Eighty years after Wall Street crashed, what did we learn?
The New York Stock Exchange floor is quiet. Little green arrows, pointing upwards, skim along the LED display above the heads of the traders. This space, the high roof obscured by twisting cable ducts, has become so emblematic of recent boom-and-bust events that the very memory of 1929 is obscured. There's a flag to commemorate American POWs still missing from the Vietnam War, a plaque to the fallen of World War Two - but nothing to say: here, once, the folly of a few ruined the lives of millions, shaping every other event that came after.
But modern financial markets have a weird relationship with the past. Every prediction mainstream economists make is based on "data points" from the past; yet for the trader there is no past - only the future concerns them. That's why they've been able to shrug off the cataclysm of September 2008 and get on with making money. Right now, courtesy of the taxpayer and the central bank, they are raking it in.
In fact there is near-euphoria. The Dow Jones Industrial Average - which lost more than half its value in the twelve months to March 2009 has now clawed back half its losses. Goldman Sachs announced a record profit. Bonuses are bigger than ever. Foreign exchange dealers are opening offices and recruiting new staff just as fast as the computer guys can install the terminals. Meanwhile ordinary Americans go on losing their jobs: on one estimate there is 16% unemployment - on the most conservative estimate it stands at one in ten.
So what's happened? How did we avoid a 1929-style collapse into Depression? Have we escaped the peril permanently - and if not, what are the dangers?
When you talk to economists there is one historical parallel that haunts the conversation: in 1929 the Dow lost 40% of its value in the first three months - but by late 1930 it had clawed back half the losses. The sheer scale of intervention now, as compared to non-intervention by the authorities back then, means that no-one expects events to play out exactly. But there are still deep concerns.
To understand why, you can look at four key events of the Depression of the 1930s and compare them to today.
1. The stock market crash itself. In 1929 there'd been an unsustainable bubble. Share prices soared despite a falling money supply, despite a downturn in farm prices. This convinced sensible people that the economy had finally escaped the cycle of boom and bust. Economist Irving Fisher famously said, days before the crash that stock prices had "reached what looks like a permanently high plateau." From October 24 - known as Black Thursday - the real slide began and by mid-November the Dow was 40% off its peak. This time around, the Dow - mirroring the average losses of global stock markets - lost 50%. Now it is back up but buoyed by what?
One measure investors use to work out if stocks are overvalued is the price-to-earnings ratio. Normally it moves within a range of 15-30. Right now, based on Q3 profits of American companies, it stands at 141. That, to me, is an danger alarm.
According to people in the markets, what is driving the stock market resurgence is the slew of cheap money pumped into the economy, both in the USA and UK, in the form of quantitative easing (QE). There is little sign of retail investors putting their money back in. And while there are some signs of an upturn in profitability in the real economy, the stock market recovery looks to almost everybody from the outside to be over-blown - based on cheap money and optimism. So, paradoxically, on the eve of the 80th anniversary of the Wall Street Crash - and as we remember the cataclysmic events of a year ago: one of the most imminent dangers is a stock market correction.
However, what has clearly NOT happened this time is the rapid slide from crash to contraction. And to understand why not you have to look at the central event: the banking crisis.
2. The Banking Crisis: On a gritty street-corner in the Bronx, overshadowed by the rusty elevated railway line, lies a one-storey sandstone building that is now a Laundromat. On the walls you can just make out, beneath 80 years of paint-jobs, the words "Bank of the United States, Bronx Branch".
This is where, on 10 December 1930, a crowd of 20,000 people gathered after a rumour the bank was bust. That night, the great and good of Wall Street held a meeting to try and force through a merger of the bank with three healthy ones. But when they looked at the books most of the bank's collateral was - guess what? - bad mortgages. By morning the bank had failed. Those who turned up to withdraw their savings found they had none. Unlike today there was no deposit insurance. Within a year 300 other banks had failed; by 1933 no fewer than 10,000 banks had gone under - 40% of the total.
In the 1930s it was the bank crisis that turned recession into Depression. The Wall Street Crash had wiped out the savings of millions; now the bank collapse would wipe out tens of millions. Even those who did not lose money directly began to hoard it, take it out of the system. The so called "money multiplier" effect of banking - whereby my $10 deposit can become the surety for maybe $30 of loans - was curtailed.
The domino effect is now well known and legendary: people stopped spending, prices fell. Farm prices halved and consumer prices fell by about 25%. Wages fell too, by an average of 20%. This is deflation - not always a catastrophe but if you have a population deeply in debt, and lots of bad debts, it is a real catastrophe.
The reasons were spelled out by Irving Fisher, who recovered his poise and reputation by coming up with the "debt-deflation" theory: if the value of your debts stays the same, but your income falls, you are forced to sell off your property at knock-down prices to keep repaying your debt, which makes prices fall even further. This spiral forced millions of people into penury in the early 1930s and turned the crash into the crisis that only a decisive, counter-crisis response could have prevented from turning into a Depression. But instead of fighting the crisis, the US authorities made it worse.
3. The Great Contraction. Between 1931 and 32 output collapsed, prices collapsed, the labour market collapsed. One in four people were out of work. None of the traditional remedies had any effect. On the first day of the crash, Wall Street bankers had tried to bid the market up by spending their own money, as they'd done in 1907. It didn't work. Now the policymakers clung to what they though were the great safety mechanisms of economic policy: balanced budgets and money backed by Gold. Incidentally, we are not just talking about conservative politicians. Even Communists in the early 1930s supported balancing the books and defending the value of the currency. Macro-economics, as a discipline, barely existed and was based on a series of intuitions, some of which turned out to be wrong.
So President Herbert Hoover, who did try and ameliorate the crisis, relied on the private sector to solve the problem. That failed. His Treasury secretary, septugenarian Andrew Mellon, thought the crisis was a great opportunity. He urged:
"Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate ... It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. "
Finally, the Federal Reserve - to stick by the rules demanded by the international Gold Standard - took measures that actually made money harder to come by. By the bottom of the crisis, in the early 1930s, the money supply had fallen by a third.
There is a big debate in economics about whether the Great Depression was inevitable, caused by objective flaws in capitalism, or whether it was all down to human error. The human error school has been aligned with a version of free-market economics built upon the monetarist theories of Milton Friedman.
If there is one reason we have not repeated the 1929-32 scenario it is because, at the time of the collapse, the man in charge of the Federal Reserve was the key proponent of the human error theory. Federal Reserve chairman Ben Bernanke had long held that the modern financial system had reduced risk. But should it ever collapse, his research told him the financial mechanisms would accelerate the crisis. You would have to throw money at the problem, said the theory. And that is what - with many hesitations, mis-steps - he did.
Instead of balancing the books President Obama has run up a 1.6 trillion dollar national debt and allocated 600bn for a fiscal stimulus; meanwhile Bernanke's Fed has printed $1.2 trillion. And the US taxpayer has recapitalised the banking system with $100s of billions worth of guarantees.
But it's left us with a moral paradox and a very sticky situation. The moral paradox is: freemarket capitalism has been bailed out by the state. What American politicians railed against in other countries - state intervention to prop up ailing firms - has become a way of life.
One year on from the September-October 08 crisis my observation is that this has had basically a tactical drag effect on economic decision making: from the Tarp to Quantitative Easing policymakers have always tried a semi-market solution first and then, reluctantly, gone the whole hog for a state-backed solution.
The sticky situation is this: the stimulus measures in America - above all quantitative easing - have benefited mainly the companies and the people that caused the crash. Wall Street is booming, bankers' bonuses have returned. Sure, some people and some banks got wiped out, but the hiring spree here in lower Manhattan means lots of people are effectively "wiping the slate clean". Meanwhile, for ordinary Americans, life is still getting worse.
There are three layers of danger ahead domestically, as put to me by eminent economist Mark Gertler, a long-time collaborator of Ben Bernanke and Professor of Economics at NYU.
First, there is still concern about some banks, particularly those exposed to commercial property. One has to assume the authorities have such banks on watch and will go at them like a Bondi-beach lifesaver goes after a floundering supermodel in the surf at the first opportunity. I.e enthusiastically and with great overkill.
Second, the danger that regulatory reform of the banks falters. The bankers are spending millions of dollars lobbying against the most crucial of the re-regulation measures. As I keep saying, this is macro-prudential - ie systemic - regulation. While more radical commentators think, like Mervyn King, banks too big to be bailed out should be broken up, what the US regulators favour is a sliding scale of capital requirements. So if you are a bank too big to fail you have to hold so much capital that you are penalised for the implicit danger you pose to the taxpayer. The problem is, capital requirements have become a universal panacea: pay big bonuses, you have to hold more capital; adopt risky strategies ditto; become too big, ditto; the economy booms and there's a bubble, ditto, ditto, ditto.
After a certain point it becomes clear that heavy reliance on - theoretical so far - capital requirements is no substitute for actual regulatory intervention. And that means passing rules that allow the state to instruct banks to break up, and which above all pin down specific banking liabilities to specific nation states.
Finally, says the prof, there is a third danger. This is how he puts it: "Class warfare". The whole purpose of bailing out the banks was to save the economy, not the bankers. So if we don't reform the banks, and they simply run away with our money again, we will have failed. Those two words, "class warfare", had a spine-tingling impact here in America. Because the do not mean an American Arthur Scargill leading mass demonstrations of miners from West Virginia. They mean social breakdown and the breakdown of the fundamental American myth that "everyone can make it".
This is the great paradox of the year we've been through. The economy was saved - at massive cost; but we seem to be going through a big ideological change despite that. Hedge fund economist Max Fraad-Wolf put it to me this way:
"There's a belief that some of the fundamentals no longer apply: I will not be richer than my parents; those who obey the rules always lose out; there is no place in America for me."
So what you've got, basically is an economy on life support: 1.2 trillion from quantitative easing and about 700bn of fiscal stimulus. A banking system with a free ride back to profitability. And a stock market that looks based on over-optimism.
And then, on top of that, you've got the international situation.
4. Global trade collapses, and then the global currency system. In 1930 America passed the Smoot Hawley Act, raising the tariffs on selected imports. Other states retaliated and by 1933 US trade was 33% of its pre-crash value. By then the global economy was coming apart.
Smoot Hawley is often cited as a bad thing. Protectionism bad, we've learned from the 1930s. But actually many economists think it hardly affected the US economy and if it did it helped counteract the crisis. Imports were only about 5% of GDP.
Far more important is what happened with the currency system. After World War One the major economies had struggled to re-institute the Gold Standard, pegging their currencies to gold. America above all revered gold.
But to remain within the system, the US Federal Reserve was forced to tighten monetary policy. Meanwhile, rival governments were forced, one by one, to come off Gold. When the 1929-31 Labour government fell, to be replaced by a coaliton that more or less immediately came off gold, one Labour minister respondent with the immortal remark: "We didn't know you could do that".
What are the parallels today? Well global trade collapsed faster than after 1929: on some measures it was off 40% in the first 3 months of the crisis. But now it has stabilised and begun to turn upwards. However this de-globalisation impact was not primarily the result of protectionism - there have been more than 100 protectionist measures, most famously Barack Obama's tariff on Chinese tyres. But the real problem was the collapse of globalised production lines, once credit was withdrawn from the system.
The second parallel is: there is no gold standard, no pegged currency system at all, except the most important one in the world: the informal dollar-RMB peg enforced by the Chinese government. This stands at the heart of the relationship between China and the west and represents, as Paul Krugman points out in today's New York Times, one massive "beggar thy neighbour" policy.
However there are smaller "beggar thy neighbour" policies beginning to emerge too. Many commentators here believe the Obama administration is revelling in a weak dollar. If so, the results speak for themselves. On the latest (August) figures, US imports are down 30% while exports are down only 15%. A weak dollar will allow America to export its way off the bottom of this crisis.
What the experience of the 1930s shows is that, given persistent economic hardships, electorates eventually vote out parties committed to orthodox economics, globalisation and balanced budgets and put in parties committed to national, rather than global, solutions to the crisis. We are not there yet, but the tendency is definitely on the rise rather than the wane. If I were to cite my biggest worry, it is that we begin to get overt national exit strategies.
In summary: if we compare the Wall Street Crash and its aftermath to Lehman and its aftermath, the crucial difference looks like policy. Policy this time was a terrified activism; monetary shock and awe, measured in trillions of dollars. But the results of this massive intervention are not very impressive in the West. The weak recovery - or non-recovery as in the UK's Q3 GDP figures out today - signifies that the exploision of September 2008 was probably bigger than the explosion of 1929.
Given that, all the huff and puff from politicians about how things are looking up has to be tempered with the question: where is the sustainable growth coming from if not driven by debt? Where are the jobs coming from to soak up 7 million jobless in America? Where are the investors coming from who will buy the hundreds of billions of dollars of bad debt the US government is hoding on behalf of the banks.
What you learn by studying economic history is that a crisis is never over until its over; and that the most obvious and orthodox and seemingly permanent economic facts and policies sometimes turn out to be the carcinogen, and that only much later does it become clear.
Watch Newsnight tonight, 2230 GMT, BBC 2, for an hour of reports and discussion on the anniversary of the Wall Street Crash. There'll be economics, but there will also be tapdancing.