The Great Depression

It is our belief that in order to truly understand how our current economic situation has evolved and to decipher what to expect in the coming years, we should look first to history. What has transpired in similar circumstances in the past? What events triggered a crisis or lead to a market collapse? How did the the general public react? What were the consequences of the crisis? In that light, today we look briefly at the Great Depression. “The Great Depression” is a term, that given historical perspective will, in our opinion, no longer refer to the 1929 economic collapse in the United States, but will be used to describe what began in 2008 and is likely to continue for years to come.

Much has been written about The Great Depression. As a result, this analysis will be brief and, we hope, to the point.

A string of terrible days led to a more than 40 percent drop in the market from the beginning of September 1929 to the end of October 1929. The market continued to decline until July 1932, more than three years later, when it bottomed out, down nearly 90 percent from its 1929 highs.

The Great DepressionDespite the Florida real estate crash, a bubble which burst in 1925, Americans were overwhelmingly bullish about the stock market. The feeling was one of “can’t lose” invincibility. The stock market was guaranteed to make everyone rich. The first world war had been won, and industrialization was resulting in previously unimaginable luxuries. It was a good time to be American.

Since the stock market was believed to be a no-risk, no-brain world where everything went up, many people poured all their savings into it without learning about the market, the underlying companies or the risks involved. With the flood of uneducated investors, the market was ripe for manipulation and fraud. Investment bankers, brokers and traders banded together to manipulate stock prices and generate large personal gains. They did this by subtly acquiring large chunks of a stock between them and trading shares back-and-forth to each other for slightly higher prices with each trade.

When the public noticed the upward progression of price on the ticker tape, the masses would jump in and buy the stock driving its price even higher. The market manipulators would then sell off their overpriced shares for a healthy profit. This  process was repeated over and over as market insiders and even some dumb, but lucky, investors turned a profit by selling the manipulated, over-priced shares to someone who wanted to own a rising stock (i.e. the “greater fool” theory of investing).

Behavioral finance shows that the less an investor knows, the easier it is for him or her to be swept up in popular opinion (herd mentality). This behavior is a double-edged sword because ignorant investors are also easily spooked into panic. Both actions, joining and fleeing, have very little basis in the news or the quality of the market. Instead, the herd follows the cow that runs the fastest, trampling the market.

During the stock market craze before the Great Depression a number of academics, including Roger Babson, were predicting a crash if things didn’t “calm the hell down”. Sadly, for every Roger Babson, there many more bull-blinded market mavens guaranteeing the eternal rapid growth of the American stock market.

Babson had been predicting the crash for years. Babson was responsible for the “Babson Break”, a three percent market drop that followed his September 1929 warning – “Sooner or later a crash is coming, and it may be terrific”. That warning proved to be the beginning of the end.

The twelve-year worldwide depression came and ended only with the declaration of World War II. This stands as the worst financial blow to the USA ever. The crash itself, though large in its own right, was nothing compared to the ensuing graveyard market and devastating depression that followed.

Market Crashes: The South Sea Bubble

It’s said that those who ignore history are doomed to repeat it. I believe that examining historical market bubbles and crashes can provide valuable insight into our current economic condition.

It is frequently implied, or even outright stated, by today’s powers that be that “this time is different”. Well, I beg to differ. This time is not different. To help illustrate that fact please examine the South Sea Bubble and crash. The parallels between the South Sea Bubble and the recent Internet Bubble are many. In summary:

  • The South Sea Company was perceived to have a “can’t lose” franchise.
    No one questioned the inexperience of South Sea Company management.
  • Few (if any) investors stopped to examine the actual business plan and practices of the South Sea Company. The frenzy to buy was such that rational caution was abandoned. Ridiculous ideas were treated as viable business plans.
  • When the bubble popped, as with all  bubbles, the descent was fast and furious – even more so than the ascent.

    In the 18th century the British empire was the big dog on the block. Their economic and political influence spanned the entire globe. For the British, the period was a time of prosperity and wealth. A large percentage of the population had money to invest and were looking for places to put their money. As a result, the South Sea Company had no problem attracting investors. The South Sea Company assumed the national debt that England had incurred during the War of Spanish Succession for £10,000,000.00.

    South_Sea_BubbleThe few companies offering stock to the public at that time were difficult investments to buy. For example, the East India Company was paying out tax-free dividends to their mere 499 investors. The South Sea Company was perched on top of what was perceived to be the most lucrative monopoly on earth.

    The first issue of South Sea Company stock wasn’t enough to satisfy the voracious appetite of investors. Investors felt that the South Sea Company was blessed with a “guarantee” of dominance, i.e. it could not fail. The popular conception was that Mexicans and South Americans were just waiting for someone to introduce them to the finery of wool and fleece in exchange for mounds of jewels and gold.

    No one questioned the repeated reissue of stock by the South Sea Company. Investors bought the stock as fast as it was offered. It didn’t matter to investors that the company wasn’t headed by inexperienced management. Those who headed the company, however, were blessed with public relations skills. They knew the value of appearances. They set up offices furnished with affluence in the most extravagant quarters. People, once they saw the wealth the South Sea Company was “generating,” couldn’t keep their money from gravitating towards the company.

    Not long after the emergence of the South Sea Company, another company, the Mississippi Company, was established in France. The company was the brainchild of an exiled Brit named John Law. I’ve discussed the Mississippi Company in another post: The Mississippi Bubble and the French Bailout. John Law’s idea would warm the hearts of central bankers the world over. He advocated switching the monetary system from one based on gold and silver into a paper currency (fiat) system. The Mississippi Company caught the fancy of continental traders. Soon the Mississippi Company’s stock was worth 80 times more than all the gold and silver in France. Law’s success on the European continent stirred British pride. Believing that British companies were superior to the French, British investors became desperate to invest their money in the South Sea Company.

Those same investors were blind to indications that the South Sea Company was a poorly run enterprise (e..g. whole shipments of wool were misdirected and left decaying in foreign ports). Investors continued to buy stock, pushing up the share price. The price of the stock went up over the course of a single year from about one hundred pounds a share to almost one thousand pounds per share – a tenfold increase.

Its success caused a country-wide frenzy as all types of people—from peasants to lords—developed a feverish interest in investing. IPOs began to sprout everywhere, including companies that promised to reclaim sunshine from vegetables and to build floating mansions to extend Britain’s landmass. Among the many companies to go public in 1720 is, famously, one that advertised itself as “a company for carrying out an undertaking of great advantage, but nobody to know what it is”.

The share price reached £1,000 in August 1720. Then the selling started. The management team of South Sea Company realized that the value of their shares in no way reflected the actual value of the company or its earnings. They sold their personal stakes in the summer of 1720. The actions of South Sea Company management quickly spread. Soon panic selling of South Sea Company stock certificates ensued. The share priced collapsed, falling to one hundred pounds per share before the year was out,. triggering bankruptcies among those who had bought on credit.

The Mississippi Bubble and the French Bailout

Why look at an event from 1720? The answer is simple. History provides perspective and lessons to be learned – lessons that, if ignored, may lead us to repeat the follies of the past. There are significant parallels between the economic bubble of the late 1720′s and today. The French government (like our own today) was in part responsible for the Mississippi Bubble. The French government contributed to the currency crisis which ultimately led to one of the largest economic crashes in history and required a massive government bailout – not so different from current events.

John Law, the central figure in the Mississippi Bubble, was a gambler and a ladies man. He was also intelligent, and early economic theorist and he had a charming personality. At the time, France was deeply in debt due primarily to war mongering. On May 15, 1716, thanks to his gambling association with the French regent – the Duke d’Orleans, Law was given a bank – the Banque Generale – and more importantly the right to issue paper currency. This was Europe’s first recorded foray into paper currency.

John Law

Thanks to the freedoms offered by paper (fiat) currency, Law was able to increase the the money supply slightly. The “stimulus” brought a new vitality to the French economy and John Law was hailed as a financial genius.

The  following year, as reward for his service, Law was granted exclusive rights to develop the new French territories of the Mississippi River valley, what we know as the Louisiana Territory. John Law’s Mississippi Company quickly became the richest company in France.

In a few short years John Law had gone from a penniless gambler to one of the wealthiest, most powerful men in Europe.

Law’s fairy tale rise to power and riches continued. In 1719 the Duke d’Orleans bestowed on him the exclusive rights to all French trade. Law formed the Company of the Indies. Law’s Banque Generale was awarded central bank powers and became the Banque Royal. Law was now at the helm of France’s central bank.

France’s currency supply continued to expand. Apparently they felt that if a little currency inflation helped the economy then a lot of stimulus would work even better. All this new currency along with the public’s first real opportunity to invest in the developing new world, led to what may be the wildest speculative boom in history. The share price of the West Indies  Company (formerly the Mississippi Company) exploded, rising more than 36 times in a period of months. This boom gave rise to the term “millionaire”.

Paris was booming due the rampant stock speculation and the increased currency supply. Shops were full and there was an  abundance of new luxury goods.  However, problems soon began to arise. Due to the inflation of the currency, prices started to skyrocket. Real estate values and rents increased 20-fold.

“New houses were built in every direction, and an illusory prosperity shone over the the land, and so dazzled the eyes of the whole nation, that none could see the dark cloud on the horizon announcing the storm that was too rapidly approaching.”

-Charles Mackay Extraordinary Popular Delusions and the Madness of Crowds

The speculative bubble spread throughout Europe. By the fall of 1720 the rampant creation of paper currency had a predictable outcome. The bear market collapse was so significant that by December 1720, John Law had to flee France. He died penniless in Venice, in 1729.

Compagnie des Indes Stock PriceThe French government was forced to step in and assume all the debts of Law’s company. And then to pay for their own folly, they began to raise taxes. That led to the collapse of the French economy and set in motion the resentment that led to the French Revolution.

Looking to government to bail out investment banks and failed corporations is a dangerous course of action. It shifts the blame for the bank’s (or corporation’s) folly to the government. It increases the risk of political instability should the government fail to improve economic conditions. What if we end up in hyper-inflation because of the massive currency printing? That will destroy the economy along with the common man’s ability to survive economically.

Our quasi-socialist way of life may be coming to an end because our promises exceed our resources. The bailout of the banks and corporations, along with the continuing monetization of debt is likely to push our government and our economy over the edge.

If we cannot see how similar events have played out historically, if we do not learn from the mistakes of the past, we are doomed to make the same mistakes over again.

A Tulip Is Just A Tulip, Isn’t It?

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

– Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds

People think currency, such as the U.S. Dollar, is money. It is not. Historically money has an intrinsic value within itself. Think of gold and silver and other precious metals – they are money. Our paper and coins are fiat currency. A fiat currency is an arbitrary order, given by a body, typically a government, which has the power to enforce it. All currencies today are fiat currencies.

Here’s a dirty little secret: Fiat currency is designed to lose value. Its very purpose is to confiscate your wealth and transfer it to the government. Government monetary policy as implemented with our fiat currency – the U.S. Dollar – is a “hidden tax” on all of us. Consider this: every time the government prints a new dollar and spends it, the government gets the full purchasing power of that dollar. Where did that purchasing power come from. It was taken from the dollars you hold in your wallet, savings or investments. As each new dollar enters circulation it devalues all the dollars in existence because they are now more dollars chasing the same amount of goods and services. This causes prices to rise. This is the insidious stealth tax of inflation.

As my previous two post illustrated here and here, governments are often to blame when creating inflation through fiat monetary policy. But remember, in the end we ultimately consent to our government’s rule. History is full of examples of greed leading a populace to do incredibly stupid things. As these incidents show we don’t need government to ruin our economy. We can do it just fine ourselves. Perhaps the best example of this lunacy is the tulip mania of 1637.

tulip_bulbs300x199

In order to truly understand the absurdity of this moment in history, you simply have to ask yourself: Would I pay $2 million for a tulip bulb? If so then please call me immediately on (810) 555-1393.  I have a limited supply of (insert worthless item here) for sale at to die for prices.

What many people don’t know is that tulips are not indigenous to Holland. They were first imported in 1593 from Turkey. They quickly became a status symbol for the wealthy. This developed into a craze, and subsequently a tulip exchange was established in Amsterdam.

Very quickly the mania turned into an economic bubble. Put in historical  perspective it is quite comical. In 1636 a single tulip bulb of the Viceroy variety was traded for the following:

  • 8,000 pounds of wheat
  • 16,000 pounds of rye
  • Four fat oxen
  • Eight fat swine
  • 12 sheep
  • 280 gallons of wine
  • Four tons of beer
  • Two tons of butter
  • 1,000 pounds of cheese
  • One bed
  • One suit of clothes
  • One silver goblet
  • 220px-Tulipomania

    At its peak in 1637 a single bulb of the Semper Augustus variety was sold for 6,000 florins. At the time the average annual wage in Holland was 150 florins. Tulip bulbs were selling for 40 times the average Hollander’s annual income. To  put that in perspective let’s assume the average U.S. salary is $50,000. That means that a tulip bulb in today’s dollars would cost you $2,000,000. Soon people began to realize how crazy the situation had become and the smart (if you can call anyone involved in this mania smart) money began to sell. Within weeks tulip bulbs fell to their real value, which was several bulbs for just one florin. The financial devastation that swept across  northern Europe as a result of the market crash lasted for decades.