8 September 2008

Recipe for a Depression (1920s vs today)

Being that history is said to rhyme, this 20-page study argues the presence of many similarities back then, as compared to today. "Recipe for a Depression: A Re-interpretation of Economics in the 1920s" concludes with the following summary. Paper is by Stephen J. Church, President - Piscataqua Research, Inc.

Author's Note

This is a study of the causes of the Great Depression. I became interested in Federal Reserve monetary policy in the Great Depression because of an article that discussed policy conflicts at the Federal Reserve during the 1920s. The article implied that recent Federal Reserve policy questions were similar to policy issues during the 1920s and 1930s. I found the implications intriguing.

Concluding excerpt

"Low interest rates encouraged exceptional investment levels in plant and equipment, structures and housing. The growth of income made debt-based investing a nearly riskless opportunity. The extended period of increasingly high profits caused by an accelerated investment process seemed to justify expectations of future earnings growth.

Eventually, the negative real interest rates had their expected effect. Credit expansion began to exceed economic growth by a substantial margin. Shortly thereafter, asset prices began to rise at an excessive rate. Finally, borrowing to purchase risky assets on the expectation of price appreciation proliferated into every asset category.

The 1920s ended when the productivity-enhancing investment opportunity set began to diminish and the Federal Reserve determined to do something about the excessive credit expansion. The asset price deflation process morphed into an income deflation process. Price deflation accelerated during the normal economic slowing. Profits declined quickly. Incomes declined quickly. Consumption declined rapidly.

Ulitmately, the Great Depression resulted from the excessively low real interest rates maintained by the Federal Reserve during a time of high levels of productivity-enhancing investments. The low real interest rates encouraged over-investment and excessive debt creation. When the Federal Reserve tried to slow the process, the underlying economic weakness was exposed."


Eerie comparisons relative to today's economic environment. And the "carry trade" process back then is just as applicable today, only Japan is the facilitator:

Interactions between the Real and Financial Economies

"The interactions between the real and the financial economies progressed as would be expected in an era of high investment opportunity and expansionary monetary policy. The process was simple and predictable.

Excessive monetary expansion through low absolute and real interest rates has predictable side effects. The side effects are increased economic investment activity coupled with increased financial investment activity. The financial investment activity starts as debt investments and morphs into equity investments as economic investments generate growth and profits.

The final phase is usually debt-financed equity investments and maturity arbitrage with short-term debt financing long-term debt investments. The final phase is known as the carry trade where current returns on investments more than cover the currently low cost of short-term borrowings...

The carry trade was...based on the profit growth from economic investment expectations and the current financing costs of low real interest rates. The predictable result of carry-trade financed equity issuance occurred. Since the capital used for the most recent economic investments was virtually costless, the investments produced excess capacity and stock dilution. Profits began to decline dramatically. The carry trade was forced to unwind as the market violently lowered stock prices."



thanks for all your great posts. could you post this paper? Thank You, Kevin


Thanks for all your great posts. Could you post this paper? Thank You, Kevin