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Back to Subjects - Economics

The Next Depression

The Next Depression Fast money, that is what a large percentage of Investors want. We are in the midst of the largest bull market ever, and the greatest financial expansion in history. What goes up must come down, right? This fundamental rule seems to not apply in today’s fast paced economy. This remarkable wealth-making machine seems unstoppable, but is it? One cannot help but be reminded of the twenties and similarities between these two decades. Investor Sentiment is at all time highs. Interest rates are low, and all seems fine. If you take a look at financial history it is clear that the business cycle flows in and out of trends. The market must correct itself. With speculation nearing all time highs, and confidence outweighing fundamentals the next big drop could be closer than most like to admit. The Roaring Twenties was a time of great economical growth. Ideas, entrepreneurs, and capital abounded. Skyscrapers were being built, new revolutionary processes were being discovered, and America’s population thrived. Wall Street was on the move as well, with record breaking performances year after year. The whole Nation in general was seeing increased productivity. The nations total realized income rose from 74.3 billion in 1923, to 89 billion in 1929. (Alexander 1) Manufacturing output more than doubled in the decade with the increased implementation of the assembly line. Advances were seen everywhere in 1920. The first transcontinental airline route, first news radio broadcast in Pittsburgh on KDKA, and the transition to city life. In 1927 Charles Lindhberg’s first flight across the Atlantic and the first “talkie” motion picture continued to put America far ahead of foreign powers. (Kidder 1) Then suddenly in 1929, the economy began to crumble following the collapse of the stock market in October. Businesses went bankrupt, banks went under, and unemployment surged. What were the causes of this great depression, and could it happen again? One of the main reasons for the crash in 1929 was the unequal distribution of wealth between Americans. Despite rising wages, and increased productivity; income distribution was extremely unequal. The top one percent of the population at the peak of the pyramid had incomes 650 percent greater than the 11 percent of Americans at the bottom. The top 0.1 percent of Americans had combined incomes equal to the bottom 42 percent; that same 0.1 percent of Americans in 1929 controlled 34 percent of all savings, while 80 percent of Americans had no savings whatsoever. One such example, was Henry Ford, founder of Ford Motor Company. Ford’s income in 1928 was 14 million dollars while the average American received wages of 750 dollars a year. Income per capita rose 9 percent from 1920 to 1929, while those with income in the top 1 percent enjoyed a exorbitant increase of 75 percent. (Alexander 2) This tremendous concentration of wealth in the hands of created some interesting problems. This scenario determined that the American economy was vastly dependant on high investment or luxury spending of the rich. This is okay except that high spending and high investments are very susceptible to fluctuations in the economy. These two instruments are much less stable than the alternative population expenditures such as food, clothing, and shelter. While food, clothing, and shelter matter they do not affect the economy as much as investment. The Federal Reserve was created in 1919 to prevent financial crisis and monitor economic activity. (North 7) The Federal Reserve reduced interest rates significantly in the 1920’s. When interest rates decrease investments increase. With rates low companies are more inclined to borrow money. This is because they will have to pay back less interest. This increased capital is used for new ventures, companies, ideas, and factories. This in turn creates more jobs and increased gains. In 1929, the Federal Reserve made a series of aggressive rate hikes that that dramatically hurt investors confidence. (Reed) When rates go up capital usually goes down, as investors decide not to weather the risk. Then the adverse happens, new ventures, companies and factories growth slows or declines, and as job cuts are made unemployment increases. This is usually used to slow growth and decrease the chance of overheating of the economy. When this happens money usually flows back into banks, bonds, and more stable investments. This did not happen. Investments for the most part continued, especially among individual investors and institutions. With the economy on a tare and the stock market rising close to twenty fold in under a decade, everyone wanted to get in on the wealth making machine. Gains increased and virtually everyone was making money. Investor sentiment rose to unprecedented highs and so did the investing. In order for the economy to keep it’s pace, the lower income level income population had to participate, and participating they did. The participation was done through a new mass marketing method of buying on credit. The concept was very popular and caught on quickly. The idea was simple. You could buy something and pay it back in installments over a period of time while paying a borrowing fee of interest in return. By the end of 1929, sixty percent of cars were bought on credit as well as 80 percent of radios. Between 1925 and 1929 the total amount of installment credit more than doubled from 1.38 billion to around 3 billion. (Alexander) People began to bypass savings for material objects and debt As the President’s Committee on Social Trends noted, “Installment credit allows one to telescope the future into the present.” (Davis 1) Telescoping they did do to Wall Street as speculation became common place. It was not long until the credit principle spilled into Wall Street. Anew form of buying stock became popular, it was buying on margin. It operated on the same principle. The bank or brokerage loans you an amount of money at a certain interest rate per month. Buying on margin allowed one to buy a large amount of stock with a little amount of cash up front. It was quite common for someone to purchase shares while paying only 3-5 percent of the cost. This scenario works as long as the market continues to go up. If the share increase is a greater percentage than the interest rate one can make a lot of money in a short period of time. Investors were pouring profits back into margin buying as they telescoped continued success and new highs in the stock market. As the Federal Reserve began to raise interest rates and decrease money supply along with some major investors realizing the extremely high valuations, the market started trading volatially. This volatility continued for a couple of weeks, but margin buying continued. On October 24, 1929 the house of cards collapsed. The stock market lost more than 4 billion dollars in a single day. (Davis 1) Banks and brokerages who had loaned large amounts of money for margin buying suddenly felt the pressure. These banks and brokerages started mass margin calls asking for investors to put up more cash. Problem, investors did not have much cash, all the money was in the market. For those who could not pay the margin calls, the banks and brokerages had to sell the stock to get the money that was owed to them. All the buying that had taken place over the previous couple of years turned to panic selling. The market continued its fall and lost 15-20 billion dollars worth in a little under a week, under massive volume of 1.3 billion shares. (2) The drastic amount of margin calls, Federal Reserve moves, and sudden drop in the market shattered investor confidence and led the way to the collapse of the stock market. When dealing with the issue of Economics, one should consider philosopher George Santayana when he warned, "Those who cannot remember history are condemned to repeat it.” (Rushdoony 1) America is in the midst of a financial revolution. Communications, personal computers, and the Internet beckoned this revolution. This revolution caused a paradigm shift to the Individual Investor. These investors have become increasingly lured by fast money, and infatuated with quick profits. This new breed of financiers should take heed to the warnings that are clearly visible through the window of history. As speculation rises; the risk, uncertainty, and the increased chance of a depression rises at a similar angle. The nineties have created unsurpassed wealth and have increased the strength of the largest bull market in history. The parallelisms to the twenties are remarkable and one could “speculate” that a similar scenario is possible, if not probable. Bibliography:

Word Count: 1435