Great Depression, Will A 90% Decline Be Likely?

I wrote a summary of Berkshire Hathaway’s AGM previously here, and one thing that really stood out of the AGM (other than the empty atmosphere) would be Buffett sharing on the Great Depression and his less than optimistic view of the COVID-19 Pandemic.

“…because if somebody had given me $1,000 on the day I was born, and I’d bought stocks with it, and bought the Dow Average, my $1,000 would have become $170 in less than two years, and that is something that none of us here have ever experienced that we may have had it with one stock occasionally, but in terms of having a broad range of America mark down 83% in two years, and mark down 89% of the peak, that was in September 3rd, 1929, was extraordinary…”

After that AGM, many value investors and investors alike may have started worrying that the Oracle of Omaha is predicting a decline in the financial markets the likes of the 1929 Great Depression. Even myself included, it did rattle me for awhile after the AGM.

However, this led me to start digging up the history of 1929 Great Depression and the events that transpired back then. A good understanding of the different events resulting in the Great Depression is crucial in determining whether something similar could actually happen in today’s context.

The Federal Reserve’s Mistakes

In 2002, Ben Bernanke, a member of the Federal Reserve Board of Governors then, publicly admitted that the Federal Reserve’s mistakes contributed to the ‘worst economy disaster in American history’.

“…regarding the Great Depression, … we did it. We’re very sorry. …We won’t do it again…” a speech given by Ben Bernanke in 2002 at a conference to honor Milton Friedman.

If I had to summarise the various mistakes that the Federal Reserve made, it would be the following:

• The Federal Reserve tightened policies (raising interest rates) to limit speculation in the financial markets
• The Government adopted a contractionary fiscal policy – implementation of the Smoot-Hawley Tariff Act, in attempt to protect the US local producers
• The Federal Reserve’s decision making structure was decentralised and often ineffective, this led to its restructuring and the formation of Federal Deposit Insurance Corporation

Differences between today and 1929

One would realise the huge differences between policies we see implemented today when a financial crisis happens vs when it happened in 1929.

Back in 1929, the Federal Reserve was much divided in opinions resulting in their failure to stem the decline in the supply of money. Some leaders thought aid should only be extended to commercial banks that were members of the Federal Reserve System. Others thought member banks should receive assistance substantial enough to enable them to help their customers, including financial institutions that did not belong to the Federal Reserve, but the advisability and legality of this pass-through assistance was the subject of debate. Only a handful of leaders thought the Federal Reserve (or federal government) should directly aid commercial banks (or other financial institutions) that did not belong to the Federal Reserve.

Furthermore, instead of making credit cheaper, the Federal Reserve made it more expensive. This would further disincentivize people to spend money when that is exactly what is needed during a financial crisis.

Mr. Bernanke and Mr. Gertler said the Fed should raise rates if rising asset prices fuel inflation, but not to prick a bubble. “A bubble, once pricked, can easily degenerate into a panic,” they said. When the bubble eventually collapses on its own, the Fed should cut interest rates to limit the damage to the financial system and the broad economy.

Ben Bernanke having studied the Great Depression in depth, and wrote two excellent papers summarising his research, basically learnt that the best way to tackle a crisis is to put out the fire (increasing money supply) and then worry about sound fiscal and monetary policies later.

Conclusion

With this, we can safely say that we are living in very different times.

While there is no such thing as impossible, I am quite certain that the chances of a Great Depression is very close to zero. Much time and effort has been devoted to studying the events resulting in the Great Depression, and the actions that exacerbated it.

By drawing upon the lessons of the past, the actions of the Federal Reserve are extremely different in tackling the crisis now compared to 1929.