Looking Back at the Second Great Depression

By Paul R. La Monica

THE SETTING: the front porch of a raised ranch house on a quiet suburban street somewhere in Long Island, N.Y. The date is Jan. 14, 2045. A distinguished elderly gentleman with a full head of flowing silvery hair sits peacefully on a plastic lawn chair sipping a mug of coffee. A young boy comes up to him. Here is their conversation.

"Grandpa Paulie, do you remember GD2?"

"The Second Great Depression? Sure I do. Those were some tough years. So many people were out of work. The stock market crashed. Banks failed. We had to get rations for food and gas and wait on really long lines to get them. It's amazing the country bounced back. Why do you ask?"

"Well, we're learning about it in my macroeconomics class and I just don't get it."

"They're teaching macro in the second grade these days? God Bless The United States of AOL Time Warner."

"Yeah, our teacher keeps trying to tell us how bad it was and that the economy these days is starting to look like it did at the beginning of the century, but I just don't understand. She keeps talking about the unprecedented level of economic expansion, a GDP of 10% or something like that. And all this stuff about the PPI and the CPI being really high so the Fed may have to raise rates. But every time someone mentions raising rates, the stock market plunges. Wall Street hates higher interest rates, but my teacher says we're doomed if the Fed doesn't raise rates. If the stock market tanks isn't that really bad news? I'm so confused. We have a big test on this next week and if I don't get an A+++++ I'll never get into Yahoo!Harvard."

"Well sonny, you came to the right place. Sit down right next to Grandpa. Your father probably never told you this but I used to write about this type of stuff all the time for a great financial Web site called SmartMoney.com."

"Smartwho.com?"

"Ahh. That's right, you wouldn't know about any of that. Well, we were big, really big. But once GD2 hit, people didn't want to read about stocks and investing anymore, and all the financial news Web sites went out of business by Aught-Three. But that's another story. Anyway, back to GD2. You see, back in the 1980s and 1990s the economy was great, kind of like today. There was a wave of technological innovation. Unemployment was low, many people were getting rich in the stock market. They were good times."

"So what went wrong?"

"I'm getting to that. In 1998 the economies of other countries took a bad turn. Russia, Asia and Latin America. So the Fed cut interest rates three times in order to make sure there would be no crisis here. Nobody wanted to see the great economic times come to an end. And it worked. Maybe too well. The economy kept growing, and the following year the Fed raised rates three times to make sure it didn't grow too fast."

"That's what I don't get. Why is it a problem if it grows too fast?"

"When there's too much growth, you then have to worry about inflation. If prices rise dramatically, which is what happened in the U.S. in Aught and Aught-One, money becomes pretty much worthless. Everything costs a lot more."

"I thought the Fed was supposed to fight inflation."

"Well, the Fed, led by a guy named Alan Greenbaum...no, wait a second, it was Greenspan...had traditionally been a big fighter of inflation. But once Y2K rolled around, the markets moaned and groaned every time he thought about raising rates. Whenever economic data came out that showed a strong economy, investors panicked because they thought the Fed would then raise rates. Greenspan kept telling people that the economy couldn't keep growing at this pace without an eventual pickup in inflation. So much wealth was being created and Greenspan was constantly worrying about what would happen to this wealth if the economy overheated. So he just wanted to cool it down a bit by raising rates."

"I still don't understand. If this Greenspan guy was so smart and he led the economy through such prosperous times for so long, how come people got all mad whenever he talked about raising rates?"

"Let me try and explain it to you simply. Say you got sick, you had a really bad cold."

"What's a cold?"

"What's a cold? I really must be showing my age, huh. Well, EliPfizerLambertMerckGlaxoBeecham did come out with a drug to cure the common cold in 2021, so you wouldn't remember what it's like to have a runny nose, now would you? Anyway, I digress. Say you get that nasty new strain of Martian stomach flu. You know that really icky medicine you have to take?"

"Yeah, I hate it. It's disgusting."

"That's the point. You don't want to take it because it makes you feel sick when you first taste it. But if you don't take it you'll just get even sicker. Investors back in Aught and Aught-One thought that higher interest rates would be bad  even if they prevented inflation  because they would make it more expensive for companies to borrow money and that would slow the rate of earnings growth of all those technology companies a little bit. So higher rates were like that yucky flu medicine. You knew it was good for you, but you didn't want to take it. Nobody wanted to think about how rate hikes could help us avoid inflation and its evil aftereffects. Boy, were we dumb.

"After a while, Greenspan got fed up with all the abuse he took. He was tired of listening to the market whining, so he just appeased them and did nothing. He started to talk about how the growth at the end of the 20th century could be attributed to a once-in-a-century acceleration of innovation. Technology had made the entire economy more productive and efficient so rapid growth could be sustained without any inflation rearing its ugly head. So there was no reason to raise interest rates."

"Oops."

"Oops is right. Because he held rates steady, inflation did come back with a vengeance. We hardly realized it at first because the stock market was still booming. But everything got more expensive and people's wages weren't keeping up with all the huge increases in prices. So the Fed decided to print more money because it still didn't want to raise rates. And that's when things started to get ugly.

"The amount of money in the system was so huge that it was practically worthless. It got to a point where I would go to the store for a loaf of bread and it would cost $15, and if I went back a week later the price would already be $20. That's inflation."

"You used to go to the store to buy bread? Wow, life must have been rough then. So when did the Depression happen?"

"Well by Aught-Two, Greenspan was the most hated man in America. Because everyone was rushing to buy things before the prices became prohibitively expensive, there was a huge drop in productivity and a lot of people lost their jobs. And people were selling all their stock in order to get cash to buy things they really needed like food and clothes. The stock market crashed, and lots of companies went out of business, so there were even more layoffs.

"So President Trump decided to bring back old Fed chairman Paul Volcker, since he had a lot of experience raising interest rates. Volcker raised rates so fast that the economy froze to a halt within a couple of months. He said the only way to get rid of inflation would be to make rates sky-high. Once the effects of the interest rate hikes kicked in, inflation finally fell to a more manageable level, but even more people found themselves unemployed. The economy shrank, and the hope was that we would just have a short recession. But the Fed was afraid to lower rates to stimulate growth, because nobody wanted a return to inflation. Lots of big companies couldn't pay back their bank loans, and many of those banks went under, putting even more people out of work. And that's how we wound up sliding into the Second Great Depression.

"It took years before the Fed finally decided to cut rates and stimulate growth again. But the early years, Aught-Three and Aught-Four especially, were really the worst of it. Since I was no longer writing for SmartMoney.com, I had to become a fisherman. People still needed to eat, you know. Well, that's the story of GD2."

"Wow, Gramps! So what you're saying is that if Greenspan would have just raised rates in 2000 and slowed the economy a little bit, there wouldn't have been another Great Depression?"

"We'll never know for sure, but it seems like it could have been avoided. We were all just a little too greedy and shortsighted, and it came back to haunt us."

"The economy is growing really fast again these days, right? I hope the Fed doesn't let inflation get out of hand again, Grandpa."

"Me too, sonny. Me too."

link at

http://www.smartmoney.com/smt/columns/rational/index.cfm?story=20000114

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Got below-cost-price GOLD???????

-- Andy (2000EOD@prodigy.net), January 17, 2000

Answers

great find, Andy. That column spells out what is going on very clearly. Maybe its like reading a Paul Erdman novel to gain a glimmer of understanding of economics. (That is where I got started. I liked his writing style and discovered I learned something...)

Gained an additional clarification of Bob Brinker's warning shot. He recommends figuring out your equity ratio for your asset allocation and then reducing the equities within that ratio to 40%. For example if someone had $1,000,000,K in equities, bonds, cash, and pension dollars and had a 75% equity ratio, reducing that to 40% equals an overall 30% equities, 70% bonds, cash, etc.

Brinker's rationale is that if the market gains 10% this year, this portfolio mix would actually gain about 7%. If the market loses 20%, the investor with this mix loses 5%. Not a bad tradeoff.

Twenty years ago, I would have been betting much more on the come line than I want to now.

-- Nancy (wellsnl@hotmail.com), January 17, 2000.

Yes. here is an article published today to make us all think:

Patriot or Deserter

-- BB (peace2u@bellatlantic.net), January 17, 2000.

I liked yahoo!Harvard... :o)

nancy,

If you go over to the www.kitco.com forum for yesterday a bunch of folks were discussing the "brinker" effect for this coming week...

you should check it out...

-- Andy (2000EOD@prodigy.net), January 17, 2000.

Wow! Thanks Andy. That was one of the most interesting and informing threads I have seen on TB since the roll over. Thanks for the links too. Am off to read them. Taz....who is thinking 3 month T Bills for right now. Don't want to have any stocks until I see what GreenSpan does and what 2/29/2000 does to the 'puters. Want to give y2k some time to play out before jumping back into the market big time. Taz

-- Taz (Tassi123@aol.com), January 17, 2000.

Pick up a copy of Barron's this week. Just got done reading the Roundtable. There is a growing unease on the street. Everyone knows the emporer (Nasdaq) is naked but no one is willing to tell the world.

One of my favorite comments is Abby Joseph Cohen's response to a question about the pressures of commodities on inflation:

"...but if you look at a 200 year record, commodity prices have been declining, because it's easier to find them.....and with an economy that is shifting away from industrial manufacturing processes into other things, most commoditieis are not needed quite as mucha as before."

All I can say is duh!

She also got busted by the roundtable on this one:

"We have asked all of your analsyts to think more and more as if they''re making private investments or venture capital investments....."

The response pointed out that this is because buying these stocks is as risky as buying venture capital.

An excellent point (me talking here now). Previously many of the companies which now trade at ridiculous multiples might never have gained legitimacy on the street. Since the street didn't/doesn't understand technology (nor do most americans) these stocks have been allowed access to easy money. Easy credit, market access and underinformed investors is a recipe for a correction and possibly a severe recession.

We should ask Abby Joseph how easy it is to source commodities like gold given their shenanigans last year in that "outdated commodity market".

What bullshit.

-- Gordon (g_gecko_69@hotmail.com), January 17, 2000.

Great posting Andy.Funny yet informative and thought provocing.Also I agree abby joseph cohen is full of bravo sierra!stockmarket guru--give me a break!

-- just a thought (tigerpm@netscape.com), January 17, 2000.

Actually, given their founders' educational choice, Yahoo!Stanford would be more likely...

-scott

-- Scott Johnson (scojo@yahoo.com), January 17, 2000.