Thursday, August 18, 2011

Lessons from the Long Depression

The below chart caught my eye earlier today, and I tweeted about it. The chart itself is a bit hard to read, but essentially its telling us that long term interest rates haven't been this low since the 1960s. The chart ends on June 30th - long term interest rates have dropped sharply since then, and the 30 yr treasury is now below 3.5%, and the 20 yr is at 3%. The last time long term rates were this low and falling, was at the start of the Great Depression.

A lot of people have written about how the 2008 financial crisis almost took us into a second Great Depression, but I think its pretty clear now that we at least dodged that bullet. It's the other time that long term rates dropped this far and kept dropping that interests me- the Long Depression from 1873 - 1896.

The Long Depression

The world of the 1880s was very different from today of course. There was no Federal Reserve, the US was on the gold standard, and the west was still being won. There was no Social Security, Medicare, or safety net of any sort really. In fact, compared to the more developed economies of Western Europe, the US was pretty much an emerging market.

And yet there are similarities. The Long Depression followed a period of debt build-up driven first by government borrowing (for the Civil War) followed by a (railway) construction boom. Then as now, inflation was never a concern (the Coinage Act of 1873 moved the US to the gold standard) - rather creating inflation was a problem. The crisis of 1873 also started in Europe (in Vienna) and then spread to the US. While bank failures spiked in the US, they were more a result of the crisis than the cause.

Another Long Depression??

The bailout of the banking system in the US in 2008, and global monetary and fiscal stimulus in 2009, at least prevented a Great Depression style economic collapse. The emerging markets of today have recovered and are roaring again. But having avoided another Great Depression, are we slipping into another Long Depression?

The main difference - while the Great Depressions was a steep sharp collapse followed by a relatively steady recovery, the Long Depression period from 1873-1896 was characterized by a sustained slowdown in overall growth. If the Great Depression was V shaped*, the Long Depression was L shaped. Recession was an ever-present specter - even after the recession ended in 1879, the US economy endured many periods of contraction. It was not till long terms rates began increasing around 1900 that the US entered another period of sustained growth. Economic performance was even worse measured in per capita terms, given the huge immigration boom of the late 19th century.

Lesson for us

Part of the reason for that huge immigration boom was that Europe was way more f**ked than the US. Italy, Austria-Hungary, and France were the worst hit, while Germany, the UK, and Russia did relatively better.

The most common explanation for the Long Depression is that it was caused by a long period of deleveraging, made worse by a slavish adherence to the gold standard. The US had better demographics and cheaper land, and combined with a slightly more flexible monetary policy, this allowed it to perform better than most parts of Europe. Faced with a similar but even worse crisis in the Great Depression, western governments eventually gave up the gold standard.

For Europe today, the hard money policies of the ECB are the equivalent of the gold standard. Europe is effectively on a Deutschemark standard. If the Long Depression is any guide, than the Euro can survive this episode, but it could very well mean a generation of lost growth for many parts of Europe.

The Fed's willingness to print money, and the US' old advantages of demographics and land, should ensure that the US will continue to outperform Europe. But sustained growth of the pre-crisis kinds may not be achievable, especially as it looks like the Fed is close to being tapped out. The US may even have to deal with another influx of immigrants from Europe.

A Third Industrial Revolution

The late 19th century was also a time of great technological advancement known as the Second Industrial Revolution. Steam shipping, railroads, the growth of the telegraph network and the opening of the Suez Canal led to an explosion in trade and eventually created the conditions for a global recovery around the turn of the 20th century. The countries that tapped into that burst of entrepreneurial energy - Britain, the US, and Germany to a certain extent, were also the ones that came out of the Long Depression in the best shape.

The Internet and the myriad innovations it has spawned are creating a Third Industrial Revolution today. The concept has been much discussed, but nobody can predict today what innovations will drive growth for the next few decades. The only thing that governments can do is foster an environment that reduces red-tape, and makes labor and capital as easily accessible and accurately priced** as possible for the entrepreneurs. The countries that do that well (my money is on the old trio- the US, UK, and Germany) will probably outperform again.

And as for individuals, don't curse the darkness, light a candle.

* more W shaped then V really.
** we learned that lesson from the dot com bubble I hope