The evolution of the economy after 2000 was, of course, entirely different than after 1929, and we have previously attributed this to the aggressive easing of monetary policy that sustained a major boom in residential construction and in sales of consumer durables sufficient largely to offset the decline of investment in equipment and software. A second difference was the aggressive easing of fiscal policy in 2001-03 through a succession of reductions in Federal income tax rates, including the tax rates on capital gains and dividends. A third major difference was that equities could be margined up to 90 percent in the late 1920s, compared to 50 percent in the 1990s, raising both the level of speculative frenzy in 1927-29 and the extent of wealth destruction when the crash finally came.
I found the entire paper fascinating. I think that both periods represent interesting examples of the Kindleberger theory of booms related to displacement. I think that the question of what made the economy less unstable in 2000 than in 1930 is an important one, and Gordon’s answer is plausible (he looks at more than simply fiscal and monetary policy, although that is what I quoted above).
I really think that empirical macroeconomics ought to be economic history. The benefit-cost ratio of econometric equations in macro has been quite low, in my opinion.
READER COMMENTS
eric
Nov 28 2005 at 10:16am
I found Kindleburger incoherent. His book merely outlines numerous independent financial cataclysms, but it is impossible to create a model out of it. There is no theme other than the prosaic note that things tend to be overdone–though in different ways and at different times. Even a Sunday Times Magazine piece tries to put a more coherent theme on the story.
So to my mind, when someone says “Kindleburger theory of booms” I think: oh, the “theory” that some prices go up a lot then down a lot because of fads.
spencer
Nov 28 2005 at 11:04am
I would agree with most of both your and Gordon comments. but I would really take exception to the argument about the role of margin in the stock market booms of the 1920s and 1990s.
Margin accounts played a major role in the 1920s, but not as big a role in the 1990s. But this does not imply that speculation was less sever in the 1990s. It was just that other meathods of speculating in stocks were developed in the 1990s that displaced margin accounts. That is why I think Greenspan was right when he said raising margin requirements probably would not have had much on an impact and could have made the situation worse.
The S&P 500 peak PE was 32.5 in 1929 versus 46.5 in 2002. By this measure speculation was almost 50% stronger in this cycle then in the 1920s.
spencer
Nov 28 2005 at 11:10am
You should read Bernanke on the role of gold and the international financial system in the depression. Especially given that the biggest problem with the classic gold based monetary system is that it is inheritently pro-cyclical.
Randy
Nov 28 2005 at 11:28am
Hypothesis; a big difference between 1929 and 2000 is that we now have a service economy, which is inherently more adaptable than the agricultural/industrial economy of 1929.
spencer
Nov 28 2005 at 11:51am
Randy — I don’t think its that a service sector is more adaptable, rather it that it is more stable. Moreover, the stability may center on the point that the services sector does not have an inventory problem like both ag and manuf have.
One of the ways this works out is inventories just no longer play the role in the economy they
use to. this is also one of the positive impacts of the information revolution that has played a major role in reducing the cyclicality of the economy in the last quarter century. Within the technology sector — a goods sector — both the desired and actual I/S ratio has been falling for 20 years.
Arnold Kling
Nov 28 2005 at 12:34pm
Randy, Gordon does mention how inventory overhangs played a role when we had more agriculture and manufacturing, and presumably the service sector is less prone to inventories being a source of instability.
Dan Landau
Nov 28 2005 at 3:20pm
It seems to me that the 1929 – 41 Great Depression had some other monetary elements. There were the 4 waves of bank failures before 1933. The banks didn’t fail in the 21st century recession.
Barkley Rosser
Nov 28 2005 at 4:48pm
eric,
Well, there is now a rather large and sophisticated literature on bandwagons and contagions, all of which is designed to explain “fads,” which you seem to think are somehow atheoretical. It is true that Kindleberger did not lay out a mathematical model, and he certainly did not assume any sort of rational expectations equilibrium, quite the contrary. But there has been a lot of theoretical work recently based on his work. Really not sure what you find “incoherent” about his work. The claim that fads in investing exist?
eric
Nov 28 2005 at 7:17pm
Barkely: I’d like to see a description of some of the general characteristics of a boom other than the ex poste finding that prices subsequently went down. Some dynamic that testable or predictive. Instead its hindsight: things that fell in value were overvalued due to excess optimism. That’s hardly a scientific theory, just a description.
Barkley Rosser
Nov 28 2005 at 9:50pm
eric,
No, it is not the fall that provides the evidence of a speculative bubble, whether or not it is irrationally fad-driven or a rational stochastic bubble. Indeed, not all bubbles burst all that dramatically, e.g. the Japanese real estate one has gone down much more slowly than it went up.
The evidence of a bubble is a rapid rise in price that is not connected with a rise in the fundamental that should underpin the price of the asset. Now it is not always easy to identify such a fundamental, or one can argue that there is a rational expectation that it is going to rise in the future, and the higher prices reflect that, even it has not. So, we have seen real estate prices zooming i the last five years in the US while rents and income have not done so, to the point that they have reached all time historical highs as ratios of those fundamentals, according to Robert Shiller in the second edition of his Irrational Exuberance. That those real estate prices now seem to be declining in many US markets is not at all surprising.
Rational stochastic bubbles should accelerate especially rapidly as their price should include a risk premium for the crash that must increase as the probability of the crash increases as the bubble proceeds. Some such as Didier Sornette have used this to forecast the point when crashes will happen.
One kind of asset where the fundamental is much clearer is a closed-end fund. They have asset values that deviate from their selling pricese. Usually they sell for discounts of about 5-10%, reflecting tax factors and management fees. A well known ten dollar bill to pick up is buying way undervalued closed end funds, 20-30%. However, when such funds run premia, especially really high ones, this is something really stupid to buy. Such funds were running premia of about 100% in the summer of 1929. As historians Barsky and DeLong noted, the stock market itself may not have been a speculative bubble, but there certainly was on in the market for closed end funds at that time.
Roger M
Nov 29 2005 at 9:53am
It’s been a while since I read Kindleberger’s book, but it seems to me that he admitted that he didn’t have a model for manias. He wrote that monetary policy played a role, as did greed and group dynamics, but seemed to lean toward credit expansion. He quoted someone from the tulip mania in the Dutch Republic who complained about maids and other servants investing in tulips. He suggested that you can spot a bubble when the shoe shine boy is giving you stock tips. Kindleberger reasoned that the poorer people only get interested in an asset when the price has just about reached its peak. At that point, otherwise cautious people, such as grandmothers, will often take money from under the mattress and invest it or lend it to someone to invest. Kindleberger seemed to argue that limits on bank credit expansion wouldn’t help much because private people would lend to others at the top of a bubble.
Roger M
Nov 29 2005 at 10:05am
Gordon writes in his abstract that “In both the 1920s and the 1990s the acceleration of productivity growth linked to the delayed effects of previously invented “general purpose technologies” stimulated an increase in fixed investment that became excessive and proved to be unsustainable…” Of course, the Austrians would comment, “What caused the excess investment in capital goods? The inflated money supply.”
spencer
Nov 29 2005 at 6:10pm
But others would ask the austrians what caused the inflated money supply?
Never ending cycle isn’t it?
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