Great Depression versus Now

http://biz.thestar.com.my/news/story.asp?file=/2008/10/22/business/2335258&sec=business

The Star Online > Business
By OOI KOK HWA" name=AUTHOR>
Wednesday October 22, 2008

Great Depression versus now

Personal Investing

By OOI KOK HWA

As much as there are similarities between the two crises, the damage caused by the current turmoil is likely to be less severe given the swift actions of central banks.

AS a result of the recent financial tsunami, some experts have started to ponder whether we are headed for a depression.

The current credit crunch and the meltdown in some financial institutions were quite similar to what happened during the Great Depression in the 1930s.

In this article we will analyse the reasons behind the 1929 Wall St crash, which kickstarted the Great Depression and compare it to the current situation to identify any signs that a depression is approaching.

Milton Friedman, the leading advocate of monetarism, argued that every great depression had been accompanied or preceded by a monetary collapse.

According to Ben Bernanke, the US Fed chairman, the main reason behind the Great Crash of 1929 was due to the tight monetary policies adopted during that period.

He said the high interest rates back then caused the US economy to fall into a recession that led to the great market crash in October 1929.

As the US dollar was backed by gold, the acute selling of dollars for gold resulted in a run on the dollar.

The Fed continued to increase interest rates in an effort to preserve the value of US dollar.
As a result, high interest rates caused bankruptcies for many companies.

At the peak of the Great Depression, the US unemployment rate hit 25%

To rub salt into the wound, massive withdrawals of cash by panicky depositors were the last straw that brought about the total collapse of financial institutions.

In that period, bank deposits were uninsured and the collapse of the banks caused depositors to lose their savings.

And due to the economic uncertainties, the surviving banks were reluctant to give out new loans.
Another culprit in the 1929 crash was margin financing which caused excessive speculation in the stock market.

Investors needed only to put up 10% capital and borrow the rest from the bank to invest in the stock market.

The collapse of stock prices led to margin calls and further selldowns.

Coming back to the 2008 crash, the banking and credit-market crisis was mainly due to the property boom and subprime bust.

The collapse of subprime loans sparked the credit crunch, which dragged some financial institutions into trouble.

As a result of the securitisation and the creation of innovative financial products like collateralised-debt obligations and credit-default swaps, the collapse of one financial institution had a domino effect, leading to the collapse of other financial institutions.

Now, the pertinent question is whether we are in a long bear market and heading for a depression.

We believe a depression like the one in 1929 may not happen exactly the way it did before.
Given the fast actions taken by central banks around the world, the damage caused by this crisis will be less severe than the one in 1929.

Central banks around the world have been putting in concerted efforts to make sure the global economy will not fall into a depression.

The rescue packages being implemented throughout the world will help stabilise the financial system.

We believe the reduction of interest rates and the increase in money supply will help cushion the impact of the credit crunch.

Besides, deposits placed with most financial institutions are guaranteed by central banks.
Even though the US unemployment rate may rise to 10% from 6.1% currently, it is still far below the peak of 25% hit during the Great Depression.

In the 1929 crash, the Dow Jones Industrial Average took about three years to reach bottom in July 1932 from its peak in September 1929.

From the peak to the trough the Dow lost about 90%.

The Great Depression in the US started in August 1929 and ended only in March 1933.
The stock market started to recover eight months before the US economy ended its depression.
At present, the Dow has already dropped for a year from its peak in October 2007, currently down about 37.5% against its peak of 14,164 points on Oct 9, 2007.

In view of the possible economic recession in most developed countries, we think the Dow will drop further from current levels.

Nevertheless, we believe it will recover much faster and the magnitude of the fall will be far less severe than the one in 1929.

Lastly, we believe the stock market will eventually recover.

At this point, to be more prudent, we may take a “wait and see” approach until things stabilise.

> Ooi Kok Hwa is an investment adviser licensed by Securities Commission and the managing partner of MRR Consulting
© 1995-2008 Star Publications (Malaysia) Bhd (Co No 10894-D)