Tuesday, April 14, 2009

What Actually Caused the Great Depression?

During times of economic crises, wacky theories concerning the origin of the crisis tend to spread like wildfire. That was the case during the great depression, and that is the case now. Some people might include my theories in that category, but that is, of course, purely based on ignorance.

At present, there are literally hundreds of theories about the crisis out there, and discussions about the great depression have also resurfaced.

With respect to the great depression in relation to the current crisis, almost all the arguments can be boiled down to the following question:

Was the great depression caused by the easy access to cheap money?

As President Obama has noted, the discussion about the great depression is far from over. The factors behind that crisis are very complex, and far beyond the understanding of most politicians. Obama recently spoke in disbelief about the continued disputes over this.

There are a few things that I believe are beyond discussion:

- The stock market crash set off the depression because so many had so much invested in the market.

- The stock market crash was caused by overly inflated values of stocks.

- The overly inflated values of stocks were caused by an unprecedented amount of speculation with borrowed money.

Following this line of reasoning, the question remains: what causes speculation? If we can nail down what causes large-scale speculation, we might be able to answer what causes depressions.

More specifically, circling back to my initial question, “was the great depression caused by the easy access to cheap money?”, the question becomes:

- Does easy access to cheap money cause large-scale speculation which in turn causes depressions?

The answer to this question can be found more easily than one would think. If you can identify periods of time in history when money was cheap and abundant, and ascertain that rampant speculation always occurred during such times, you have your answer.

A quick look back in history tells us that this is not so. There have been many periods in history when borrowing money was cheap, but when speculation was minimal. This is noted in what is widely considered to be a standard work on the depression, “The Great Crash”, by John Kenneth Galbraith.

During several periods in the 19th century, cheap money was available, but without the result of large-scale speculation. This was also the case in the 1950s and 1960s. So, to say that cheap money alone causes large-scale speculation would be erroneous from a scientific standpoint.

I tend to believe that speculation can trace its roots to something far more basically human. I believe that speculation does not occur just because it CAN occur, but because there seems to be a reason to for people to speculate.

Greed is a human emotion that can never be extinguished. Everyone is guilty of it, and when a human sees an opportunity to make a quick buck without effort, whether this is prudent or not, he or she often takes that opportunity.

The most classic example of speculation is the tulip bulb speculation in Holland in the 16 Hundreds. This business went so far that a single tulip bulb could be worth an entire year’s salary at the time. What this speculation frenzy also featured were contracts with rights to buy bulbs in the future, trading fictitious bulbs that had not yet been grown, and all the other classic speculation behaviors that we see again today.

We may think we’re so advanced today, but greed, this inescapable human emotion, has already conjured up the complicated schemes of speculation many times before in the history of man.

If you can buy a tulip bulb and sell it the next day, and then not have to work for the rest of the year, who wouldn’t do that? If you can buy a house in Florida, sell it within weeks for a comparable profit, how could you resist?

In short, humans need a reason to start speculating, and in the case of the great depression, people got excited about mainly two things which will sound familiar to everyone today: real estate and new technology.

People started buying second homes to be resold shortly afterwards, and stocks in new technologies like radio and automobiles.

Speculation frenzies will probably always exist, but when such a frenzy gets out of control, it can shake the very foundations of society. When too many people start getting in to the frenzy, perhaps even the government (by relying on the stock market to provide basic public services, such as pensions, infrastructure and, of course: jobs), the country becomes utterly dependent on the continuation of the speculative bubble.

A speculative bubble can never be upheld forever, and it can never be re-inflated, so when a bubble of sufficient proportions is created, a country will not be able to avoid a depression.

In the decade before the depression, President Coolidge repeatedly praised the wonders of the stock market. In addition, most of the powerful politicians in Washington, and the members of the Federal Reserve Board, were themselves highly vested in the stock market, and were hence not at all interested in reining it in, even though they could see ominous signs.

It seemed at this time that all of America could become prosperous without any effort on the part of Washington politicians. This is extremely similar to how the Reagan, Clinton and Bush Jr. administrations operated. Hands off, hope for the best and leave the provision of American prosperity to private corporations.

Then as now, the United States was utterly dependent on the upholding of the inflated values of the stock market.

The question then becomes whether the current speculative bubble is large enough to cause a depression. I believe that the answer is, unequivocally: yes.

Moreover, I advise that the winner-takes-all voting system should be destroyed


Anonymous said...

the papers are now reporting that another bank (JP morgan) just announced a profit, but how can this be if they are still sitting on billions of dollars in toxic assets?

Are the financial reporters that clueless about what is really happening or are these banks really making a profit?

Jacob said...

As far as I know, Chase is better off than Bank of America and Citibank. Chase may not be technically insolvent, but no one really knows.

The banks may very well have made a few bets that have paid off this year, so in that sense they may have made a short-term profit.

But imagine that you had $1 million in credit card debt and just got a pay check of $2,000. That's how these news should be viewed.

In other words, it doesn't matter. If you add up all the profits that these banks have made in the last 20 years, it roughly amounts to what the banks have already lost, even before disclosing what the true extent of their problems are.

So, ask me again in 40 years.

Anonymous said...

Why even bother reporting a fake profit if you are a bank? don't they think people can figure out what they are doing?

I was just listening to a report on NPR about the job situation. A professor from a local university stated that white collar professionals are not losing their jobs. The job losses so far, he argued, have been confined to blue collar workers. In fact, I think he said there had been zero job losses for white collar professionals.

This "research" by the professor was quite stunning to me. The callers on the show also said that they expected the economy to rebound within 2 years.

Are people not getting it?

Jacob said...

0% job losses for white collar workers seems like a very strange research finding. How do you classify the tens of thousands of Wall Street jobs that have already been lost in Manhattan alone then?

The sad truth is that very few people understand things like bank crises, including politicians. The American school system is "interesting" to say the least when it comes to making students understand how society works

Anonymous said...

I understand the NPR interview about the employment picture to state, no "net" change in white collar jobs. Financial services jobs certainly have been shed, but other white collar job sectors (believe it or not)have added enough positions to make it a wash. Blue collar jobs, like construction have been hit hardest, and nothing has replaced them. To date, and a national level, it seems like a fair assessment to me. This likely change, if/as things worsen?

Anonymous said...

How can there not have been a net change in white collar white jobs when companies earnings are dropping?

Jacob said...

I haven't listened to the NPR report that was mentioned, but it does not sound right to me. As far as I know, there has been a small increase in government jobs and perhaps healthcare, but we've been losing over half a million jobs per month during this whole year, so I just don't see how it's possible that there is no net change in white collar jobs.

I also don't see how it's helpful to break out the financial industry from the category "white collar jobs", since many sectors can be attributed to the financial sector in one way or another. If you do break it out like that, you're not left with much. I guess you're left with academia, media, healthcare, government and a few more.

So, sort of misleading