number never fell.

This has little to do with low interest rates. We know that credit card companies have dramatically increased rates over the past two years. So…people are saving more and paying off debt.

And these numbers are skewed as the savings rate is even greater. Clearly (and sadly) the unemployed can not save; so, they don’t contribute to the top line figures (gross wages), and they detract from the bottom line figures (the unemployed are generally not net savers while they are unemployed).

If you look beyond the numbers, 91.9% of American consumers have, in the aggregate, been paying off debt and saving more and more in recent months. The American consumer spent $240 billion less last quarter than in the previous quarter.

(This, in turn, helps bank balance sheets as well which ultimately helps get us out of the crisis. As consumers save and get healthier, banks also get healthier.)

Forget GDP for a second. It’s dropping. It will continue to drop for a while. The key to a healthy consumer-based economy is not higher GDP – that can be accomplished through nothing more than inflation, if needed. The real key to a healthy consumer-based economy is, well, a healthy consumer.

But We Don’t Manufacture Anything! Trade Deficits!

I know it’s easy to think that. Many of us, especially those of us that are online, reading investment websites, are in cities working service jobs. We also know that the US is a net importer – we’ve been running a trade deficit for years. Some people attribute that deficit to a lack of manufacturing in this county; others say that it’s due to our insatiable demand for foreign goods.

Is manufacturing and production dead in this country? Hardly. In 1929, for each citizen in the United States, we exported about $44 in goods and services. By 2008, that number had grown to more than $4,200 per person. As a percentage of GDP, exports have grown from about 4% in the 1930s to more than 7% in the 2000s.

Both per person and as a percentage of GDP, we manufacture and export more in this country than at any other time in the past seventy years. (Want to fix the trade deficit? I’m not one for “protectionism;” but, if we all just chose to spend $98 per month more on American than foreign goods, our trade deficit is gone.)

In fact, after taking into account inflation, we now produce and export fifteen times more than we did in 1950. Do we produce stuff in this country? More and more each year. So, before we jump to the conclusion that we have no manufacturing outflows from this country, or that the US is a black hole, sucking down foreign goods and services and giving nothing back to the world, consider this: As a percentage of GDP, the amount of goods we exported and the amount of services we exported in 2007 and 2008 were higher than they have ever been since 1929.

In addition, our trade deficit isn’t impossible to overcome. In fact, ours has been shrinking since its 2006 peak. As it shrinks, GDP and our economy grows as a net trade deficit reduces GDP while a net surplus would add to GDP.

When Businesses Cut Back, Look Out

Over the past seventy years, “private investment” has averaged about 15% of GDP. This isn’t investing in the sense of stocks and bonds; rather, it’s the spending that businesses do on equipment, plants, etc. Business investors call these “capital expenditures.”

In every recession, businesses cut their spending on these items as they anticipate lower revenues which will lead to a strained ability to generate cash. The chart below shows Private Investment as a percentage of GDP since 1950, with the grey areas being periods of recession.

To preserve cash, these businesses also lay off workers. In essence, they shrink in real terms…for a while.

To quote Buffett on deferring capital expenditures:

…though dentists correctly claim that if you ignore your teeth they’ll go away, the same is not true for [capital expenditures].

Eventually, these businesses will have to repair or replace equipment, and otherwise ramp up spending. That doesn’t happen, of course, until we’ve swung from “panic and fear” to “I’m glad that’s over.”

In every economy, businesses, in the aggregate, swing like a pendulum – hiring and spending when times are good, and firing and preserving cash when times are bad. In addition to business spending, part of this “private investment” component to GDP is residential spending – spending by households on, well, houses.

If we take residential spending out of the picture for a second, here’s a chart of “private investment” as a percentage of GDP.

Remove Real Estate? But It Is Real Estate, Stupid!

Real estate spending has slowed. Then again, residential real estate spending falls in every recession, and even a few times when we’re not in a recession. Here’s the chart:

We know that foreclosures are still rising; but, let’s think logically about this for a second: In the mid-2000s, we had rampant real estate speculation. People had two, three, four homes/condos. Everyone with a pickup truck was a “developer,” their mothers were real estate agents, and their fathers were mortgage brokers. (Just like when everyone was a day-trader in the late 1990s and early 2000s.)

When home prices started falling, the first to get hit were the speculators. A mechanic with four condos waiting to be flipped was in no better position if he only held three; so, speculators like this had no choice but to flood the market with inventory – being foreclosed on two, three, four properties at a time. Other careless speculators would also walk away from their “investments” as soon as they knew they couldn’t flip them for a profit.

In that sort of environment, we would expect foreclosures to surge initially, especially in the “hottest” real estate markets – places like Nevada, California, Arizona, and Florida. It should come as no surprise, then, that these states have the highest foreclosure rates.

Making up just 21% of this country’s population, these four states have 53% of the country’s foreclosures. Though rising unemployment will add to these figures, the overwhelming majority of gainfully employed people will not walk away from their homes simply because others have. And, while the media focuses on the people struggling to modify their mortgages on underwater homes, let’s keep in mind the tens of millions of people that didn’t buy homes in 2005 through 2007.

(People are using scare tactics as though everyone in this country, or even the majority of people, bought overpriced homes in 2006, are now underwater, and will soon leave the banks to foot the bill on every mortgage they hold.)

Because of that, even though we’re seeing rising unemployment, foreclosures in these four states rose 46% over the past year while foreclosures in the remaining 46 states fell, in the aggregate, by 2%.

(These statistics reflect foreclosure filings, default notices, auction sale notices, and bank repossessions.)

Then Versus Now

You can’t compare today to the Great Depression. In 1930, GDP fell 12%. By the end of 1933, GDP had fallen more than 45% from its 1929 levels, and unemployment was wildly out of control.

What changed in 1933 and 1934 that would turn the economy around?

I hate to say it…Government Spending.

Gasp. Government Spending.

The fourth component of GDP (after consumer spending, private investment, and net imports/exports) is government spending. The government is not a stimulative factor to the economy; rather, it is an employer and spender of last resort. When businesses are firing and cutting back on private investment, the government typically ramps up its hiring and spending to keep the consumer afloat until businesses can get back on track for growth.

By 1941, prior to World War II, the US economy was already larger and stronger than it was in 1929. Unemployment had fallen to less than 10%, GDP had more than doubled from its 1933 bottom, and businesses, which had previously cut private investment from $16 billion in 1929 to just $1.7 billion in 1933, were back on track spending $18 billion in 1941.

Without World War II, our recovery would have continued to be gradual. From an economic standpoint, World War II put our economic recovery on steroids. The butcher, the baker, and the bread maker sprinted back to the US.

But This Spending Is Different! It’s Too Much!

In 1929, non-defense federal spending was just 0.77% of GDP. During the first three years of the Depression, the government did nothing to help curb the decay, actually paring back spending while Americans were losing jobs. Enter Roosevelt, the New Deal, and deficit government spending. (Roosevelt took the country off the gold standard to fund the recovery. Imagine what the headlines were back then!)

Roosevelt more than quadrupled non-defense federal spending to where it would ultimately become more than 5% of GDP in 1936. In essence, Roosevelt and the US Government filled the void when businesses couldn’t or wouldn’t put people to work. By 1942, unemployment was back below 5%, private investment was back on track, having grown tenfold since the 1932 low, and the consumer was healthy again.

One could argue that today’s proposed spending is too much. I’m not going to speak to the fundamental policy changes they’re proposing; but, I’ll tell you this: When Joe American loses his job and can’t find work, he’ll gladly help the government build the high speed train from New York to LA so that he can put food on his table.

So long as Joe is getting a paycheck, we won’t have a depression.

But Higher Taxes Kill Growth!

So the government is proposing higher taxes, and that stunts economic growth, right? After all, who in their right mind would ever start a business or grow their business if Uncle Sam is taking a bigger piece of the pie?

Yet from its 1933 low to pre-war 1941, the economy grew 125%, roughly 10% per year (faster than China today), while taxes on the “rich” went from 25% in 1929 to 81%, with the lowest bracket going from 0.375% to 10%, all while businesses were being launched, business spending was on the rise, and unemployment was dropping.

Though lower taxes might encourage growth, higher taxes don’t kill growth. They provide critical funding for the spender and employer of last resort at a time when businesses are ratcheting down their spending and work force. (This is not a political or partisan statement, but a matter of history.)

And let’s not forget – our country did pretty darn well and a lot of businesses were started and grew from 1940 through 1986, a time during which the top tax bracket was never below 50% (and sometimes as high as 92%).

I’m not one for higher taxes; but, ours are extremely low compared to the historical average.

The Stock Market, Then and Now

A lot of people look at the stock market as a sign of our economic health, the same way that they view daily stock prices as a sign of a company’s health. A year into the Great Depression, stocks had fallen at a pace similar to what we’ve seen over the past eighteen months. Stock prices, however, are not a sign of the economy.

The 90% stock market plunge of the Great Depression was insane. Then again, from top to bottom, GDP – the US economy – fell 45% from 1929 through 1933. Their market effectively crashed in October; our market started crashing in October. They had a banking crisis; we have a banking crisis. Theirs was global in scope; ours is global in scope.

Those are about the only similarities one can draw.

By this time in the Great Depression, unemployment was nearing 20%. Today it’s 8.1%. First year Depression GDP had fallen 12%; ours grew 3% in the first year of this crisis. Depression-era government did nothing to stop the fall in the first three years; ours is trying to stop the bleeding and to, in time, create jobs to keep the consumer healthy and offset business losses.

I can promise you this: The inflation that follows as a result of today’s actions is certainly better than the hard times of the Depression. Nobody would dare say that the high inflation of the late 1970s and early 1980s was anything like the utter despair of the early 1930s.

Those Toxic Assets & Credit Flow

Let me end with the garbage that started this in the first place: Frozen credit and level 3 “assets.” Let’s start with Buffett on these level 3 derivatives in his 2002 Letter to Shareholders:

In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind.

With so many banks, brokers, insurance companies, pensions, and hedge funds tied together in a derivative cesspool, the failure of any one of these large institutions would pose a systematic risk. Lehman failed, and the system froze. (Hence the bailouts, to prevent further problems and “minimize links of any kind.”)

We’re all mad as hell, and rightfully so. Still, it’s not the end of the world.

The economy is shrinking somewhat, but certainly not as fast as the Depression. In addition, we have the backstops in place (government spending) to keep us afloat if businesses continue to contract. Though we’re engaging in deficit spending, we’re issuing bonds at 2%.

At 2%, the government should borrow as much as it can, reinvest it in America at 5% or 6% GDP growth, and thank the world for providing the funding. This is good debt, assuming our leaders don’t waste it all studying pig farts.

People are saving more and paying off debt, which directly strengthens bank balance sheets. Though credit locked up in October of 2008, it has gradually started flowing again (see the TED Spread) which means that businesses and individuals – healthy businesses and individuals – can conduct business or manage their finances.

(The fact that the $18,000-a-year couple still can’t get a $700,000 mortgage like they could two years ago is a good thing.)

The stock market is getting to a point where it is predicting the end of capitalism. Some businesses will go away; some will grow stronger. Be realistic for a second: until the government gets into the soft drink business, Coca-Cola is a pretty safe bet. Of course, most people don’t belong in stocks in the first place.

Is this the end of capitalism and America? If we ignore the facts and listen to the media, it must be. And I fear it will end the same way America ended during the last six depressions:

Early last week, when the headlines noted that the market’s losses had reached the worst levels of any decline since the late- 1930s, some analysts dutifully trotted out new “how low can it go” numbers for the Dow Jones industrial average. Would 6,000 do it? Maybe 5,000? One estimate came in at 777, with a forecast for an accompanying U.S. economic depression. – LA Times, 10/13/2002

No. The nation is in an economic depression. Gramm-Rudman is not going to solve that, and cutting the budget to the bone will only make things worse. We need to return to American System economics, and fast. We need aid from the Asians and Europeans, and the Paris-Berlin-Vienna triangle of industrial production. – Scott Gaulke (D), LA Times, 05/27/1990

Economic depressions may not be a thing of the past, according to some respected economists. The experts cite some striking parallels between 1929 and today, including the overheated stock market, trade imbalances and the rise in protectionism, greater polarization in the distribution of wealth and the prevailing mood of optimism among investors and the general public. – Chicago Tribune, 10/9/1987

Concerned that there’s no relief in sight from high interest rates, many Americans believe the country is now in an economic depression. – Washington Post, 7/26/1982

Depression. It is a word to send shivers down the spine of anyone over 50 years old. It evokes dark images of bread lines and bankruptcies, dust bowls and suicides. It is also a word being used by responsible public figures generally liberals for the first time since the nineteenthirties to describe the state of the nation’s economy. – NY Times, 3/7/1975

Marshall McLuhan, the intellectual comet from Canada who now resides at Fordham University, startled broadcasting executives here today with a forecast that the United States will have an economic depression “within about five years.” – Washington Post, 9/29/1967

A Note From Joe Ponzio

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