Appendix - 3 :: Looking Back

IN many ways the current crisis constitutes the second -- and higher -- stage of the one that appeared with the "dot-com bubble burst".  And it is not without reason that it is being compared to the GD of 1930s. To better understand the present, let us therefore take a short and a rather long look back.

The Dot-Com Bubble Burst

Also known as "I.T. / New Economy bubble", the "dot-com bubble" was a speculative bubble covering roughly 1995–2000, during which stock markets in Western nations saw their value increase rapidly thanks to growth in the new Internet sector and related fields.  The period was marked by the founding of a group of new Internet-based companies commonly referred to as dot-coms. They relied on harnessing network effects by operating at a sustained net loss to build market share or “mind share”. These companies expected that they could build enough brand awareness to charge profitable rates for their services later. The motto "get big fast" reflected this strategy. During the loss period the companies relied on venture capital and especially initial public offerings of stock to pay their expenses. The novelty of these stocks, combined with the difficulty of valuing the companies, sent many stocks to dizzying heights and made the initial controllers of the company wildly rich on paper.

Historically, the dot-com boom can be seen as similar to a number of other technology-inspired booms of the past including railroads in the 1840s, automobiles and radio in the 1920s, transistor electronics in the 1950s, and home computers and biotechnology in the early 1980s.

As evident from these experiences, a bubble occurs when speculators note the rapid increase in value and decide to buy in anticipation of further rises, rather than because the shares are undervalued. Many companies thus become grossly overvalued. When the bubble "bursts," the share prices fall dramatically, and many companies go out of business.

This was what happened this time too. Several communication companies, burdened with unredeemable debts from their expansion projects, sold their assets for cash or filed for bankruptcy. WorldCom, the largest of these, was found to have used illegal accounting practices to overstate its profits by billions of dollars. The company's stock crashed when these irregularities were revealed, and within days it filed the largest (till then) corporate bankruptcy in U.S. history. Other examples include NorthPoint Communications, Global Crossing etc.

Altogether the dot-com bubble crash wiped out $5 trillion in market value of “new technology” companies from March 2000 to October 2002. Most of the new high-speed optical fiber infrastructure remained unutilised, and came to be known as dark fiber.

Several companies and their executives were accused or convicted of fraud for misusing shareholders' money, and the U.S. Securities and Exchange Commission fined top investment firms like Citigroup and Merrill Lynch millions of dollars for misleading investors. Various supporting industries, such as advertising and shipping, scaled back their operations as demand for their services fell. A few large dot-com companies, such as Amazon.com and eBay, survived the turmoil and are now doing reasonably well.  So did a number of small players who were able to weather the financial markets storm.

After the dot-com bubble burst, instead of channeling finance capital back into production through institutional reform, US authorities paved the way for another bubble by reducing interest rates. Regarding people with investable funds, Yale economist Robert Shiller wrote in 2005, “Once stocks fell, real estate became the primary outlet for the speculative frenzy that the stock market had unleashed. Where else could plungers apply their newly acquired trading talents? The materialistic display of the big house also has become a salve to bruised egos of disappointed stock investors.” (Cited by M. Obstfeld in “Models of currency crises with self-fulfilling features”; European Economic Review 40 (1996), pp. 1037-47.)

The Great Depression

World War I was followed by a sharp postwar recession and during the 1920s millions of Americans began to purchase stocks for the first time. Stock prices rose steadily. Investors eventually realized that a large imbalance existed between stock prices and the real assets available to back them up, including profits, and decided to sell. On October 29, 1929, great numbers of people tried to sell their stocks all at once. Prices tumbled so drastically on the NYSE and other exchanges that the event became known as the crash of 1929.

This precipitated the Great Depression (GD).The economy raced downhill. Unemployment, which affected 3 percent of the labor force in 1929, reached 25 percent in 1933. People with jobs had to accept pay cuts.  Demand for durable goods—housing, cars, appliances—and luxuries declined, and production faltered. By 1932 the gross national product had been cut by almost one-third. By 1933 over 5,000 banks had failed, and more than 85,000 businesses had gone under.  

In cities, the destitute slept in shanties that sprang up in parks or on the outskirts of town, wrapped up in “Hoover blankets” (newspapers) and displaying “Hoover flags” (empty pockets). In African American communities, unemployment was disproportionately severe. In Chicago in 1931, 43.5 percent of black men and 58.5 percent of black women were out of work, compared with 29.7 percent of white men and 19.1 percent of white women. The depression quickly spread throughout the world. For example, nearly 40 percent of the German workforce was unemployed by 1932, bringing grist to Hitler’s mills.

The proximate cause of the GD, as Irving Fisher argued, lay in loose credit and over-indebtedness, which fueled speculation and asset bubbles that inevitably crashed. In 1929 margin requirements in stock markets were only 10%. In other words, brokerage firms would loan $9 for every $1 an investor had deposited. When the market fell, brokers called in these loans, which could not be paid back. Banks began to fail as debtors defaulted on debt and depositors attempted to withdraw their deposits en masse, triggering multiple bank runs. Government guarantees and Federal Reserve banking regulations to prevent such panics were ineffective or not used. Bank failures led to the loss of billions of dollars in assets. Outstanding debts became heavier, because prices and incomes fell by 20–50% but the debts remained at the same dollar amount. After the panic of 1929, and during the first 10 months of 1930, 744 US banks failed. By 1933, depositors had lost $140 billion in deposits. In all, 9,000 banks failed in the US during the 1930s.

Bank failures snowballed as desperate bankers called in loans but many borrowers defaulted. With future profits looking poor, capital investment and construction slowed or completely ceased. In the face of bad loans and worsening future prospects, the surviving banks became even more conservative in their lending. Banks built up their capital reserves and made fewer loans, which intensified deflationary pressures.

The liquidation of debt could not keep up with the fall of prices which it caused. The mass effect of the stampede to liquidate increased the value of each dollar owed, relative to the value of declining asset holdings. The very effort of individuals to lessen their burden of debt effectively increased it. Paradoxically, the more the debtors paid, the more they owed. This self-aggravating process turned the recession into a great depression. Fisher called this phenomenon debt-deflation, the specter of which is again looming large on the horizon today, according to many an economist based in US.

A good many similarities between the GD and the current crisis are quite evident. Both started in the financial sector and gradually spread to the real sector as credit dried up. During both crises many financial institutions either defaulted or had to be bailed out. In both cases the crisis started with the bursting of a bubble. And of course, both crises started in the US and subsequently spread to other countries.

The differences also are no less notable. Responses of both fiscal and monetary policies today are much swifter and vigorous. The GD was characterized by beggar thy neighbor policies.  In mid 1930 the US Congress passed the Smoot-Hawley Tariff Act that raised tariffs on over 20,000 imported goods to record levels. Other countries retaliated by also imposing restrictions on imports and engaged in competitive devaluations of their respective currencies. This led to a serious contraction of international trade. This time major trading partners have so far largely avoided the temptation to tread this path, keeping in mind the adverse consequences of such actions during the 1930s. Some economists believe that thanks to these differences, the current crisis will not assume such alarming proportions as the GD did.

On the other hand, there are a number of differences that adds to the difficulties of tackling the present crisis.  More important among these are the extreme complexity and lack of transparency of financial operations, the enhanced interpenetration of financial markets across the world, the excessive preponderance of the financial sector vis-a-vis manufacture, agriculture, manufacturing and commodities trade.  

Elected President in 1932, Franklin Delano Roosevelt instituted a program termed the New Deal, which included several measures aimed at rebuilding the economy. By the start of Roosevelt’s second term in 1937, some progress had been made against the depression; the gross output of goods and services reached their 1929 level. Unemployment was still high, and per capita income was less than in 1929. The economy plunged again in the so-called Roosevelt recession of 1937, caused by reduced government spending and the new social security taxes. To battle the recession and to stimulate the economy, Roosevelt initiated a spending program which served to tone up demand to some extent.

The New Deal never ended the Great Depression, which continued until the United States’ entry into World War II revived the economy. As late as 1940, 15 percent of the labor force was unemployed. Nor did the New Deal redistribute wealth or challenge capitalism. But in the short run, the New Deal averted disaster and alleviated misery, and its long-term effects were profound in rebuilding the socio-economic infrastructure.

From memoirs of Marriner S. Eccles

Inequality of Wealth and Income

The author served as Chairman of the Federal Reserve under Franklin D. Roosevelt from November 1934 to February 1948. Here he details what he believed caused the Depression.

“As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth -- not of existing wealth, but of wealth as it is currently produced -- to provide men with buying power equal to the amount of goods and services offered by the nation's economic machinery. [Emphasis in original.]

Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.

That is what happened to us in the twenties. We sustained high levels of employment in that period with the aid of an exceptional expansion of debt outside of the banking system. This debt was provided by the large growth of business savings as well as savings by individuals, particularly in the upper-income groups where taxes were relatively low….The stimulation to spend by debt-creation of this sort was short-lived and could not be counted on to sustain high levels of employment for long periods of time. Had there been a better distribution of the current income from the national product -- in other words, had there been less savings by business and the higher-income groups and more income in the lower groups -- we should have had far greater stability in our economy. Had the six billion dollars, for instance, that were loaned by corporations and wealthy individuals for stock-market speculation been distributed to the public as lower prices or higher wages and with less profits to the corporations and the well-to-do, it would have prevented or greatly moderated the economic collapse that began at the end of 1929.

The time came when there were no more poker chips to be loaned on credit. Debtors thereupon were forced to curtail their consumption in an effort to create a margin that could be applied to the reduction of outstanding debts. This naturally reduced the demand for goods of all kinds and brought on what seemed to be overproduction, but was in reality underconsumption when judged in terms of the real world instead of the money world. This, in turn, brought about a fall in prices and employment.

Unemployment further decreased the consumption of goods, which further increased unemployment, thus closing the circle in a continuing decline of prices.

This then, was my reading of what brought on the depression.” [from Beckoning Frontiers (New York, Alfred A. Knopf, 1951)]