In The 1920s Credit Bubble, I explained how a credit binge gave rise to serial bubbles in housing, durable consumer goods, and the infamous stock bubble of the 1920s. Last week in The Panic of 2008: a Turning Point I gave a big picture overview of how our current credit crunch is unfolding. At that time I pointed out that there were some important differences between our credit crunch, and the collapse of the 1920s credit bubble into the Great Depression. The goal of this diary is to peer into our near future by means of a chronological examination of how the apparently mild if abrupt downturn that began in late 1929 transformed into a much more serious downturn that ultimately snowballed into the Great Depression, during the year following the stock market crash, 1930.
Imagine it is a time like now, where there has been a remarkable credit binge that has ended in dramatic fashion, with the stock market suddenly crashing and losing 1/3 of its entire value. Consumers are saddled with debt, as are many who speculated on the newest baubles on offer by Wall Street. The assets pledged as collateral to back up the loans that went to buy both the consumer and financial baubles is caught in a vicious downward spiral. Eventually, and very soon, all of this bad debt is going to have to be liquidated, and both debtors and creditors may go under as a result.
Now imagine that your income in real terms is only half of what it is now . And not only for you, but for everybody you know, in fact for 90% of the entire country. You live in a house that is only half of the house you live in now, your car is only half as good as the one you have now, and so is everybody else's. So are your savings and investments, as are everybody else's. And your savings are not insured. Your bank only has on reserve perhaps less than 10% of the total cash it would need to redeem all deposits. Should it be unable to do so, it will close and your entire deposit will be lost.
Not only that, but instead of having bought your appliances and consumer goods with cash or credit, you are instead in the process of buying on an installment loan, a loan with terms so draconian that if you miss just one payment, the appliance will be repossessed and all of your equity in that appliance will be lost.
There are rumblings of possible wage cuts, and the actual beginnings of layoffs, as manufacturers abruptly cut back production.
How do you think you would feel, and act? This very scenario is exactly what faced the vast majority of Americans as 1929 drew to a close.
II. The Initial Reaction
1929 was one of the few occasions when the stock market did not serve as a "leading economic indicator". Rather, the economy itself had peaked by about June, while the stock market continued to soar until September, before rapidly losing 20% of its value before crashing at the end of October.
At the end of 1929, the Federal Reserve yearly review nevertheless began:
The keynote of the industrial record of 1929, as distinct from financial and speculative episodes, was a rapid increase in the output of manufactured goods., which gave rise to a quickening of activity throughout many branches of industry.
It is almost impossible to determine whether the domestic market, which is the chief reliance of American producers, absorbed commodities at the same increased rate at which they were being turned out during the year. No adequate data on mechandising exist....
...in the last quarter the reduction in [factory] employment was noticeably more rapid....
During November, despite the fact that production of manufactured goods was sharply curtailed, prices of manufactured articles declined, and this continued into December.... The reasons for the recent general decline in prices are to be found partly in conditions of oversupply of manufactured goods earlier in the season, but in the main, conditions of demand -- in general hesitancy on the part of buyers in view of the very uncertain future of business. In the last three months of the year almost all prices have decreased.
The truth is:
that, until the summer or early fall of 1930, almost everyone expected the economy to recover, just as it had in 1921.
III. Neither Federal Reserve policy, tariffs, bank panics, nor the gold standard can explain how the downturn that started at the end of 1929 obtained vicious force by autumn 1930
The New York Fed, which was the most important Federal Reserve Bank at the time, did not restrict credit:
[T]he Federal Reserve [was not] entirely passive. During the crash the Fed lent liberally to banks so they could sustain securities lending. Interest rates were allowed to drop rapidly. The discount rate (the rate at which the Federal Reserve lends to commercial banks) fell from 6 percent in October 1929 to 2.5 percent in June 1930. The money supply (cash in circulation plus checking and time deposits at banks) declined only slightly in the next year. Tighter Federal Reserve policy in 1928 and early 1929—intended to check stock market speculation—may have helped trigger the economic downturn. But the Federal Reserve was not stingy in early 1930 and was not driving the economy into depression at that time. It was not until 1931 and later that the Federal Reserve failed to act as the "lender of last resort" and allowed so many banks to fail.
As a recent Federal Reserve study indicated, monetary mistakes magnified but did not cause the minor initial contraction to turn into a major economic catastrophe; although one commentator shows that money supply did indeed decline (slightly) even before June 1930, mainly because banks as well as their depositors were hoarding money due to fear and uncertainty about the future. But the high interest rates of 1929 had triggered the initial downturn. As we will see later, by the time the lower interest rates of 1930 worked their way through the economy, deflation was already at -7% compared from the summer 1929 high in prices, and it was too late.
Not only did the Federal Reserve Bank not actively worsen the situation in 1930, but three other symptoms of the Great Depression did not take their toll until later in the process. The Smoot-Hawley tariff took effect in June 1930, but by that time the contraction was well underway. Furthermore, the best evidence is that while the tariff exacting a crushing toll on other economies, the US economy was not sufficiently intertwined at the time for the tariff to seriously worsen the domestic depression in the US:
While many have attributed the Smoot-Hawley Tariff to the start of, or catalyst to, the worldwide Great Depression, this analysis shows that free trade was already doomed by 1930. Most countries would likely have turned towards protectionist measures of their own regardless of the Tariff
Bank runs also did not materialize dramatically until later in the year. There had been an increasing number of bank failures throughout the 1920s, and while they increased in early 1930, nobody saw any crisis until later. The first signs of increased banking stress occurred in the farming states in later 1930 as a bad drought affected crops. But the first of the Depression's "run on the banks" did not happen until the very end of 1930, when the unfortunately-named Bank of the United States collapsed in New York City:
The stock-market crash of October 1929 made it more difficult for many businesses to repay their loans to the banks, and many banks found their balance sheets impaired as a result. But the most important cause of the bank runs that began in October 1930 was bad times in the farm belt, where the banks were especially weak and poorly diversified. The number of bank runs increased exponentially in December 1930—in that single month 352 banks failed. Most of the failing banks were in the Midwest , their failures caused by farmers who defaulted on their loans because they were hit hard by the economic downturn.
0/research-and-data/publications/business-review/1997/november-december/brnd97tt.pdf">The Philadelphia Federal Reserve has reported:
While it is difficult to distinguish between runs that occur at the same time in many banks and contagious ones, some researchers have been able to identify contagious runs....
Soon after Caldwell [Bank’s] closing, the Bank of United States also failed. Friedman and Schwartz maintained that the bank’s name led to confusion about its official status, constituting a serious blow to depositor confidence. They concluded that the banking panic of November - December 1930 was the result of a contagion of fear that spread among depositors, accelerating the bank failure rate, reducing the money stock, and worsening the economic downturn.
Nor did the gold standard constrain the economy until 1931, when Great Britain went off the gold standard, causing the Fed to raise interest rates again in order to stem a run on the nation's gold supply, and thereby make matters much worse:
In fact, the Federal Reserve faced conflicting demands to end the depression and to protect the gold standard. The first required easier credit, the second tighter credit. The gold standard handcuffed governments around the world. The mere hint that a country might abandon gold prompted speculators and international depositors to change local money into gold or a convertible currency. Deposit withdrawals spread panic and squeezed lending. It was a global process that ultimately forced all governments off gold. In May 1931 there was a run against Creditanstalt, a large Austrian bank. The panic then shifted to Germany and, in late summer, to Britain, which left gold in September.
The Federal Reserve had to ensure that every dollar of paper money was backed by at least forty cents of gold. Once Congress ended the obligation to exchange gold for currency, the Fed was largely liberated from worrying about gold. This may have been the most important part of the New Deal's economic program.
IV. Industrial cutbacks started immediately with deflation and intensified as 1930 wore on.
So, unlike our current predicament which I have previously described as a "Neutron Bomb over Wall Street", and is concentrated on failing financial institutions, in 1930 the financial panic really did not start until well into the economic collapse. In fact, by early 1930 almost the entire stock market losses of the Great Crash of October 1929 had been recovered.
Rather, prices had moved in and out of inflation and deflation, by small amounts, throughout the 1920s. In 1928 and 1929, there was a brief inflationary episode of just a few percent. Prices peaked in late summer and early autumn 1929, and immediately started to decline. Prices went down - 2.5% after 4 months, by March 1930. Within 5 more months, by August, prices had decreased - 5%. This was not a mild, beneficial deflation of - 1% or - 2%. A vicious deflationary spiral had started immediately.
Unfortunately, almost everyone underestimated the forces pulling the economy down. One was the drop in trade that resulted from collapsing commodity prices. Kindleberger has argued that the price collapse was worsened by the stock market crash. The connection lay in a drying up of credit. Many loans used to buy stock had come from foreigners and big corporations, and they demanded repayment when stock prices plummeted. New York banks assumed some of the loans, but they cut loans to the importers of raw materials. Demand for these products (rubber, cocoa, coffee) dropped, and prices fell. Strapped for funds, countries that exported commodities reduced their imports of manufactured goods from industrial nations.
Further, as the Federal Reserve summation from December 1929 shows:
[After] June 1929 [when] the turning point was reached .... to December ..., the volume of production was reduced 20%....
employment in factories, like industrial production, had reached the low levels of December 1927... involv[ing] the discharge of over 700,000 workers between the time of the seasonal peak in September and December.
Layoffs continued and accelerated throughout 1930.
Some 2,500,000 persons nationwide were without jobs in April 1930. By October the figure was 4,000,000.
President Herbert Hoover took quite progressive action for his time. Business plus government spending in early 1930 actually exceed that of 1929, but it was "pushing on a string" :
[There had been a] glut of 26,000,000 new cars and other consumer goods flooding the market. ...[T]he average worker's wages of $1,500 a year failed to keep pace with the spectacular gains in productivity achieved since 1920. By 1929 production was outstripping demand.
The United States had too many banks, and too many of them played the stock market with depositors' funds, or speculated in their own stocks.... In addition, government had yet to devise insurance for the jobless or income maintenance for the destitute. When unemployment resulted, buying power vanished overnight. Since most people were carrying a heavy debt load even before the crash, the onset of recession in the spring of 1930 meant that they simply stopped spending.
Together government and business actually spent more in the first half of 1930 than the previous year. Yet frightened consumers cut back their expenditures by ten percent. A severe drought ravaged the agricultural heartland beginning in the summer of 1930. Foreign banks went under, draining U.S. wealth and destroying world trade. The combination of these factors caused a downward spiral, as earning fell, domestic banks collapsed, and mortgages were called in. Hoover's hold the line policy in wages lasted little more than a year.
Pulled from newspaper and magazine archives, we can recapitulate of the relentless and intensifying downsizing of jobs and wages throughout 1930.
Already by February 1930 the Department of Labor noted grave concern:
Wage changes have shown a steady downward trend in each of the last three months, and if industrial production continues to decrease in pace "we are in for a great deal of trouble," says the February issue of Facts for Workers, a monthly review published by the Labor Bureau, Inc.
In March in Salt Lake City, Wages of miners in silver-lead mines of Utah were reduced 50 cents daily and wages of silver-lead smelter workers cut 25 cents daily by mining companies. By April, per capita earnings of workers during February were 4 per cent lower than in February, 1929. Farm wages were the lowest for that date since the Bureau of Agricultural Economics began to collect their figures on a quarterly basis in 1923. A strike at the Aberle Hosiery Mills was because of "an unfair reduction of wages" of 10 to 15 per cent.
In May, copper companies throughout Arizona announced a 5 per cent cut in wages. Union miners demanded that wages not be cut. Later that month, they posted notices of a 10 per cent reduction in the wages of miners and a corresponding slash in the salaries of officers, effective June 1. The Los Angeles Times reported that "The 50-cent wage reduction put into effect last week by Tonopah mining companies is expected to be adapted throughout the precious-metal camps of Nevada. The new scale pays miners $5.25 per day, with muckers receiving $4.75." And employees of the United Railways of Havana objected to a general order reducing wages of all employee of officials of the company. Meanwhile the Bell Telephone system bucked the trend by raising wage scales. The Washington Post reported that the Chesapeake Beach Line Railroad was to Increase salaries 10 Per Cent. And on May 22, 1930, the New York Times reported, optimistically, that "President Hoover received credit for having brought the country safely through the recent business crisis without any reduction of wages in a speech delivered today by Secretary of Labor James J. Davis."
Instead of being over by summer, instead the industrial slowdown spread, as related in this story from Seattle:
In June 1930, massive reductions at lumber mills began, followed by reductions in other industries, particularly the seasonal sectors such as fishing, flour milling, ship building, and coal mining. Those businesses that avoided layoffs maintained wages, but cut back the number of hours worked. Workers shared jobs. By the fall of 1930, volunteerism and local charities were at their limits serving free meals to long lines of jobless men.
Also in June,
President Green of the A. F. of L. took an opposing and much less optimistic view of the labor situation and inferentially disputed the census figures with this declaration:
"The hoped-for improvement in unemployment did not materialize in June. Reports from trade unions show unemployment just as high as in May with 20% of the Union membership still out of work. The Federation estimate of the total number unemployed in May is 3,600,000. This figure does not include office workers or farm laborers. . . . Our June figures show a very serious unemployment situation. More than twice as many men are out of work this year as in June last year. -. . . Layoffs always come with the summer dull season [which] seems to have begun earlier than usual."
In July, the Conference Board reported that
"The stability of hourly and weekly earnings is the most significant feature in the trend of wages in the United States in recent years and was affected only slightly by the business reaction following the stock market disturbance of last October
But in the very same month, wage cuts included such large companies as Chrysler Corp. and National Cash Register Co. (10% each). The heightened anxiety with regard to wage cuts showed in "Twelve telegrams from industrial leaders, in which they view wage and salary reductions with disfavor and as tending to augment the economic depression, will appear today in an article by Roy Dickinson, published in Printers' Ink."
The Labor Bureau reported in August "Additional wage cuts and a further drop in the number of wage increases for July as compared with the previous month." Other businesses sought to avoid massive layoffs by use of a "Part-Time Plan as [the] Fairest Method."
In October, the National Association of Manufacturers continued to claim that "Business is on the upswing and wages are holding firm, according to a nation-wide survey .... The survey embraced reports from 800 members of the association and had been brought up to Sept. 30."
But by November the balance had tipped. The Labor Bureau reported 93 wage reductions compared with 46 wage increases (which was nevertheless better than October). While Alfred P. Sloan, Jr. declared that "General Motors Corporation has maintained salaries and wages.... [A] reduction in the wage scale would not only delay the return of more normal times but unnecessarily limit the future prosperity of the Nation," at the same time, a workers' organization charged that "many employers were decreasing pay surreptitiously." AFL President Green "Open[ed] fire on Wage Slashers", declaring that
"Employers Who Reduce Pay Are"Public Enemies... who are taking advantage of economic industrial distress to lower living standards."
One week later, in December 1930, "The policy of some industries to cut wages at this time was assailed as "short-sighted" by Miss Frances Perkins, State Industrial Commissioner, in an addxess at the final session of the New York Industrial Safety Congress."
The bottom line to all of the layoffs and job cuts that continued relentlessly through 1930 was that the entire economy shrank by over 10%!
V. The Key was the Collapse of the Consumer
But we are still left with a quandary: what happened in the first 6 months of 1930 that turned what almost everybody thought would be a small downturn into a vicious spiral of layoffs, wage cuts, and commodity deflation?
And there, we are left with the consumer. Quite simply, consumer spending collapsed even in early 1930. That is what caused a minor downturn to snowball into a greater crisis that ultimately became the Great Depression.
Households were shouldering an unprecedented burden of installment debt. Down payments were large. Contracts were short. Equity in durable goods was therefore acquired quickly.Missed installment payments triggered repossession, reducing consumer wealth in 1930 because households lost all acquired equity. Cutting consumption was the only viable strategy in 1930 for avoiding default.
As another study put it:
What made matters worse was a big drop in U.S. consumer spending—far more than can be explained by the stock market crash. The drop may have been a backlash to the rise of installment lending (for cars, furniture, and appliances) in the twenties. The prevailing practice allowed lenders to repossess an item if the borrower missed just one payment. People may have stopped making new purchases to reduce the risk of losing things they already had bought on credit. Whatever happened, the slump soon fed on itself. Weak spending depressed prices, which meant that many farmers, businesses, and nations couldn't repay their debts. Rising bad debts prompted banks to restrict new loans and sell financial assets, usually bonds. Scarce credit led to less borrowing, less spending, lower prices, and more bankruptcies. Trade and investment spiraled downward. Confidence crumbled, and as it did, bank runs—people clamoring to convert deposits into cash—ensued.
Yet another commentator put it this way:
This speculation and the resulting stock market crashes acted as a trigger to the already unstable U.S. economy [d]ue to the maldistribution of wealth..... The rich stopped spending on luxury items, and slowed investments. The middle-class and poor stopped buying things with installment credit for fear of loosing their jobs, and not being able to pay the interest.... [S]oon people starting defaulting on their interest payment. Radios and cars bought with installment credit had to be returned. All of the sudden warehouses were piling up with inventory. The thriving industries that had been connected with the automobile and radio industries started falling apart
It turns out that the unique properties of the 1920s credit bubble -- buying household goods on installment plans -- turned vicious with a vengeance once the downturn began. Remember that the average American household in real terms earned only half the income compared with households today. A study comparing personal consumption spending in 1930 and 2003 found that spending on food and clothing alone made up almost 40% of households' budgets then, compared with only 18% in 2003. Martha Olney’s article in the 1999 Quarterly Journal of Economics, “Avoiding Default: The Role of Credit in the Consumption Collapse of 1930”, analyzes what happened:
To explain the drop of consumption in 1930, she presents Mishkin’s and Romer’s ideas that change in household balance sheets caused a sharp decline in purchases of durable goods and that the 1929 stock market crash increased uncertainty and caused decreased purchases of irreversible durable and semi durable goods. However, Olney argues that there are many other reasons that contribute to the drop in consumption. She explains that the combination of high consumer indebtedness and default consequences are reasons that consumption dropped in 1930
As Olney explained, in the late 1920s and early 1930s the laws governing installment contracts were particularly harsh on defaulting debtors.
As household income fell during the Great Depression, people drastically reduced their consumption expenditures in an attempt to avoid defaulting on installment payments. Again, the threat of bankruptcy may have inhibited recovery....
The available evidence indicates that the rate of default on consumer credit remained low throughout the 1920s. The loss ratio for General Motors Acceptance Corporation ... even at the lowest point of the Depression in 1933 ... only rose to 0.83....
The personal loan industry reported extremely low rates of loan losses....
... [H]ouseholds desperately tried to avoid default during the 1920s, even in the face of large decreases in income. How does one reconcile low and stable default rates with rapidly rising non-business bankruptcy? The answer lies in the increased supply of consumer credit. Although the likelihood that a particular debtor would default did not increase during the 1920s, the number of households with significant consumer debt did increase. An increase in the number of households with debt will result in an increase in the number of defaults even if the probability of default among debtors remains constant.... The increase in the debt-to-income ratio was not just a matter of the same households taking on more debt, but an expansion in the number of indebted households. Increased household indebtedness was driven by innovations in credit supply. Finance companies were created to finance inventories of retailers, and buying on installment became ubiquitous. For instance, the percentage of households that purchased automobiles on installments increased from 4.9 percent in 1919 to 15.2 percent in 1929. In 1925 10 percent of households had radios; by 1930 46 percent had radios. E. R. A. Seligman estimated that, as of 1927, 75 percent of radios were bought on time.
Installment credit was not the only area where innovation took place. The adoption by the states of the Uniform Small Loan Law ... allowed [lenders] to charge higher interest rates than most usury laws had allowed.
In summary terms, households struggled heroically to avoid repossession of already purchased consumer items, cutting back drastically on all other non-essential spending as a result. This was the trigger of the vicious cycle that ultimately became the Great Depression.
Perhaps the last word should be given to FDR's Federal Reserve Chairman, Marriner S. Eccles who wrote in his study of the Great Depression:
The time came when there were no more poker chips to be loaned on credit. Debtors thereupon were forced to curtail their consumption in an effort to create a margin that could be applied to the reduction of outstanding debts. This naturally reduced the demand for goods of all kinds and brought on what seemed to be overproduction, but was in reality underconsumption when judged in terms of the real world instead of the money world. This, in turn, brought about a fall in prices and employment.
Unemployment further decreased the consumption of goods, which further increased unemployment, thus closing the circle in a continuing decline of prices. Earnings began to disappear, requiring economies of all kinds in the wages, salaries, and time of those employed. And thus again the vicious circle of deflation was closed until one third of the entire working population was unemployed, with our national income reduced by fifty per cent, and with the aggregate debt burden greater than ever before, not in dollars, but measured by current values and income that represented the ability to pay. Fixed charges, such as taxes, railroad and other utility rates, insurance and interest charges, clung close to the 1929 level and required such a portion of the national income to meet them that the amount left for consumption of goods was not sufficient to support the population.
A Federal Reserve Bank concerned about loose credit and stock market speculation finally tightened interest rates in 1928 and 1929. While a moderate downturn began in summer 1929, the October stock market crash caused consumers to freeze their spending, as they did not know how much real economic damage the financial markets may have inflicted. As layoffs and wage declines increased, consumers focused on using any leftover discretionary income to save goods bought on draconian installment programs. Those whose goods were repossessed simply added to unsold inventory. Between the sudden collapse of consumer spending, and the accumulating inventory of unsold and repossessed goods, and declining wages, a vicious cycle took root.
The Federal Reserve tried to help the swooning economy by lowering rates to 2.5% by June 1930, but by that time the deflation rate was already -5%, meaning that the "real" interest rate, at +7.5%, was still strangling the economy.
And the effects of the attempted accomodation came too late. Consumers (ever more of whom were unemployed) who had savings in banks tapped into those savings, as did producers whose access to cheap credit was cut off due to high real interest rates. This in turn impaired banks' financial bases.
Crop failures due to the incipient dust bowl were probably the last straw. To the vicious cycle was added bank failures in autumn in the farm belt, and then the calamity of a large NYC bank failure in the first real contagious run on the banks in November and December.
What could have been a mild downturn was snowballing into the Great Depression.
Fast forward to 2008: it is widely acknowledged by commentators of all stripes that we are witnessing the greatest challenge to the financial sector since World War 2 at very least. A credit bubble even bigger than that of the 1920s has been unleashed by reckless laissez-faire crony capitalism in the government and the banks, aided and abetted by policies that have caused the most vast disparity of wealth and income in American society since 1929. Now with the housing bust destroying land values and balance sheets of borrows and lenders alike, the credit deflation is upon us. So much for the similarities.
There are some important and favorable disparities. American families on average have twice as much wealth, twice as much income as their 1920s counterparts, meaning that as tough as times may be now, our grand- or great-grand parents' generation lived much closer to the economic precipice. There was no FDIC insurance guaranteeing up to $100,000 in bank deposits. Moreover, in our era of credit cards, debtors maintain possession of many if not all household goods in typical bankruptcies, whereas 80 years ago, installment contracts with draconian forfeiture of equity and repossession clauses were widespread.
Thus, so far, as oppose to 1930's consumer consumption crisis, 2008 has unfolded as a Neutron Bomb over Wall Street, leaving the real economy of manufacturing and retail sales in a slowdown but still growing.
But there is one ominous comparison, however, which must give all of us pause: in 1930, the US was a rising global economic hegemon and the largest international creditor, with a strong currency. In 2008m the US is a declining hegemon, the world's largest international debtor, and is suffering a dramatic weakening of its currency.
A review of the unfolding of events in 1930 teaches us that whether or not in the next 12 months there is a major downturn of the "real' productive economy with rapidly increasing layoffs is a key to just how critical our situation becomes.