Lessons from the 1930s Great Depression applied today

The Great Depression of the 1930s was a complicated, traumatic period in human history. While the recent experience of the COVID-19 pandemic has generally been much less severe, by revisiting this unique period and the policy response, we may be able to better understand the vulnerabilities and reactions of our economy and capital markets to global business cycles, macroeconomic policy and capital flows. In this article we explore the events of the 1930s and consider to what extent they can be applied to the contemporary environment of ultra-low interest rates and significant fiscal stimulus.

Before delving into the Depression lessons, it is vitally important to first understand the key similarities and differences of the 1930s to the 2020s so that we, as students, can better grasp the nuances of this complex decade and the degree to which the two periods may be compared.

Similarities to 2020s

During the 1930s, the macroeconomic environment was marked by:

• Short-term interest rates maintained at near zero.
• Significant fiscal stimulus following the election of President Franklin D. Roosevelt (‘FDR’) and the enactment of his ‘New Deal’ and other government spending programs.
• Quantitative easing (QE) by the US Federal Reserve which commenced buying Treasury securities in 1932, leading to an expansion of the Fed’s balance sheet and which marked the bottom of the stock market.
• More QE and unconventional policy, with the US Government effectively taking over QE in 1934 by converting unsterilised gold inflows into currency, therefore further expanding the monetary base.
• Populism, political deadlock and more extreme political views amongst liberals and conservatives.
• Elevated levels of income and wealth disparity in society not seen in decades, partly contributing to the abovementioned populism.

Differences to 2020s

While the 1930s had a series of similarities to today’s environment, stark differences appear that complicate some of the comparisons to the 2020s, including:

• The nature of the 1930s crisis, namely, a credit crisis stemming from the instability of the banking system.
• The existence of a gold standard and its crucial role in the recovery with the US departure from the gold standard in 1933.
• A less interdependent and integrated global economy.
• Market indices dominated by industrial companies (US Steel, General Motors, Standard Oil etc).
• Equities trading at substantially cheap valuations, typically at significant discounts to book value (giving rise to the term “value” in the investment vernacular).

What happened in the post-Depression recovery?

Following the election of FDR in 1932, the United States entered a new period of hope and resilience after seeing the Dow Jones Index fall by almost 90% and unemployment increase to 25%. FDR pledged to make sweeping changes and deviate from the mistakes of the prior Hoover Administration’s ‘laissez faire’ economic policies. He sought to galvanise the population with significant fiscal measures to stabilise the banking system, take the US off the gold standard and rebuild consumer and business confidence. To better understand what it was like to be on the ground during this period, Benjamin Roth, a young lawyer from Ohio, kept a diary during the Great Depression and insightfully wrote on 2 January 1936 regarding the preponderance of fiscal stimulus, “the worst feature of it all is that people are no longer worried about government spending. An additional billion or two seems to mean nothing.” The applicability of this observation to the current environment is apparent.

Investors saw the Dow rally 39% in 1935 and another 25% in 1936, following reassurance from FDR of significant fiscal support and the Federal Reserve’s long overdue accommodative stance (zero rates and commencement of QE). The graph below highlights this market rally, which seems to be overshadowed by the large drop in prices from 1929-32.

As the market rallied between 1935-36, the sentiment at the time amongst market commentators was similar to today and may be summarised as:

• The market again seems to be driven by rampant speculation
• The market is experiencing a mania similiar to that of 1929
• The market looks overvalued and is bound for a pullback

The rally then carried over into early 1937 even while the US Government implemented contractionary fiscal policy. The budget deficit was slashed in 1936-37 as tax revenues picked up and FDR sought to balance the budget (see CPI graph below showing the remarkable recovery from deflation).

Coinciding with these fiscal policy changes during the recovery, monetary policy also took a turn. The Fed’s QE program ended a couple of years after it started since the Fed thought it was ineffectual, interest rates were hiked in 1937 and bank reserve requirements increased as confidence in the banking system returned and the unemployment rate came down to 17% by the end of 1936.

Ultimately, the US ended up in recession again in 1937 and the Dow sold off aggressively with prices falling by over 40%. The recovery from the 1937 recession commenced in June 1938 — and it wasn’t until September 1939, with Britain and France’s declaration of war against Germany, that the world truly changed for posterity as it entered a wartime era where a rapid ramp up in economic activity to meet the war effort once and for all broke the back of what we now call the ‘Great Depression’.

What we can learn from the 1930s

Our main takeaways from this review of the 1930s that investors today should consider can be summarised as follows:

• Government and central bank policy intervention is often intentionally transient -temporarily used to effectively stabilise economic conditions leading to a strong equity market recovery. In these circumstances, thoughtful investors recognise that these strong rallies (or ‘good times’) underpinned by accommodative macroeconomic policy come to an end eventually and changes in the current policy framework are likely to ensue as it did between 1936-37 (i.e. less fiscal and monetary support and a renewed national emphasis on individual self-reliance).    The pendulum of the policy response during severe economic downturns (which thereby further polarise the political environment) can swing economic, social and political outcomes substantially in a short timeframe.
• Extreme policy support can have its consequences. The 1930s illustrated that the implications can include currency devaluations, sovereign debt defaults (partial or full), higher taxes, de-levering of central bank balance sheets and a focus on curbing deficit spending. These factors are seldom positively received by markets.
• Tightening policy conditions. The risk that a tightening of monetary and fiscal policy occurs faster than expected, and potentially when markets remain particularly fragile and sensitive to a change in the policy framework.

The experience of the 1930s does raise some interesting questions for investors today contemplating the future trajectory of economic activity and markets:

• Will the Fed of the 2020s ever have the nerve to tighten monetary conditions voluntarily such as it did in 1937, either because of strong economic activity and/or an emergence of inflation?
• If policy is tightened, will it result in a potentially misguided market sell-off if such policy arose from strong economic conditions, despite that this may be a preferred alternative scenario to zero interest rates precipitated by a deadly pandemic?

While talk of the experiences during the 1930s can seem distant, fanciful and far-fetched almost a century later; in extraordinary times such as the present, we can benefit from detaching ourselves from our own experiences which represent a narrow slice of human history and cast our minds back to experiences from other extraordinary periods to better understand the world we are living in today.