Thursday, January 29, 2009

Galbraith Revisited

To follow up on my post from a while ago, Galbraith sited 5 key reasons for the 1929 crash and following depression:
1. The bad distribution of income.
2. The bad corporate structure.
3. The bad banking structure.
4. The dubious state of the foreign balance.
5. The poor state of economic intelligence.

To compare this to today:
1. Bad income distribution.
1929 - Top 5% received about 33% of all personal income.
1929 - Top 1% held 44% of all wealth.
2000 - Top 1% received about 20% of all personal income.
2004 - Top 1% held 34% of all wealth.

Here is a picture of the real income gains between 1979 and 2005 by percentage. It is clear that the top income groups are gaining ground faster than lower income groups - creating an income distribution that approaches 1929.

2. Bad corporate structure. In the 1929 era there had been a large rise in a "vast structure of holding companies and investment trusts... In particular the dividends from the operating companies paid the interest on the bonds of the upstream holding companies... the temptation to curtail investment was obviously strong." In addition this structure was practically non-regulated.

In today's market, the hedge funds have obviously created a system that rivals the structure of the holding companies and investment trusts of the 1920's. Hedge Funds manage roughly $2.5 Trillion of assets and according to a 2007 WSJ article accounted for about 60% of bond trades. And obviously there is very limited regulation and visibility - witness Madoff...

3. Bad Banking Structure. Galbraith writes "Loans that would have looked perfectly good were made foolish by the collapse of the borrower's prices or markets for their goods or the value of the collateral he had posted. The most responsible bankers were often made to look the worst. A depression such as that of 1929-32, were it to begin as this is written, would be damaging to many currently impeccable banking reputations."

Of course the similarities to today are striking. Looking at the November housing data, prices fell over 18% from the previous year. And of course housing makes up the largest percentage of wealth in the US.

The CDO's have a way of amplifying this. In my mind the CDO's are the increased leverage similar to the high margin leverage in the stock market of the 1920's. Meaning that if the margin or CDO leverage had not been there, the crisis would have been far less severe.

The good news is that the Fed, FDIC and SEC make a very big difference between today and the 1920's. They provide a level of coordination, control and confidence that was non-existent 80 years ago.

4. The Foreign Balance. Of course this is several orders of magnitude different (and from Galbraith's perspective) worse than the 1920's. The global economy and the meaning of imports and exports and multinational companies just brings a whole new perspective. I am not sure this is a real driving impact to this crisis - meaning it is not making it worse IMHO.

5. The poor state of economic intelligence. Galbraith feels the economists and politicians of the era did not understand what was happening and did not respond appropriately. He discusses how Hoover enacted large tax cuts for business, however there was no corresponding increase in capital spending, investment or hiring. There was also a central focus on balancing the budget. In fact Roosevelt's Democratic Party in 1932 ran on the platform of an "immediate and drastic reduction in government expenditures to accomplish at least a 25% decrease in the cost of government." He adds that the fear of inflation reinforced the demand for a balanced budget.

This is a major difference between then and now. We have very active Fed monetary actions, Treasury bank stabilization actions and coming tax cuts and new spending programs. These actions aren't quite the level of government intervention that WWII brought, but they are much more aggressive than the combined actions of the 1930's.

In summary, the similarities are at the very minimum concerning. It is understandable why Ben Bernanke, a careful student of the Depression Era, has been very aggressive in his moves. It is also the driving factor why there is general consensus in the government that major fiscal stimulus is needed. Let's hope it works...