The Bear’s Lair: 1930s, here we come!

Pundits all over the media are proclaiming gloomily that we are in for a re-run of the 1970s. They are far too optimistic. If you look at the world with an unprejudiced eye, we currently have aggressive power blocs, rapidly escalating protectionism, overpriced stock and real estate markets and a huge mass of malinvestment from the last decade that will need to be written off. Guys and girls: that is not the 1970s, it is the 1930s, albeit with rather more inflation.

The 1970s were different in Britain and the United States, as I remember from spending time in both countries during the decade. In the U.S. inflation peaked at just above 10% and there were two quite substantial recessions, in 1974-75 and 1979-82, the second being a “double-dip” affair. However, there was no great move towards protectionism. The world was not fully free trading – the Soviet bloc was largely cut off from the West — but if anything during the decade the world trade system opened somewhat as tariffs came down under previously agreed trade deals (the Kennedy Round had been signed in 1967) and the beginnings of an economic opening to China took place.

There was a large asset price decline, but it was disguised by inflation. The Dow Jones Industrial index declined by about 75% in real terms between 1966 and 1982, but by only 20% in nominal terms, as inflation ate away at the real value of stocks. Finally, while the OPEC oil embargo demonstrated the end of U.S. hegemony, there was a relaxing rather than an increase in international tensions, with the end of the Vietnam war, an opening to China and a modest if overstated “détente” with the Soviet Union.

In Britain, the 70s were significantly more unpleasant. Inflation hit 25% rather than 10% and the Financial Times Share Index fell by 70% in nominal terms, not just in real terms, between 1972 and the end of 1974. House prices did not collapse, but only because retail prices doubled between 1973 and 1977, making previously sky-high house prices appear a relative bargain. There was also a massive liquidation of malinvestment, that bankrupted almost all the entrepreneurial (and therefore highly leveraged) public companies – only the dozy dinosaurs survived, to be taken out by the second more severe recession of 1979-82.

However, even in Britain, it was not the 1930s. To forecast a re-run of the 1930s is thus a fairly extreme statement (less so in Britain, where good policy after 1931 turned the economy round quickly). Nevertheless, the preconditions for that claim appear to be in place.

First, the Russian invasion of Ukraine can be equated quite closely to the 1931 Japanese invasion of Manchuria. It was an unjustifiable act of aggression, that was yet justified in the minds of its perpetrators by Western acts of hostility and contempt, such as the 1922 Washington Naval Treaty, which brought an end to the long-standing Anglo-Japanese Alliance and resulted in the isolation and (in their ‘face’-conscious eyes) diminishment of Japan. It also began a period in which the world was divided into sharply distinct trading blocs, with each bloc seeking to optimize trade only with its own group – the German autarkic attempts to cut off Bulgaria and other East European countries from non-German influence were a case in point.

Today a very similar process is taking place. Russia has been cut off from the international trading system, while China has largely allied itself with Russia and may be moving into antagonism with the west. A Chinese invasion of Taiwan, quite likely during the weak remainder of the Biden administration, would cement this fissure in place and fully re-create the mutually hostile autarkic blocs of the late 1930s.

On the trade front, the 1930s saw the Smoot-Hawley Tariff of 1930, followed by the British Ottawa Agreements of 1932, raising protectionism to its highest ever level and causing world trade to fall by 66% from its 1929 peak to its 1934 trough and recover only sluggishly thereafter. With the dismantling of globalization, the world trade system is currently moving in the same direction, as it was not in the 1970s.

Here however one important distinction must be drawn. In the 1930s, the previous decade had not been one of free trade. Britain was in the last stages of its period of unilateral trade disarmament, but even there the McKenna Duties imposed during World War I were not removed in the 1920s, so tariffs on “luxury” goods such as automobiles were quite high, as they had not been before 1914. The United States, France and Germany also imposed substantial trade tariffs, so the average global tariff rate in 1929 was much higher than it is today. Thus, if the world of today avoids a return to full protectionism, it may be able to avoid a two-thirds collapse in world trade, as in 1929-34. We shall see.

The collapse of stock and to a lesser extent real estate markets provided the first impetus for the 1929-33 slump, as is well known. By the end of 1929, stock prices had halved from their peak and both politicians and business had braced themselves for the onset of a severe economic downturn, as in 1920-21. However, the market overvaluation of 1929 was nothing like as extreme as that of today. The premier growth stock of the 1920s, Radio Corporation of America (RCA), was trading at only 28 times earnings at the peak of the market, a valuation that was well justified by its future prospects. Overall, U.S. monetary policy had been only moderately loose, real interest rates remained positive and, outside the Florida land boom, which had collapsed in 1926, there were no great excesses in real estate.

After 1929, the market decline was inevitable, but it was greatly worsened by two massive policy errors. First, the Fed effectively tightened money supply after the end of 1930, by not correcting for the slew of banks failing, each of which failures took “money” out of circulation. The Fed maintained a fairly loose, approximately neutral policy in terms of interest rates, but it should have expanded the money supply aggressively to counteract the bank failures.

The second error was President Hoover’s insane decision, at the bottom of an already serious depression, to increase the top rate of income tax from 25% to 63%. This produced a hugely damaging further downward leg in the stock and real estate markets in 1932-33, and an additional massive wave of bank failures, accounting for a third of all U.S. banks in existence, which again the Fed failed to correct for. The period of utter economic despair that occurred in the winter of 1932-33 was entirely avoidable, and entirely caused by government idiocy.

This time around, we began 2022 at the end of a period of Gosplan monetary policy, forcing interest rates to artificially low levels for more than two decades. Consequently, our level of malinvestment – assets and companies that should not exist in a balanced market and represent speculative excess – is orders of magnitude greater than it was in 1929. Even if the government avoids the egregious errors of 1930-33 (and under the Biden administration and the feeble Powell Fed it seems almost impossible for equivalent errors to be avoided) the liquidation of rubbishy overinvestment will be as painful as in 1929-33, meaning that the economic damage that liquidation causes will be equivalently severe. The nearly uninhabitable and grossly overpriced “pencil” towers of New York, about which I wrote last week, are just one example of this – without over-inflated asset values, they will have neither purpose nor buyers.

There is one additional factor. In 1929, the U.S. government was tiny, well managed and running a budget surplus. None of those conditions holds today. In 1932 President Hoover needlessly raised taxes in a deep depression, because he worried about the budget deficit – in reality, U.S. Treasury bonds were in 1932 about the one investment in which people still had confidence. This time around, the authorities may try to avoid Hoover’s mistake, but the markets may not let them. The combination of inflation, a collapsing economy and a spiraling budget deficit will almost certainly cause a “buyers’ strike” in the bond market such as we saw in 1978-79. The Fed may try to meet that with manic money printing, but that will simply cause hyperinflation. Eventually, since the government will be congenitally unable to cut spending, taxes will have to go up thus, however unwillingly, repeating Hoover’s 1932 mistake.

This time around, we won’t even have the Golden Age of Hollywood to look forward to!

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)