June 22, 2009

Impressions of the week June 16-21, 1930

June 22, 1930 was a Sunday with no Journal to summarize, so once again I'm going to drop the mask of objectivity and make with a little editorial commentary and impressions of the past week.

Do the Country Shuffle - If there was a single item that made me sit up from my normally slumped position this week, it was the first one in the Market Commentary from Saturday:

Editorial noting that large US loans to foreign countries are beneficial to US business because the money gets recycled to buy US goods; this helps to absorb our production capacity, which is greater than domestic demand.

Now let's see, a country that has a big creditor position, a production capacity too big for its own people to absorb, and that therefore is loaning money to other countries to get recycled back into a trade surplus... might that remind you of any country today? (Hint: A Inch). Now, I'm ashamed to admit that until I saw that item it hadn't occurred to me that while the current situation might bear some resemblance to 1930, the countries might have to be shuffled around to really make things correspond - the flash of insight was blinding! Well, if China now is us then, then who then are we now? Let's see ... proud owner of the world's reserve currency franchise ... running sizable merchandise trade deficits ... I think I got it! (Hint: Baring Attire). OK, but then who now is Germany then? Let's see ... huge outstanding debts, postponing dealing with them as long as possible through a series of temporary gimmicks, government reaching a state of deadlock... got it! (Hint: Facial Iron)

Hmm ... that isn't exactly encouraging when it comes to what happens next ... although, on the bright side, at least in the case of California the consequences of having a strange looking Austrian in charge haven't been anywhere near as drastic this time ...

The Tariff Revisited - As expected, I got some adverse reaction to my opinion last week that the tariff didn't seem to have been a major factor in the decline so far. Let me clarify a couple of things. I'm not in favor of protectionism, nor do I think the tariff was a good idea - it probably wound up doing some damage. All I said was that in my personal, constitutionally protected opinion, it didn't seem to have been that much of a factor in the decline so far (I'm not excluding the possibility that it later did become more damaging). To review, I think this because:

- The trade crash already appeared to be well in progress before the tariff passed - in fact, this trade crash is even more remarkable given anticipation of the tariff, since we would normally expect a big bump in imports before the tariff was passed as importers stocked up as much as possible to avoid the raised duties.

- Tariffs were not exactly unknown at the time; many were already in effect around the world; as Mellon says this past week, previous tariff raises had also caused “gloomy prophecies”, but trade had nevertheless always increased in the past. It's also not the case that the tariff was hugely more punitive than previous ones - if I may cheat slightly and use an item from tomorrow, 80% of imports were duty-free or had duties reduced or unchanged under the tariff, and Hoover had made his intention clear to use the flexibility provision to address complaints about the remaining items.

- My final point was that the stock market declines seemed to be happening more in response to bad business news and commodity price declines than to the progress of the tariff bill. This is, of course, a subjective judgement and I invite the readers to come to their own conclusions.

Regarding this last point, however, I can't restrain myself from responding to one analysis that I was pointed to about the tariff's impact. This was by none other than the late supply side guru Jude Wanniski: http://polyconomics.com/ssu/ssu-010713.htm

Now, when I referred last week to a religious war among economists, I didn't expect to have to take on one of the Grand Ayatollah's himself, and without even a couple of warmup bouts with tomato cans. However, I will not shrink from my duty. Let me at least do a few pushups to warm up ... ninety nine ... a hundred ...

OK, here goes. With all due respect, this is one of the most bizarre and stupid analyses I've ever seen. A point-by-point refutation would be way too long, but here's a few of the high points. Mr. Wanniski starts right out with a whopper:

The most common explanation of the crash is that the market was overpriced, the victim of heedless speculators who had somehow lost their grip on reality in the mad rush for quick profits. But that explanation has never quite satisfied, either empirically or logically. There is no real sense in which the market can be 'underpriced' or 'overpriced.'”

And here i've wasted all these years listening to suckers like Buffett or Soros who claim that the market has been known, on occasion, to go stark raving bonkers. Yes, it's all clear now. The market didn't crash because hot stocks like A&P were selling for 40-50 times earnings or more, and the most reliable measure of market valuation as a whole, the PE10, hit a peak over 30 not to be equalled until 2000 (see figure 1.3 in http://press.princeton.edu/chapters/s7922.pdf ). It didn't crash because traders were, if I may be excused for using a technical term, leveraged out the wazoo, with margin debt setting new records every week. It didn't crash because business started to decline. No, Mr. Market is always cool and rational:

The market places a value on each company listed on its exchange, based on its calculations of that company's future income. ... If one accepts this rational model of stock market behavior, it's logical to believe that the market at its 1929 peak was exactly where it should have been, and that the crash resulted from some stupendous error ...”

So, what did cause the crash? What rational cause was there to reduce the valuation of all US industry by approximately 50% in around 3 weeks starting on Black Thursday, October 24? Clearly, the only explanation is:

On Thursday, October 24, the anti-tariff forces suffer another setback; casein tariffs are raised 87%.”

Hmm ... casein. Well, it is one of the more commercially important milk-derived protein byproducts, but still, a 50% haircut for the value of the entire US industrial base does seem a little ... what's the word ... demented? To be fair, I guess Mr. Wanniski is arguing that it wasn't the casein tariff itself but that the market somehow at that moment realized that the anti-tariff forces were beaten and tariff passage was inevitable (although Smoot-Hawley didn't in fact pass for another nine months after much further sound and fury). But lets examine this a bit further. By Mr. Wanniski's theory, the mere realization by the market that tariffs were probably to be raised at some future time justified that 50% haircut. Now let's fast forward to Friday the 13th of June, 1930. Until that point, despite Mr. Wanniski's version of events, it appears that there still was some doubt about passage of the Smoot-Hawley tariff, since it still didn't have the votes to pass in the Senate (this is probably why there was an editorial against it roughly every other page in the WSJ). It's an item from that day that's really the final nail in the coffin:

Passage of the Smoot-Hawley tariff seems likely. With Senator David Reed, declaring his support, the bill is likely to pass in the Senate by two votes, and then to be adopted by the House. President Hoover is likely to sign in order to end “business uncertainty surrounding tariff consideration”; it's feared that a narrow defeat or veto would simply lead to the reintroduction of the issue at the next session of Congress. Senator Reed says the bill has been improved more than generally appreciated; his action followed meetings with Secretary Mellon and President Hoover.

This switch by Senator Reed and another Senator is what gave the tariff a majority - and, since he announced it after conferring with Hoover, it's clear that a veto is also not to be expected. So what was the market's response to this? If the mere probability of a tariff bill nine months later was enough for a 50% haircut, surely the inevitability of one in a few days would cause a cataclysm! Dow on Friday ... drumroll please ... up 2.51 points (1.0%).

I will skip the company review this week due to being worn out from wrestling with Mr. Wanniski, but I hope to have an expanded version next week. Until then ...


  1. Have you posted this blog in Digg? This is the kind of thing digg users like to read.

    I'm not sure if I understand you correctly. You think we are now Germany? I thought we were England.

  2. This is a great blog. Please keep going.

    As far as the stock prices. The reason they were able to go so high to begin with, was that people were borrowing on margin to buy them at very high rates of leverage (much higher than allowed now.) Worse, the price of the shares being bought, effectively allowed people to use them as collateral for further loans, to buy more shares.

    So prices went up even more. So just as today, with Asset Backed Securities, a loan feedback loop was triggered, which resulted in the commercial banks lending far more money than the economy could in fact support. Worse, at least some of the money was provided by commercial companies, providing short term profits/funds to the banks at quite high rates of interest. (Partially caused by the Federal Reserve, which was desperately raising interest rates to shutdown the bubble.)

    When stock prices started crashing, it triggered cascading margin calls, that caused further stock sales as investors desperately tried to cover their loans. Since they were based on loan inflated share prices, this simply wasn't possible, and the eventual result was massive defaults, taking out a significant part of both the banking and corporate sector.

    - cc

  3. Joshua -
    Thanks for the suggestion! I'll add a Digg button. I guess I was too obscure with the country jumble, since most of my friends also didn't understand. To fully clarify, those are anagrams:
    A Inch = China (= US then)
    Baring Attire = Great Britain (= US now)
    Facial Iron = California (= Germany then)
    Sorry everyone for the confusion!

    Cargo -
    That sounds like a pretty decent summary to me. Or, as Homer Simpson might put it:
    "Leverage ... the cause of, and solution to, all life's problems."

  4. I'd agree on britain and china.
    But I'd say Germany then = Japan now.
    -Japan = 180% debt to gdp.
    -Just came off lost decade so already depressed population, germany was coming off WW1.
    - Tech powerhouse, similar to Germany, particularly with robot capabilities and such.
    -Japan gov't deadlocked and not taking action, companies for the first time reneging on the lifetime employment contracts and firing workers.
    -Sounds to me like 10 years of pain, inaction, too familiar debt increases, and layoffs and Japan would be well positioned to elect a nationalistic populist to fix what ails them. They don't have an army, but if they turn their spare capacity on building a mechanized one there's no sunk costs to stop them. They can build it until it's good and ready before starting.

    I wonder if 10 years of depression down the road we need to worry about Japan's robot armies crushing asian competitors like south korea.