Real Clear Analysis 4: The (Second) Great Depression

The Great Depression is a hot topic of conversation these days as we all wonder “how bad this could get.” It is therefore useful to revisit the Great Depression and other Panics in American history to find or dismiss parallels with our own time.

Most histories of the Great Depression involve complex discussions of government policies, monetary policies and stock market dynamics. Indeed, many people think of the 1929 stock market crash as the cause, or even the entirety, of the Great Depression itself.

Data analysis suggests that the cause of Panics and Depressions may be simpler than most historians suggest.

To recap, the First Great Depression (of 1873) was the result of a massive capital build-out that doubled the Railroad capacity of the country and connected it coast-to-coast by rail. The build-out consumed far more capital than the country had in liquid assets and therefore required unprecedented levels of new debt and equity. The build-out ended naturally when the project was complete following the driving of the Golden Spike. Without the impact of the build-out, the economy was doomed to shrink back to “normal”, though the productivity impact of the new technology rendered the prospects for pricing and employment even lower than they had been before. As the poor outlook for profits and threats to invested capital became clear, investors reasonably tried to get their money back before it was lost forever. Though it seemed like a panic, the Panic of 1873 was rational and a symptom of the wider economic situation rather than a cause. The country was left with a dramatic slowdown that the Government was essentially powerless to combat even if it had tried. It was only as the United States grew into the added capacity and increased productivity that the Depression could end.

A similar narrative applies to the Second Great Depression (of 1929). Instead of Railroads, the 1920s saw the concurrent build-out of the electricity, telephone and motor vehicle industries that consumed about $50 billion in capital. In addition, the 1920s saw an unprecedented level of investment in residential and commercial construction that consumed another $49 billion. All told, the $100 billion of capital-build-outs made the economy $10-$13 billion “too big” in each year of the latter part of the 1920s.

With frightening synchronicity, each of the build-outs reached completion in 1929-1930: At a moment when there were about 25 million non-rural households, electricity, telephones and automobiles came to reach virtually all of them. As with the Railroads of 1873, when the build-out was finished it simply stopped. Millions of miles of wire had been run and millions of cars and tractors had been built in a headlong rush to equip Americans with the latest technology. Once equipped, the build-out ended.

The end of the build-out left a $13 billion annual hole in the economy that was made even worse by the enhanced productivity made possible by technology. Electricity, in particular, made possible dramatic gains in manufacturing productivity that displaced thousands upon thousands of workers.

At the same time, the new technologies carried the seeds of their own destruction: once capacity was in place, the downward pressure on electricity rates, telephony rates and automobile prices was relentless. As in 1873, the immediate cause of the 1929 Panic had been the sudden realization that profits would not be anywhere near what investors had dreamed. In 1873 it had been the failure of the Northern Pacific, in 1929 it was the news that Boston Edison profitability would be limited by lowered rates. The diminished outlook for profits had a predictable, albeit violent, effect as investors tried to get their money back by selling shares, cashing in bonds and making runs on their banks.

By 1929 a significant slowdown was inevitable – the next build-out was not on the horizon (and there may not have been enough capital to fund it if it had been). The scale and shape of the Depression was an echo of the build-out that had caused it. Indeed, while the Great Depression is seen as a generalized disaster, it was actually quite concentrated: 2.2 million of the 2.8 million lost manufacturing jobs in the early 1930s were in industries directly related to the build-out. Likewise, in the stock market, Industrial stocks had tripled from their 1932 lows by 1937 while Utility stocks had recovered only modestly.

The Depression may also have been inevitable, though much effort was made to fight it. Beginning in 1931, the Federal Government made significant efforts to mitigate the impact of the slowdown. Between 1931 and 1937 the Government took on $20 billion of new debt to finance social and infrastructure spending, more than doubling the National Debt. Unfortunately, it was $20 billion of money thrown into a $100 billion hole.

There are four simple lessons to draw from the two Great Depressions:

1. Financial Panics are a symptom, not a cause, of inevitable economic slowdowns following massive capital build-outs.
2. The size and shape of a Depression is an echo of the build-out that preceded it. The ability of new economic activity (or Government spending), to neutralize the effects of the Depression depends entirely on the size of the “hole” that needs to be filled.
3. Productivity makes things temporarily worse – the greater the productivity gains, the worse the Depression.
4. If the size of the “hole” in the economy is large, the Government will not have sufficient resources to meaningfully mitigate its effects – especially if existing Government debts are large.

The relevance to our own times is equally straightforward:

1. Are the financial markets to blame? Despite all the attention on banks and bankers, they are not the cause of the current economic slowdown. The cause is a capital build-out that has already happened.
2. What build-outs drove the economy beyond its natural size and by how much? Home Building, Technology and Retail Infrastructure have certainly been important build-outs, but more important may be the infrastructure build-outs in China, India and other countries where Americans and others have invested in pursuit of greater productivity.
3. How great are the permanent productivity gains from recent investments in technology and infrastructure? Production costs per unit have dropped meaningfully by the use of cheap overseas production. The permanence of these productivity gains will have a great impact on the length of the current slowdown.
4. Does the Government have the resources to mitigate the effects of the slowdown? Since the Great Depression (of 1929), the Government definitively has not salted away resources in order to fight the next slowdown. Indeed, the opposite has happened, with borrowing becoming only greater. The Government doubled the National Debt in a largely failed bid to mitigate the Great Depression. A similar doubling of the current debt is certainly impossible. The failure to “make hay while the sun shone” will limit flexibility to fight the current slowdown.

To be continued