This document came across my desk today. A thoughtful article on an important subject.
by Mark W. Riepe, CFA, Senior Vice President, Schwab Center for Financial Research
October 8, 2008
Editor’s note: This is an advance copy of an article from the October 2008 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.
Buffeted by weeks of withering financial news, nearly six out of 10 Americans now believe the U.S. economy is somewhat or very likely to fall into a depression, according to an October 4–5 CNN/Opinion Research Corp. poll. But while the U.S. economy is not as strong and our financial system isn’t as healthy as it needs to be, we’re nowhere near the types of economic difficulties seen in the depths of the Great Depression—nor does Schwab believe we’re headed there.
For context, consider these two realities. First, the U.S. economy is much stronger today than during the Great Depression. In the 1930s, America was primarily an industrial powerhouse, and industrial production shrank 52% from peak to trough, while gross domestic product (GDP) shrank 27%. As an example, if we assume December 1, 2007, is ultimately declared the start of a recession, you can see below that GDP and industrial production are nowhere near depression levels. Industrial production declines suggest a garden-variety recession, and GDP is still positive (although we don’t expect it to stay that way).
click graph to enlarge
Second, the employment situation is much better. Although today’s employment environment certainly doesn’t feel good to those who are unemployed—or fear they might become so in the near future—the current rate of unemployment is 6.1%, about a quarter of the peak rate of 25% during the Depression. While we see the unemployment rate getting worse, we don’t foresee depression-era jobless rates.
What about all the bad news swirling about? Isn’t GDP going to get to Depression levels? Wasn’t the Depression a downward spiral that just kept getting worse and worse? Aren’t we at the beginning of that spiral? Schwab doesn’t believe so, for the following seven reasons:
1. Jobless recovery. Remember this phrase? It refers to the slow rate of hiring by businesses after the last recession. We believe that past corporate tightfistedness is now helping to prevent the job losses currently being reported from becoming even worse. Why? Because firms didn’t overhire during the recent expansion, there are fewer jobs to cut during this downturn. We expect this should prevent the unemployment rate from getting out of control.
2. Fiscal policy. In the early years of the Depression, the linkages between fiscal policy and the economy weren’t as well understood as they are today. At that time, the prevailing view seemed to be that the federal government should have a balanced budget except in times of war. There’s a lot to be said for the efficacy of that approach under normal circumstances, but it backfired under the Hoover administration. From 1929 to 1933, the federal government deficit was a tiny 1.4% of GDP. As private spending and investment declined, federal spending wasn’t there to pick up the slack. Today, policymakers are far more willing to open up federal spigots to soften the blow when the economy first begins to list, and over short periods, fiscal stimulus can work. The increase in real GDP growth from 0.9% in the first quarter of this year to 2.8% in the second quarter is an example of what fiscal stimulus can do.
State unemployment benefit programs, which can smooth out the effects of normal fluctuations in the economic cycle, will also help. And although continually using deficit spending to prop up the economy will have negative, long-term consequences, fiscal stimulus can provide short-term relief while more permanent fixes can be put into place. Federal policymakers didn’t use that cushion in the early 1930s. Fortunately, we see today that they are.
3. Globalization. Complaining about globalization has been a fashionable pursuit over the past few years, but don’t forget its benefits. In the 1930s, the infamous Smoot-Hawley Tariff Act became law. Its intent was to choke off imports, and it worked, as U.S. imports dropped 65%. The politicians who voted for it either forgot, didn’t care or didn’t understand that global trade is a two-way street: U.S. exports also dropped 66%. Did anyone win in that global trade war? In our view, it was a tie—everyone lost. Today, trade is more open between countries, and the U.S. economy as a whole has benefited. We shudder to think where it would be right now without the recent boom in exports. Since December, exports have risen 15%, providing an important outlet for U.S. industries seeking to offset weak domestic demand. We’re optimistic that a new administration and Congress will remember history and, when weighing trade bills, won’t pull this source of strength out from under the economy. While we have some concerns about the ability of other countries to absorb U.S. exports given their own weakening economies, we believe that a two-thirds drop in trade just doesn’t seem likely.
4. The FDIC. Banks exist to loan money, but they can’t do it without depositors. The Federal Deposit Insurance Corporation (FDIC) was created in 1933 in reaction to the huge number of banks that had gone under, evaporating the savings of many depositors. As a result, confidence in banks was gutted, as was consumer spending. FDIC insurance is a key pillar in preventing that from happening again. As long as the program continues to work smoothly, we think depositors will have the confidence to leave their money in banks, providing another important stabilizer to the overall system. The temporary increase in the FDIC insurance limit from $100,000 to $250,0002 only helps boost that confidence. Likewise, we see European governments taking similar actions to boost confidence in their banks.
5. Money supply. While well-known to economists, the role that monetary policy played in increasing the severity of the Great Depression is probably less understood by the general investing public. The Federal Reserve constricted money supply, causing it to plunge 29% during the 1930s. When money gets that tight, deflation occurs, and in the early 1930s, the Consumer Price Index declined 27%. These days we spend a lot more time worrying about inflation—so much so that we don’t recall the devastating impact that deflation can have. Japan’s economy was crippled for the entire 1990s as a result of a bout with deflation.
What’s wrong with deflation? Think about it from the standpoint of a business. The business purchases raw materials and invests in the infrastructure to turn those raw materials into a product. Deflation means that by the time this process is complete and the product is ready for sale, the retail price has fallen, preventing the business from turning a profit. Price deflation within just a few industries is manageable (think of computers, for example). But when it affects almost every industry, the economy and stock market begin to suffer in a big way. Compare the actions of the Fed today to the Fed of the past—it’s pumping very large sums of money into the economy to try to make sure that the required liquidity is present.
6. Housing near the bottom. Multiple related, yet distinct crises are occurring simultaneously. However, the bursting of the housing bubble is the best candidate for the root cause—which means that the road to recovery begins with home price stability. We at Schwab don’t think we’re there yet, but don’t be misled by the continuing scary double-digit year-over-year price decline statistics. To get a glimpse of the future, pay more attention to the month-over-month declines. What you’ll see there is a fairly steady reduction in the magnitude of the losses. Inventories of new homes seem to have plateaued, and builders are cutting back considerably on new construction. We’re not bullish on housing, but because we do think a bottom is in sight, we’re confident that the overall slide we’ve been experiencing will stop.
7. Emergency Economic Stabilization Act. This law authorizes the U.S. Treasury to buy troubled mortgage-backed securities from financial institutions. Rarely is one law ever a panacea for big problems, but the credit crunch had reached a state where even well-qualified borrowers were unable to borrow (e.g., small companies were finding access to credit cut off, and outstanding commercial paper—very short-term bonds issued by businesses—suffered the biggest one-week drop on record). Businesses can’t function without access to credit, and it’s hoped that this law will begin a thawing of the credit markets. We think this will occur. Right now, banks won’t lend to banks because it’s difficult to ascertain the true credit quality of the borrower. By allowing banks to sell hard-to-value securities to the Treasury, the law should improve transparency and enable banks to sell off securities to raise capital, which should in turn help them begin lending again.
Important Disclosures
1. Gross domestic product, the federal deficit and U.S. exports for the “Great Depression” column are reported over the period from 1929 to 1933, while money supply, industrial production and consumer price index (CPI) cover the period from August 1929 to March 1933. For the “today” column, GDP is from the third quarter of 2007 to the second quarter of 2008; industrial production and CPI are from December 1, 2007, through August 31, 2008; the federal deficit is as of the second quarter of 2008; U.S. exports are from December 2007 to July 2008; and money supply is from December 1, 2007 to September 19, 2008. The unemployment rate is as of August 2008 for “today” versus its peak level during the Depression. Money supply is measured by M1.
2. On October 3, 2008, FDIC deposit insurance temporarily increased from $100,000 to $250,000 per depositor through December 31, 2009. IRAs and certain other retirement accounts for which the deposit insurance limit already was $250,000 prior to October 3, 2008 will continue to be insured up to $250,000.
This report is for informational purposes only and is not an offer, solicitation or recommendation that any investor should pursue a particular investment strategy. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
update: Lord Abbett and Company’s perspective on the same subject,
More Perspective on Today’s Panic October 31, 2008
Today’s economy bears no resemblance to those of the mid-1970s or the Great Depression.
