Looking Back Even Further

One reason why so many analysts failed to anticipate the worst financial crisis this century stems from their lack of historical perspective. Many believed that since the world had "progressed," there was little point in taking account of what had occurred in less sophisticated times.

That meant they generally ignored developments that took place more than a decade or two ago, or in the best case, prior to World War II. Of course, if they had not limited themselves in that way, they might have been more open to seeing circumstances that bore a sriking resemblance to those of today.

Yet even I have been somewhat limited. While I saw parallels between the excesses of the past decade and those of the 1920s, there have been other periods that likely would have provided additional color in terms of how things might play out from here.

In a commentary for The Chronicle of Higher Education, "The Real Great Depression," Scott Reynolds Nelson, an author and professor of history at the College of William and Mary, highlights one dark period in our past that offers up some potentially tantalizing clues about our future.

The depression of 1929 is the wrong model for the current economic crisis

As a historian who works on the 19th century, I have been reading my newspaper with a considerable sense of dread. While many commentators on the recent mortgage and banking crisis have drawn parallels to the Great Depression of 1929, that comparison is not particularly apt. Two years ago, I began research on the Panic of 1873, an event of some interest to my colleagues in American business and labor history but probably unknown to everyone else. But as I turn the crank on the microfilm reader, I have been hearing weird echoes of recent events.

When commentators invoke 1929, I am dubious. According to most historians and economists, that depression had more to do with overlarge factory inventories, a stock-market crash, and Germany's inability to pay back war debts, which then led to continuing strain on British gold reserves. None of those factors is really an issue now. Contemporary industries have very sensitive controls for trimming production as consumption declines; our current stock-market dip followed bank problems that emerged more than a year ago; and there are no serious international problems with gold reserves, simply because banks no longer peg their lending to them.

In fact, the current economic woes look a lot like what my 96-year-old grandmother still calls "the real Great Depression." She pinched pennies in the 1930s, but she says that times were not nearly so bad as the depression her grandparents went through. That crash came in 1873 and lasted more than four years. It looks much more like our current crisis.

The problems had emerged around 1870, starting in Europe. In the Austro-Hungarian Empire, formed in 1867, in the states unified by Prussia into the German empire, and in France, the emperors supported a flowering of new lending institutions that issued mortgages for municipal and residential construction, especially in the capitals of Vienna, Berlin, and Paris. Mortgages were easier to obtain than before, and a building boom commenced. Land values seemed to climb and climb; borrowers ravenously assumed more and more credit, using unbuilt or half-built houses as collateral. The most marvelous spots for sightseers in the three cities today are the magisterial buildings erected in the so-called founder period.

But the economic fundamentals were shaky. Wheat exporters from Russia and Central Europe faced a new international competitor who drastically undersold them. The 19th-century version of containers manufactured in China and bound for Wal-Mart consisted of produce from farmers in the American Midwest. They used grain elevators, conveyer belts, and massive steam ships to export trainloads of wheat to abroad. Britain, the biggest importer of wheat, shifted to the cheap stuff quite suddenly around 1871. By 1872 kerosene and manufactured food were rocketing out of America's heartland, undermining rapeseed, flour, and beef prices. The crash came in Central Europe in May 1873, as it became clear that the region's assumptions about continual economic growth were too optimistic. Europeans faced what they came to call the American Commercial Invasion. A new industrial superpower had arrived, one whose low costs threatened European trade and a European way of life.

As continental banks tumbled, British banks held back their capital, unsure of which institutions were most involved in the mortgage crisis. The cost to borrow money from another bank — the interbank lending rate — reached impossibly high rates. This banking crisis hit the United States in the fall of 1873. Railroad companies tumbled first. They had crafted complex financial instruments that promised a fixed return, though few understood the underlying object that was guaranteed to investors in case of default. (Answer: nothing). The bonds had sold well at first, but they had tumbled after 1871 as investors began to doubt their value, prices weakened, and many railroads took on short-term bank loans to continue laying track. Then, as short-term lending rates skyrocketed across the Atlantic in 1873, the railroads were in trouble. When the railroad financier Jay Cooke proved unable to pay off his debts, the stock market crashed in September, closing hundreds of banks over the next three years. The panic continued for more than four years in the United States and for nearly six years in Europe.

The long-term effects of the Panic of 1873 were perverse. For the largest manufacturing companies in the United States — those with guaranteed contracts and the ability to make rebate deals with the railroads — the Panic years were golden. Andrew Carnegie, Cyrus McCormick, and John D. Rockefeller had enough capital reserves to finance their own continuing growth. For smaller industrial firms that relied on seasonal demand and outside capital, the situation was dire. As capital reserves dried up, so did their industries. Carnegie and Rockefeller bought out their competitors at fire-sale prices. The Gilded Age in the United States, as far as industrial concentration was concerned, had begun.

As the panic deepened, ordinary Americans suffered terribly. A cigar maker named Samuel Gompers who was young in 1873 later recalled that with the panic, "economic organization crumbled with some primeval upheaval." Between 1873 and 1877, as many smaller factories and workshops shuttered their doors, tens of thousands of workers — many former Civil War soldiers — became transients. The terms "tramp" and "bum," both indirect references to former soldiers, became commonplace American terms. Relief rolls exploded in major cities, with 25-percent unemployment (100,000 workers) in New York City alone. Unemployed workers demonstrated in Boston, Chicago, and New York in the winter of 1873-74 demanding public work. In New York's Tompkins Square in 1874, police entered the crowd with clubs and beat up thousands of men and women. The most violent strikes in American history followed the panic, including by the secret labor group known as the Molly Maguires in Pennsylvania's coal fields in 1875, when masked workmen exchanged gunfire with the "Coal and Iron Police," a private force commissioned by the state. A nationwide railroad strike followed in 1877, in which mobs destroyed railway hubs in Pittsburgh, Chicago, and Cumberland, Md.

In Central and Eastern Europe, times were even harder. Many political analysts blamed the crisis on a combination of foreign banks and Jews. Nationalistic political leaders (or agents of the Russian czar) embraced a new, sophisticated brand of anti-Semitism that proved appealing to thousands who had lost their livelihoods in the panic. Anti-Jewish pogroms followed in the 1880s, particularly in Russia and Ukraine. Heartland communities large and small had found a scapegoat: aliens in their own midst.

The echoes of the past in the current problems with residential mortgages trouble me. Loans after about 2001 were issued to first-time homebuyers who signed up for adjustablerate mortgages they could likely never pay off, even in the best of times. Real-estate speculators, hoping to flip properties, overextended themselves, assuming that home prices would keep climbing. Those debts were wrapped in complex securities that mortgage companies and other entrepreneurial banks then sold to other banks; concerned about the stability of those securities, banks then bought a kind of insurance policy called a credit-derivative swap, which risk managers imagined would protect their investments. More than two million foreclosure filings — default notices, auction-sale notices, and bank repossessions — were reported in 2007. By then trillions of dollars were already invested in this credit-derivative market. Were those new financial instruments resilient enough to cover all the risk? (Answer: no.) As in 1873, a complex financial pyramid rested on a pinhead. Banks are hoarding cash. Banks that hoard cash do not make short-term loans. Businesses large and small now face a potential dearth of short-term credit to buy raw materials, ship their products, and keep goods on shelves.

If there are lessons from 1873, they are different from those of 1929. Most important, when banks fall on Wall Street, they stop all the traffic on Main Street — for a very long time. The protracted reconstruction of banks in the United States and Europe created widespread unemployment. Unions (previously illegal in much of the world) flourished but were then destroyed by corporate institutions that learned to operate on the edge of the law. In Europe, politicians found their scapegoats in Jews, on the fringes of the economy. (Americans, on the other hand, mostly blamed themselves; many began to embrace what would later be called fundamentalist religion.)

The post-panic winners, even after the bailout, might be those firms — financial and otherwise — that have substantial cash reserves. A widespread consolidation of industries may be on the horizon, along with a nationalistic response of high tariff barriers, a decline in international trade, and scapegoating of immigrant competitors for scarce jobs. The failure in July of the World Trade Organization talks begun in Doha seven years ago suggests a new wave of protectionism may be on the way.

In the end, the Panic of 1873 demonstrated that the center of gravity for the world's credit had shifted west — from Central Europe toward the United States. The current panic suggests a further shift — from the United States to China and India. Beyond that I would not hazard a guess. I still have microfilm to read.

Comments

[roger]

6 cheers & loud applause!!! this is the most intelligent piece
of research I have read so far its got meat on the bone!
I'm really impressed .It deals with fundamentals not the petty
shit distracting details.

[Jes]

Wow--this is real food for thought. Thank you for posting it.

[mountainaires]

Okay, you're really scaring me now. Bernanke is an expert on the Great Depression of 1929. If this compares more to the Panic of 1873, then it's no wonder Bernanke is having such trouble dealing with it. We could be doomed to repeat history after all; just not the historical era Bernanke prepared for.

Ya gotta laugh. Or you'll cry. ;o}

[Independent Accountant]

I think the model is the German inflationary depression of 1922-23 and have said so many times. Historical fact: the US went back to the gold standard in 1879. I predict we will return to gold again.

[sarge]

Also of interest, the US Army was forced to turn their attention away from the Indian Wars during the economic crisis

[ron]

"None of those factors is really an issue now. Contemporary industries have very sensitive controls for trimming production as consumption declines"

Yes and no, We have a demand side economy not only is it 70% of the GDP but our employment growth comes from the need to generate more and more demand from the citizens. Our industrial manufacturing base is volume driven and very sensitive to slack consumption as the automation and productivity continue to displace direct factory workers and put more emphasis on demand creation.
The rise of the financial sector over the past 25 years along with marketing,advertising and sales is a natural outgrowth of our demand base economy that requires easy credit and other incentives to spur over consumption.
The economic issues ahead relate to overconsumption and the distribution of wealth and how the general population responds to a lower standard of living centered on basic needs vs advertising created wants.

[VoiceFromTheWilderness]

While I'm certainly not an economist, I am fairly good at telling when people are including relevent factors, and when people are ignoring reality. It seems to me that most mainstream analysis is completing ignoring reality, and most of the remaining while realistic, have biases built into their methodology that are preventing them from seeing a much more dire situation.

What is that bias? We tend to want to compare data from one time period to another -- in fact, obviously, all analysis depends on it. The problem is that the numbers cannot show us how the environment that creates that number is changing. So for example, if you want to compare stock market prices today, to stock market prices in say 1980, one should ask 'does the price of stocks reflect changes in the business of stock market'. What do I mean? Well for example in 1980 the internet didn't exist, day trading on the scale we have today didn't exist, hedge funds using massive computation power beyond the scale of any government in the world circa 1980 didn't exist. So is today's stock market comparable to 1980's? Well the data is able to be compared, but that doesn't mean the conclusions are valid.

So, the main point: We have spent the last 30 years doing two main things: 1)Coupling the entire world together. Remember that the supposed value of derivatives is their ability to 'spread risk around'. Free trade agreements obviously create coupling, as does technological innovation in communication and transportation, and computing. This is obvious. 2) Destroying the regulatory environment -- world wide -- that followed the catastrophe of the great depression. One might ask why didn't record debt/GDP ratios in 1980 (beyond the 1920's) lead to a debt crisis? Answer: regulatory structures were still in place to prevent the worst excesses of individual actors. Thank god we got rid of those!

Conclusion: We are in completely unprecedented territory. We will be lucky if this is only as bad as the great depression. The reality is that for the first time in human history we have an entire planet acting in concert and following laissez-faire 'free market' rules under the direction of a global hegemon -- the US. Where ever, in the past these rules have existed, trouble has rapidly followed. The point made in the article quoted seems quite apt. This isn't like 1930, not being an expert I can't say if this comparison is correct but it sounds right. However, one thing that isn't noted in the piece is the differing scale. This time is much, much, much bigger. I would say I've just made a case that we are enterring the largest economic crisis in world history...

[Black Star Ranch]

.....all boiled down from the point-of-view of an old retired hobby gardener:

I'm glad I have a plot of warm dirt, home, chickens and a cow with lots of water to ride this thing out. Nowadays there's no better investments than bullets, bacon & butter.

[R M]

I am almost as impressed with the quality of the comments here (first visit to site) as I am with this article.

Folks looking for more info might have a profitable dig and skim over at www.mises.org, and some at
www.lewrockwell.com

Thanks for great article. Very insightful!

[Austrian Banker]

Sorry the comments the author makes is nonsense. If you read AGD by Rothbart you'll find that the current set of events is near identical to what took place 1920s leading up to 1929. Also, talking about inventories etc speaks volumes. Look at this with Austrian school eyes and you see it is just more of the same old story relating to monetary inflation.

I will go so far as saying that you can sit with AGD in one hand and the internet with the other and you can match it up identically. Excess reserve inventories in monetary supply is identical to the 1930s experience.

[Oldsmoblogger]

I found my way here from a comment left at Dr. Helen's blog. Speaking as a relative newcomer to Austrian thought (I've read Economics in One Lesson, The Case Against the Fed, and a lot of essays) I'll say this -- you make out a case. Intriguing. Well done.

[roger]

Yes there are similarity's in the sphere of money circulation,
bankruptcies ,graphs and a host other things,what people like
me are saying is that it goes way beyond that,it's a complete
change in the global relations with the US being dethroned as
the world leader (it happens all the time)the only way to understand
that is to have a good grasp of the dialectics that produce these
historical events.The Austrian school offers none of that,is a
laissez faire approach that does not comprehend the power struggle
taking place in between nations witch by the way produce these
monetary crisis

[John Lounsbury]

Michael -

I have read and appreciated a number of your posts on Seeking Alpha. This piece (and the comments) are excellent. I have not studied the 1873 crisis at all and have not done a thorough job on the 1920's, so what I have read here has been very informative. I have spent some time on the Roosevelt era, but now I recognize that looking at his successes and mistakes is possibly giving an incomplete picture of what needs to be considered currently.

I am bookmarking your website for future reference.

[farang]

Interesting that European "political analysts targeted "foreign banks and Jews" [Many political analysts blamed the crisis on a combination of foreign banks and Jews. Nationalistic political leaders (or agents of the Russian czar) embraced a new, sophisticated brand of anti-Semitism that proved appealing to thousands who had lost their livelihoods in the panic. Anti-Jewish pogroms followed in the 1880s, particularly in Russia and Ukraine. Heartland communities large and small had found a scapegoat: aliens in their own midst.]

"because the jews were "aliens in their midst."? Unconnected coincidence? That is the SOLE reason? Got a shred of evidence to submit with that assertion? Because this author saying so doesn't make it true.

So, exactly why "foreign banks AND Jews"? Because of "...a new, sophisticated brand of Anti-semitism..?" Ya sure? Or because they had reason, good reason, to be PISSED?

Just in case we "missed the point" the author repeats it AGAIN in closing: [ In Europe, politicians found it's scapegoats in Jews, on the fringes of the economy.]

Are THESE GUYS below on the "fringes of our economy", Professor?

WHY did the 1870s "political analysts" point to that combo, Mr. Rubin? Mr. Paulson? Mr. Greenspan? Mr. Bernanake? Mr. Sanford Weill? Mr. Maurice Greenberg? The list goes on and on with all the "failed" and now "bailed out" (spelt: LOOTED by insiders) Wall Street institutes, quite extensively.

While I certainly would never generalize against any segment of the population as being monolithic in their beliefs, including American Jews, and would vigorously oppose anyone doing so, I certainly would have to be wearing thick blinders not to see this:

[Counterpunch, November 13, 2008:

A Credit Crisis or a Collapsing Ponzi Scheme?
The Two Trillion Dollar Black Hole

By PAM MARTENS

Purge your mind for a moment about everything you've heard and read in the last decade about investing on Wall Street and think about the following business model:

You take your hard earned retirement savings to a Wall Street firm and they tell you that as long as you "stay invested for the long haul" you can expect double digit annual returns. You never really know what your money is invested in because it’s pooled with other investors and comes with incomprehensible but legal looking prospectuses. The heads of these Wall Street firms have been taking massive payouts for themselves, ranging from $160 million to $1 billion per CEO over a number of years. As long as new money keeps flooding in from newfangled accounts called 401(k)s, Roth IRAs, 529 plans for education savings, and hedge funds (each carrying ever greater restrictions for withdrawing your money and ever greater opacity) everything appears fine on the surface. And then, suddenly, you learn that many of these Wall Street firms don't have any assets that anybody wants to buy. Because these firms are both managing your money as well as having their own shares constitute a large percentage of your pooled investments, your funds begin to plummet as confidence drains from the scheme.

Now consider how Wikipedia describes a Ponzi scheme:

“A Ponzi scheme is a fraudulent investment operation that involves promising or paying abnormally high returns (‘profits’) to investors out of the money paid in by subsequent investors, rather than from net revenues generated by any real business. It is named after Charles Ponzi...One reason that the scheme initially works so well is that early investors – those who actually got paid the large returns – quite commonly reinvest (keep) their money in the scheme (it does, after all, pay out much better than any alternative investment). Thus those running the scheme do not actually have to pay out very much (net) – they simply have to send statements to investors that show how much the investors have earned by keeping the money in what looks like a great place to get a high return. They also try to minimize withdrawals by offering new plans to investors, often where money is frozen for a longer period of time...The catch is that at some point one of three things will happen:

(1) the promoters will vanish, taking all the investment money (less payouts) with them;

(2) the scheme will collapse of its own weight, as investment slows and the promoters start having problems paying out the promised returns (and when they start having problems, the word spreads and more people start asking for their money, similar to a bank run);

(3) the scheme is exposed, because when legal authorities begin examining accounting records of the so-called enterprise they find that many of the 'assets' that should exist do not."

Looking at outcomes 1, 2, and 3 above, here’s where we are today. The promoters have clearly not vanished as in outcome 1. In fact, they are behaving as if they know they have nothing to fear. As over $2 trillion of taxpayer money is rapidly infused through Federal Reserve loans and over $125 Billion in U.S. Treasury equity purchases to keep these firms from collapsing, the promoters are standing at the elbow of the President-Elect in press conferences (Citigroup promoter, Robert Rubin); they are served up as business gurus on the business channel CNBC (former AIG CEO and promoter, Maurice “Hank” Greenberg); they are put in charge of nationalized zombie firms like Fannie Mae (Herbert Allison, former President of Merrill Lynch); they are paying $26 million and $42 million, respectively, for new digs at 15 Central Park West in Manhattan, where their chauffeurs have their own waiting room (Lloyd Blankfein, CEO of Goldman Sachs; Sanford “Sandy” Weill, former CEO of Citigroup, who put his penthouse in the name of his wife’s trust, perhaps smelling a few pesky questions ahead over the $1 billion he sucked out of Citigroup before the Fed had to implant a feeding tube).

We are definitely seeing all the signs of outcome 2: the scheme is collapsing under its own weight; there are panic runs around the globe wherever Wall Street has left its footprint.

But outcome 3 is the most fascinating area of departure from the classic Ponzi scheme. Legal authorities have, indeed, examined the books of these firms, except for one area we’ll discuss later. They found worthless assets along with debts hidden off the balance sheet instead of real depositor funds. Instead of arresting the perpetrators and shutting down the schemes, Federal authorities have developed their own new schemes and pumped over $2 trillion of taxpayer money into propping up the firms while leaving the schemers in place. Equally astonishing, Congress has not held any meaningful investigations. This has left many Wall Street veterans wondering if the problem isn’t that the firms are “too big to fail” but rather “too Ponzi-like to prosecute.” Imagine the worldwide reaction to learning that all the claptrap coming from U.S. think-tanks and ivy-league academics over the last decade about efficient market theory and deregulation and trickle down was merely a ruse for a Ponzi scheme now being propped up by a U.S. Treasury Department bailout and loans from our central bank, the Federal Reserve.

Fortunately for American taxpayers, Bloomberg News has some inquiring minds, even if our Congress and prosecutors don’t. On May 20, 2008, Bloomberg News reporter, Mark Pittman, filed a Freedom of Information Act request (FOIA) with the Federal Reserve asking for detailed information relevant to whom the central bank was giving these massive loans and precisely what securities these firms were posting as collateral. Bloomberg also wanted details on “contracts with outside entities that show the employees or entities being used to price the Relevant Securities and to conduct the process of lending.” Heretofore, our opaque central bank had been mum on all points.

By law, the Federal Reserve had until June 18, 2008 to answer the FOIA request. Here’s what happened instead, according to the Bloomberg lawsuit: On June 19, 2008, the Fed invoked its right to extend the response time to July 3, 2008. On July 8, 2008, the Fed called Bloomberg News to say it was processing the request. The Fed rang up Bloomberg again on August 15, 2008, wherein Alison Thro, Senior Counsel and another employee, Pam Wilson, informed the business wire service that their request was going to be denied by the end of September 2008. No further response of any kind was received, including the denial. On November 7, 2008, Bloomberg News slapped a federal lawsuit on the Board of Governors of the Federal Reserve, asserting the following:

“The government documents that Bloomberg seeks are central to understanding and assessing the government’s response to the most cataclysmic financial crisis in America since the Great Depression. The effect of that crisis on the American public has been and will continue to be devastating. Hundreds of corporations are announcing layoffs in response to the crisis, and the economy was the top issue for many Americans in the recent elections. In response to the crisis, the Fed has vastly expanded its lending programs to private financial institutions. To obtain access to this public money and to safeguard the taxpayers’ interests, borrowers are required to post collateral. Despite the manifest public interest in such matters, however, none of the programs themselves make reference to any public disclosure of the posted collateral or of the Fed’s methods in valuing it. Thus, while the taxpayers are the ultimate counterparty for the collateral, they have not been given any information regarding the kind of collateral received, how it was valued, or by whom.”

As evidence that Bloomberg News is not engaging in hyperbole when it uses the word “cataclysmic” in a Federal court filing, consider the following price movements of some of these giant financial institutions. (All current prices are intraday on November 12, 2008):

American International Group (AIG): Currently $2.16; in May 2007, $72.00

Bear Stearns: Absorbed into JPMorganChase to avoid bankruptcy filing; share price in April 2007, $159

Fannie Mae: Currently 65 cents; in June 2007 $69.00

Freddie Mac: Currently 79 cents; in May 2007 $67.00

Lehman Brothers: Currently 6 cents; in February 2007, $85.00

What all of the companies in this article have in common is that they were writing secret contracts called Credit Default Swaps (CDS) on each other and/or between each other. These are not the credit default swaps recently disclosed by the Depository Trust and Clearing Corporation (DTCC). These are the contracts that still live in darkness and are at the root of why the Wall Street banks won’t lend to each other and why their share prices are melting faster than a snow cone in July.

A Credit Default Swap can be used by a bank to hedge against default on loans it has made by buying a type of insurance from another party. The buyer pays a premium upfront and annually and the seller pays the face amount of the insurance in the event of default. In the last few years, however, the contracts have been increasingly used to speculate on defaults when the buyer of the CDS has no exposure to the firm or underlying debt instruments. The CDS contracts outstanding now total somewhere between $34 Trillion and $54 Trillion, depending on whose data you want to use, and it remains an unregulated market of darkness. It is also quite likely that none of the firms that agreed to pay the hundreds of billions in insurance, such as AIG, have the money to do so. It is also quite likely that were these hedges shown to be uncollectible hedges, massive amounts of new capital would be needed by the big Wall Street firms and some would be deemed insolvent.

Until Congress holds serious investigations and hearings, the U.S. taxpayer may be funding little more than Ponzi schemes while companies that provide real products and services, legitimate jobs and contributions to the economy are left to fail.

Pam Martens worked on Wall Street for 21 years; she has no security position, long or short, in any company mentioned in this article. She writes on public interest issues from New Hampshire. She can be reached at pamk741@aol.com

New in the Print Edition of CounterPunch

Greenspan’s Confession
For his 20-year stretch as Fed chairman, they all fawned on him – presidents, Congress, the press. Only a handful of left economists said he was pushing the economy over the cliff. Now Greenspan admits it in a humiliating confession. As the world’s financial structure tumbles in ruins, guess what? “I found a flaw in the model… To the extent that I figure out where it happened and why, I will change my views.” Read Frederic Claremont’s savage assessment of the fool who has plunged millions into misery.]

Well, I guess pointing out FACTS to this professor at W&M will earn ME an epitaph, too.

That's alright, I am the duck, and it rolls down my back. It is "geniuses" like this professorr and his "conventional thinking" that keeps us SILENT and mired in this mess.

And GOD KNOWS the Ukrainians never suffered from the (mostly Jewish leadership) Bolsheviks eh Professor?