dangerous history lessons: 1929 and analogies with the great
TRANSCRIPT
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Dangerous history lessons: 1929and analogies with the Great
Recession of 2008
Hans-Joachim Voth
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Key points
Important similarities between 2008 and
the Great Depression Like generals fighting the last war, policy
makers (especially in the US) are treatingthe current crisis as a rerun of 1929
As the biggest economic policy experimentin our lifetime unfolds, we learn about thepast and economics in general andmaybe, we got the history wrong.
If 1929 and 2008 are balance sheetrecessions (like Japan 1989+), currentpolicy probably misguided
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Output, then vs. now
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The effect of banking crises
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The sudden return of history - 2
Recovery because of
End to deflation good side of leavinggold, competitive devaluations
Fiscal stimulus (All those autobahns +rearmament)
Bank stability (nationalizations; bankholidays)
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Early abandonment of gold spurredrecovery
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Central banks then: Villains of thepiece
Monetary policy was tight after1929
Weak LOL policies wide-spread
bank collapse Policy today (Bernanke, Romer):
Rerun of 29-32, with different policy
response
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The sudden return of history
Ben Bernankes
apology:
I would like to say toMilton and Anna:Regarding the Great
Depression. You'reright, we did it. We'revery sorry. But thanksto you, we won't do itagain
What we used to think:Great depression greatbecause of Collapse in money
(Friedman-Schwarz):"the contraction is in facta tragic testimonial to theimportance of monetary
forces." Collapsing banks
(Bernanke) Autonomous declines in
consumption (Romer-Temin)
Bug**r-thy-neighbor(protectionism,competitive devaluations)
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Government deficits are muchbigger
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Interest rates are much lower
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Money supply is way up
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Trade and the GD what do wereally know?
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Maybe its not over yet
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Alternative view (Mellon view)Liquidate labor, liquidate stocks, liquidate the farmers,liquidate real estate it will purge the rottenness out of
the system Values will be adjusted, and enterprisingpeople will pick up the wrecks from less competentpeople.
nominal factor and asset price adjustment inevitableworldwide, synchronized balance sheet recessions are less
susceptible to aggressive monetary and fiscal responses Continue until balance sheets (of surviving) firms,
households strengthened A bit of inflation may help, but the basic dynamics of flows
doing the adjustment to a shock in levels remain If this is so, key question is how do you avoid the
buildup of bubbles and balance sheet fragility in the firstplace?
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Speculative Bubbles and CentralBank Policy
Reasons for a central bank to worry about
bubbles: misallocation of capital during the bubble period
wealth effects during the period of increasing
asset prices may cause overheating in theeconomy, inflationary pressures
sudden collapse of asset prices may amplifyrecession. Asset used as collateral for lending;
process of credit intermediation unravels(Bernanke-Gertler; Miskhin etc.)
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Speculative Bubbles and CentralBank Policy - 2
Reasons not to intervene
difficulty of telling the difference betweenbubbles and asset price increases justified byproductivity gains (Krugman 1999)
generally higher interest rates put a brake oninvestment, consumer spending in the economyat large
simulation studies show that volatility of interest
rates, output, inflation may actually increase ifthe central bank raises targets asset prices(Bernanke and Gertler 1999)
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What to do?
Policy Options for Central Banks
general credit restriction, raising interest rates(historical examples: US 1929, Japan 1989) open mouth operations (Greenspan 1996) surgical strike attempt to limit lending to
stockmarket alone, higher lombard rates, punishment
of banks that fail to curtail lending to thestockmarket, impose higher margin requirements etc.(US 1929, Germany 1927)
Strategies Simulations
Estimating monetary policy rules, weight of assetprices in central bank policy rule
Case studies
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What not to do
German central
bank intervenes inMay 1927
Puts pressure onbanks
Black Friday 13.5.1927
Price collapse by
12%; 25% byyear-end
400
600
800
1000
1200
1400
1600 3
4
5
6
78
1925 1926 1927 1928 1929
Intervention
Dividend Yield
Stock Price Index
Dividend Yield and Stock Prices in Germany, 1925-30
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Central bank analysis
speculation is primarily responsible for the extraordinaryexcesses in terms of equity valuations. There are people who
claim that, at a time when the money market rate is at 5%, a valueof 300 for a share paying a 15% dividend is not too muchI wouldnot like to enter into a theoretical argument, but would like to pointout what the situation in 1913 was like. The yield of fixed securitiesquoted on the Berlin stock exchange was 4.5%. The [dividend] yieldof shares was somewhat lower, 3.97%, since shares offer aspeculative upside. The difference in yield between bonds andshares was a mere 0.5%. Today, we see bonds offering a yield of7.12%, while shares (even if we look at the latest dividend figures)yield 3.44%. That not only means that todays [dividend] yield islower than in 1913, when we [the German people] were richer, butit also means that the difference in yields is more than 3.5%nowThis proves how unhealthy current conditions are;
everybody is buying shares because they think there w ill befuture capital gains - Report of Reichsbank President Hjalmar Schacht to the German
cabinet, May 1927
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Implied rates of dividend growthValuation Measures
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
1926 1927 1928
ImpliedRateofDividendGro
wth
8%
real return on shares, 1870-1913
real return on gold-backed
mortgage bonds + 3%
actual rate of dividend growth, 1870-1913
actual rate of dividend growth, 1925-30
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Fallout
-2
-1
0
1
2
-3
-2
-1
0
1
2
80 85 90 95 00 05 10 15 20 25 30
Reichsbank
intervention
real
stockmarketindex
new shareissues
New share issuance and real stock market index
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Fallout - 2
In 1926, 30% of capitalformation finances via equity
issuance [i]ndustrial leaders declare
that the restriction of bankcredits not only will affectshare prices adversely butalso will handicap theindustrial life of the country.It is pointed out that thereorganisation of Germanysindustries has not beenfinished and can be carriedout successfully only if theBourse is able to absorb the
new shares which Germanysindustries will be obliged tomarket. AP correspondent,May 1927
US slump starts with adownturn of consumption
German slump starts earlier(1927/28) with a fall ininvestment
Weak balance sheets in theGreat Depression Banks very weak due to
equity losses additionalaccelerator effect (historicalcost accounting hides muchof this)
Firm balance sheets weaker less good a risk for loans,etc.
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Where do all the bubbles comefrom?
Keynes (1936)
It might have been supposed thatcompetition between expertprofessionals, possessing judgmentand knowledge beyond that of theaverage private investor, would
correct the vagaries of the ignorantindividual left to himself.
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Where do all the bubbles comefrom?
0.00
0.20
0.40
0.60
0.80
Mar-98 Jun-98 Sep-98 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99 Mar-00 Jun-00 Sep-00 Dec-00
Proportion inves ted in NASDAQ high P/S stocks
Zw eig-DiMenna
Soros
Husic
Marke t Portfolio
OmegaTiger
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Two assets:
t = 0 1
Safe asset: 1 1.5
(variable supply)
Risky asset 1 unit 6 w. pr. 0.25
(fixed supply) costs P 1 0.75
ER = 2.25All investors are risk neutral
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The fundamental
Investors have wealth 1 and invest own money
Equating marginal returns
2.25 = 1.5PF 1
PF = 2.25 = 1.5
1.5
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Intermediated case
Investors have no wealth of their own
They can borrow 1 at date 0 and repay 1.33at date 1 if they can
Lenders cant observe how loans areinvested
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Can P = 1.5 be equilibrium price?
Borrow 1 and invest in safe asset
RSafe = 1.5 1.33 = 0.17
Borrow 1 to buy 1/1.5 units of risky asset
RRisky = 0.25( 1 x 61.33) + 0.75x0 = 0.67 > 0.17
1.5
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What is the equilibrium P?
Since risky asset is in fixed supply, P will be bid up
until returns are equated
0.25( 1 x 6 1.33) + 0.75 x 0 = 1.5 1.33
P
P = 3
Theres a bubble since P = 3 > PF = 1.5
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Implications
Monetary policy a poor tool in
Preventing crises
Dealing with crises
If 1929 and 2008 are balance sheetrecessions
There is very little we can do today,beyond pumping up confidence
The key is avoiding similar imbalances inthe future
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Implications
Avoiding future imbalances
Reduce the strength of the link assetprices confidence (less houseownership, less funded pensions, etc.)
Reduce incentives for bubbles Limit lending, lower L/V
Reign in pay + bonuses
Strengthen short selling, guarantee crediblyopportunities to go short
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Sic transit...
We turn to history when theory fails
Two golden moments for monetary policymakers: 1920s and 1990s/2000s
GD and GR demonstrate how marginal the
fine-tuning of the economic cycle is,compared to the risk of major disruptions
Monetary policy either weak or the wrong
tool altogether (avoidance/dealing with thefallout)