I offer a chance to test yourself as King of the World. By that, I mean top dog at the Federal Reserve Bank.
The test is based on two scenarios, one describing our circumstances today and I’ll explain the second in a moment, although you may figure it out without my explanation.
Here are a few characteristics of each scenario:
As you can see from the data, the second scenario would mean pandemonium at today’s Fed. The jobs picture alone would call for aggressive action. But the deflation, in particular, would have the FOMC in a tizzy.
In the economist groupthink of the last decade, nothing can be worse than a fall in prices, however slight the drop may be. Even a mild inflation rate of below the Fed’s 2% target is cause for alarm, as we saw in 2003 when core inflation of slightly above 1% prompted a cut in the federal funds rate to 1%, which we thought at the time was super low. Little did we know then.
Now let’s look at a few financial market indicators in the two scenarios:
On balance, there’s not much in the second table to suggest the Fed would ease its deflation battle in Scenario #2. Tepid house prices – slightly down on a two year look back as shown in the table – would only reinforce policymakers’ resolve to give the economy a boost.
And while stock prices are rising more quickly in Scenario #2 than they are today, that’s not unusual of an economy that’s pulling out of recession (recall from the first table that the last recession ended a couple of months ago). What’s more, the earnings multiple of 15.8 is well below today’s 17.5 multiple.
Have you recognized the second scenario yet? Here are more clues:
If you haven’t guessed, Scenario #2 is early 1928. Benjamin Strong was near the end of a long stint as head of the New York Federal Reserve Bank (he passed away in October 1928), where he enjoyed the same immense power that Ben Bernanke has today. The economy had just begun to recover from a recession in December 1927, and there was much unemployment and spare capacity. According to the Bureau of Labor Statistics, the jobless count jumped by 1,874,500 from the unemployment trough in 1925 to early 1928. Farmers were especially downtrodden. Agriculture was booming during and immediately after World War I, based on thriving exports to Europe. Overinvestment during the boom then gave way to stagnation in the 1920s.
The most worrying connection between 1928 and today may have less to do with the statistics above, though, and more with the global backdrop. Europe was in a bad state in the late 1920s, just as it is now. What’s more, two of the world’s three largest economies are now in Asia, and these economies face similar challenges to those of 1920s Europe.
Here’s my summary:
While analogies are never perfect, the parallels with early 1928 are troubling. When the world slipped into depression in the late 1920s and early 1930s, it was on the back of imbalances and debt overhangs that are oddly similar to those that we face today.
Put your beliefs to the test
Getting back to the test I promised, I recommend applying your economic and policy beliefs to early 1928 conditions, and then asking how your decisions might have played out. Imagine you’re Benjamin Strong, puzzling over a strange brew of rising stock prices, uneven economic recovery, suspect banking practices and unusual strains in Europe’s monetary system.
For background, Strong acknowledged that his July 1927 decision to lower rates was a mistake. The stock market seemed to interpret the credit easing as a green flag, taking off on a dizzying two year climb that ended with the October 1929 crash. In a claim that reveals quite a lot about changes in central banking practices since the 1920s, Fed Governor Adolph Miller later called the 0.5% rate cut “the greatest and boldest operation ever undertaken by the Federal Reserve System, … [resulting] in one of the most costly errors committed by it or any other banking system in the last years” (as reported in Liaquat Ahamed’s bestseller, Lords of Finance).
Strong tried to correct his mistake by lifting rates in several stages, from 3.5% in February 1928 to 5% by July. It was too little, too late, though, as far as controlling speculative excess.
That’s not to say that a stock bubble and eventual downturn could have been averted completely with different interest rate policies. There was much more to the interwar boom/bust cycle, such as game changing innovations in money markets that allowed margin debt to reach ridiculous heights.
But the crazy part of the comparison to our current situation is this: It’s hard to imagine that today’s Fed would have responded to early 1928 conditions with anything other than extreme stimulus. Applying the Fed’s deflation phobia, full employment goal and formal inflation target to the data above, the case for stimulus was stronger than it is now.
Another way to look at it is that Strong hiked rates three months into a recovery because he was concerned about speculation, and that kind of thing just doesn’t happen anymore. By comparison, Alan Greenspan waited 35 months to hike rates in the 1990s recovery and 31 months in the 2000s recovery.
And not only has Ben Bernanke never initiated a rate hike cycle, but his policy framework is based on encouraging rather than discouraging speculators. It’s no exaggeration to say that he’s trying to turn all savers into speculators, by reducing Treasury yields to a pittance and unlocking wealth effects that are a critical part of his thinking.
Of course, Bernanke’s approach is based mostly on his interpretation of the Great Depression. The risks that I’ve flagged in this article (and others) are the potential side effects to his depression-fighting remedies. And the 1920s experience suggests that these side effects could include, well, another depression.
(Click here for data sources and other technical notes about this article.)