Tuesday, September 30, 2008

A Reminder from the Great Depression

Reactions of the Wall Street slump

Nov 23rd 1929, Finance & Economics, The Economist

IT'S an ill wind that blows nobody any good. The fall of Bank rate on Thursday by another half per cent is an outward and visible sign that the dramatic and precipitous slump of the last three weeks in Wall Street has definitely relieved the pressure on the world's money markets which the New York situation has been exerting so continuously for the last two years. Very few could have dared to hope, when Bank rate was raised to 6½ per cent on September 26th, that it would be back again at 5½ per cent in less than two months. That advance, indeed, was a by no means negligible factor in turning into the opposite direction the tide of funds which had been flowing so strongly towards New York, and in causing the edifice of American speculation to totter. But that it would collapse so completely was hardly to be expected. In the event the financial strain has been lifted, and money rates have fallen to such an extent that for the last two weeks, Bank rate, which fell to 6 per cent on October 31st, has been ineffective, three months' bills having fallen this week to a bare 5 per cent. In the circumstances the Bank had no alternative but to lower its rate. Indeed, some people had thought that it should be even bolder and reduce the rate to 5 per cent.

This optimistic view, however, did not take sufficient account of the gold situation. Since the end of September the Bank has continued to lose gold to France, and has barely balanced these losses by receipts, its holding today being about the same as when the rate was raised. But there is a vast difference between a situation in which the Bank is fully holding its own and one in which it was losing heavily every week. There is no urgent need for the Bank to embark on a drastic policy for the purpose of rebuilding its reserves. It is clear that we are about to enter on a period of considerably cheaper money, and the rebuilding process can take place steadily when a new world level has been attained.

The slump on the New York Stock Exchange, which has resulted in this great change in the monetary outlook, is one of the spectacular episodes of financial history. A prolonged upward movement, the extent of which is illustrated by some graphs which we print in a later column, has been built up over a series of years on the amazing and unexampled prosperity of America. But some two years ago the speculative movement seemed to lose all touch with reality; and in spite of occasionally vigorous but more often half-hearted, measures by the banking authorities of the United States, speculative fever spread throughout the nation and carried prices, mainly with the aid of borrowed money, to fantastic heights. Writing of the efforts made to check the movement, a high authority observes:

"The market fought its way upward against Reserve banks and member banks, and there was truth in the boast that it defeated them . . . bankers are not the owners of the funds in their custody, and the market defeated them by going round them and inducing depositors to place their funds at the disposal of 'the street.' Democracy triumphed over authority and leadership in the advance, and the orgy at the finish was all its own."

Highly coloured stories of devastating ruin and of paralysis of economic life must, as always in such cases, be heavily discounted; but it is natural that people should be asking themselves how widespread and of what character will be the economic reactions of this slump. The question acquires added importance from the fact that in its later stages the Wall Street movement pervaded the whole world by drawing money, not merely from all corners of America, but from every continent. It resulted in an embargo on the export of gold from Canada and monetary difficulties in the Argentine, while its financial repercussions were painfully felt in every monetary centre. If this was the effect of the boom what will be the effect of the collapse?

Turning first to the direct effects in this country, there are undoubtedly many private investors, as well as trust companies and other financial institutions in London who have suffered substantial losses. But circumstances have somewhat mitigated what might easily have been much more serious effects in Great Britain. There has notoriously been considerable British buying of American securities during the last two years, and the advent of the Labour Government gave an added incentive to those who thought that it was time to escape from the British frying-pan into what, in the event, proved to be a very hot American fire. In September, however, the shock to the London Stock Exchange caused by the Hatry disclosures, together with the growing uneasiness as to the giddy heights to which American securities were soaring, undoubtedly led, in some cases, to forced sales and, in others, to precautionary withdrawals of money invested in the United States. There were signs of a backward movement from the United States even before Bank rate rose in September; but after the rise these withdrawals rapidly increased. London's interest in Wall Street was thus considerably lightened before the slump occurred. After the slump had taken place, large quantities of international securities were offered in the London market at, in some cases, very low prices. These have been absorbed and London has thus done something to stop the rot.

But while the direct effects are not of really serious importance to this country, the influence on the economic situation here depends on more general considerations than the technical position at the time of the slump and, above all, on the answer to the question which everybody is asking but no one is prepared to answer, namely, what will be the economic effect of the slump on business in the United States? It has many times been pointed out that the present slump differs from most of its predecessors in the fact that it has not been accompanied by industrial over-production or rising commodity prices resulting from an expansion of credit. If the industrial situation is unduly expanded, as in 1920, and the whole economic situation is precariously balanced like an inverted pyramid upon its apex, even a moderate shock from the Stock Exchange might produce a general collapse. This is not the situation today. The question presents itself rather in this form: Can a very serious Stock Exchange collapse produce a serious setback to industry when industrial production is for the most part in a healthy and balanced condition?

Optimists say that there is no precedent for such a harmful reaction, and that the worst that need be expected is a slight shock reflecting itself in a short-lived hesitation. Even though some temporary contraction of demand for consumers' goods of the luxury type may be inevitable, it is argued that cheaper money should lead to increased expenditure on capital goods by industrial corporations, and that official encouragement, backed by the steady propaganda of the "sunshine artist," should quickly produce a renewal of the upward trend of industry as a whole. A more serious view is taken by others, who point not only to the heavy "break" in certain commodity prices which has accompanied the slump, but to the danger that Wall Street losses may have gravely shaken the psychological confidence of America in the prospect of unlimited expansion. These observers think that the orgy of speculation in the United States has been so widespread that persons of all classes deceived by, in some cases, real, but in many more cases, purely paper profits from their investments, have been living beyond their means, or, at all events, mortgaging their future by purchasing luxury goods up to, or even beyond, the full limit of their incomes.

It is said that this has resulted in a precarious situation owing to the extensive buying on the instalment plan, and that the slump will lead to widespread defaults and a slowing down of production in the trades chiefly concerned. The ordinary man, however, cannot spend paper profits without realising them, and while it may be true that the confident expectation of large Stock Exchange profits may have encouraged an extravagant scale of living which may have to be reduced, it remains true that the bulk of instalment buying rests upon the income of wage and salary earners which will not be affected by the present slump, unless it extends its ramifications throughout industry and produces unemployment. Indeed, as Professor Seligmann has recently argued, "instalment credit, extended as it is largely to recipients of wages and salaries, is likely to produce less effect on the business cycle than producers' credit, resting upon profits." It may, however, be taken for granted that there will be some curtailment of the consumption of luxury goods, and that this will mean a certain restriction of trade.

How far this will extend must at present be a matter of conjecture. A great deal must in any case depend upon the situation of the banks. The one influence that could throne back the full brunt of the speculative collapse upon industry and produce a real depression throughout the country would be banking trouble. Certain Wall Street banks made some spasmodic efforts to check the slump, but were careful to dispose of their holdings at the first opportunity, and there is no reason to suppose that they have seriously handicapped themselves by efforts which never went the length of attempting to stop the rot by holding large blocks of stock off the market. There are, however, known to be large quantities of securities not yet absorbed by the public which for the time being have to be carried by banks and finance houses. Many banks will, moreover, have made very large bad debts, while others will have to finance customers for a long or short period. Some bank failures, no doubt, are also to be expected. In the circumstances will the banks have any margin left for financing commercial and industrial enterprises or will they not? The position of the banks is without doubt the key to the situation, and what this is going to be cannot be properly assessed until the dust has cleared away. On the whole, the experts are agreed that there mint be some setback, but there is not yet sufficient evidence to prove that it will be long or that it need go to the length of producing a general industrial depression.

It remains to consider what effect a setback, whether great or small, in the United States will have upon other countries. The trade reports contained in our Supplement this month show a not unnatural hesitation as to the effects of the American situation. The fear is, however, expressed that if United States producers suffer from a diminution of their home market, it will, on the one hand, strengthen the demand for an increased tariff at Washington, and, on the other, lead to the exporting of the surplus products at low prices abroad. This last event is one which has long been awaited with some misgiving by European producers. But the expectation that there will be a flood of American exports as a result of the tide having turned in the United States overlooks one or two features of recent American development. In the first place, American technique has developed on the lines of very greatly reducing production for stock and it is the practice today to curtail output schedules at the first sign of reduced sales. Secondly, mass production means production at a very narrow margin of profit per unit of output. Thirdly, the apparatus of foreign sales, except in those products which already have a foreign market, cannot immediately be improvised. We need not, therefore, assume either that there already exist in the United States, or that manufacturers will continue producing so as to create, large surplus stocks of manufactured goods; nor can they afford to sell abroad at less than cost, at the expense of the American producer, more than a small proportion of their output. While, therefore, there may be some sales of goods at low prices, which may prove embarrassing for competing producers, it is not to be contemplated that the great stream of American production can suddenly be switched from the home market into export channels.

In any case, against any disadvantage arising from American competition must be set the great advantage which we mentioned at the outset, namely, the return to cheap money conditions. This should assist trade recovery throughout the world, which has been handicapped for so many months past by the abnormal financial conditions in New York. If we are justified in assuming that the setback in American industry will only be temporary, we may look forward to steady development in 1930, free from the incubus that has of late been hampering world conditions.

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