Why Lessons From The First Great Depression Mean The Next Four Months Will Be Very Painful For Stockholders

Tyler Durden's picture

Scott Minerd, CIO of Guggenheim Partners, parses through the years of the Great Depression, and focuses on the pivotal 1936, which contained in it the seeds for the destruction of the period of relative economic growth and stability from 1932 to 1936, and resulted in a plunge in the economy in the second great recession of the Depressionary period: that of 1937 and 1938. While the first period saw "GNP grow at an annualized rate of 10 percent, the Dow rose approximately 20 percent per annum, and unemployment declined from as high as 25 percent in 1933 to as low as 11 percent in 1937" the second and much more dire phase of 1937-1938 . saw a unprecedented plunge in economic data: "national output declined by 5.4 percent, unemployment skyrocketed from 11 percent back to 20 percent, the Dow Jones Industrial Average declined 49 percent, and four years of healthy price recovery receded into 3 percent annual deflation." What precipitated the second collapse? "The short answer is that it was a confluence of factors, a perfect storm of monetary and fiscal policy mistakes" yet the immediate catalyst, if one can be defined was "the fiscal policy missteps of the Roosevelt Administration, who, in an effort to balance the budget after six years of deficits, implemented a series of tax increases in 1936 and 1937 that caused output, prices, and income to fall and sent unemployment skyrocketing." We are currently faced with precisely the same juncture, and unfortunately for America, things now have a far lower probability of occurring "just as they should" in order for the country to emerge in one piece on the other side of the tunnel. Here is why.

First a question - what caused Rooselvelt to flip out and commence on a series of disastrous economic policies? Minerd explains:

In response to such Republican criticism of his fiscal policies, Roosevelt fired back by issuing the following points in the Democratic Party platform of 1936 (my paraphrase, followed by direct excerpts originally published June 23, 1936):

1. Deficit spending was a result of the crisis inherited from the previous Administration: “We hold this truth to be self-evident – that 12 years of Republican leadership left our Nation sorely stricken in body, mind, and spirit; and that three years of Democratic leadership have put it back on the road to restored health and prosperity.”

2. The Democratic Party restored confidence in America, thus the cost of deficit borrowing had declined to extremely low levels: “We have raised the public credit to a position of unsurpassed security. The interest rate on government bonds has been reduced to the lowest level in 28 years.”

3. The Democratic Party would still balance the budget through the austerity of limited growth in government and by higher taxes: “We are determined to reduce the expenses of government...Our retrenchment, tax, and recovery programs thus reflect our firm determination to achieve a balanced budget and the reduction of the national debt at the earliest possible moment.”

Does any of this seem familiar? It shoud, as should the fact that in his several years in office the budget deficit had soared, and the attempt to balance it resulted first and foremost in an explosion in unemployment, as the chart below demonstrates:

What specifically went wrong to cause the 1937-1938 episode?

Someone once asked me what Roosevelt did that was so bad leading up to the recession of 1937-38. The answer I give is simple: “He attempted to balance the budget at the wrong time.” More specifically, he attempted to balance thebudget by increasing tax revenues at a time when the economy was still finding its footing and the Federal Reserve was attempting to reverse policy. Even after the four years of recovery following the Great Depression, when Roosevelt began his series of tax increases unemployment remained over 12 percent, which on its own would be considered the worst labor market in modern U.S. economic history.

If the Roosevelt Administration’s driving purpose was to prove to the world that it could balance the budget, it was successful. In 1937, the budget deficit declined by 1.9 percentage points in relation to GNP. In 1938, that trend continued with the deficit declining another 1.4 percentage points in relation to GNP. By December of 1938 the Roosevelt Administration had essentially achieved its goal of a balanced budget.

But what was the cost of such actions? According to data from BCA Research, the unemployment rate went from 11.2 percent in May of 1937 to 20.0 percent just 14 months later. Data from the Federal Reserve Bank of Minneapolis shows the overall economy contracted 5.4 percent in 1938. The Dow Jones Industrial Average fell 49 percent from March 1937 to March 1938. Two years later, in March of 1939, the equity market remained depressed, still 30 percent below its March 1937 levels. The U.S. economy, which had whipped unemployment down from 25 percent in 1933 to 11 percent in 1937, limped into the 1940s with unemployment hovering just over 15 percent. The silver lining of all this economic carnage? For one month in 1938 the budget deficit was reduced to just $89 billion dollars – nearly, but not quite balanced.

So have we learned anything from the past? And even if we have, will the imminent expiration of the tax cuts be the equivalent of the tax hike the rapidly plunged America into the biggest economic deterioration at the tail end of the Great Depression? Alas, the answer is probably yes.But not before the Fed embarks on a proper QE strategy, one that has the potential to not only spike asset prices as the Primary Dealers bid up everything that is not nailed down, but this would happen in a time of surging unemployment. With the true unemployment rate already in the 20% ballpark as calculated by objective, non-governmental estimates, will the outcome of the tax changes of 2011 result in the biggest economic catastrophe in US history? We should look back in time for the answer...

It’s evident from Chairman Ben Bernanke’s speech in Jackson Hole last week that the Fed stands ready to continue to provide quantitative easing if necessary. I believe it will be necessary since the economic data in the next few months is likely to be pretty ugly and the rhetoric out of Washington is likely to devolve into a nightly news highlight reel of partisan feuding.

Yet despite the Fed’s commitments, some of the same issues that occurred in 1937 loom on the horizon today. For instance, in the first quarter of 2011 the United States faces massive tax increases. Similar to the mid-1930s, many have argued that deficits must be tamed now and that the economy is healthy enough to sustain austerity measures. Under such political pressure, it appears unlikely that even a portion of the Bush tax cuts will be extended.

There are a host of economic forecasts about the potential size of the fiscal drag that would result from a full expiration of the Bush tax cuts. Macroeconomic Advisers, for instance, believes it will subtract 0.9 percentage points off GDP. ISI Consulting thinks it could be even larger, around 1.2 percentage points. Arthur Laffer, the famed supply-side economist, prefers a number significantly larger, predicting as much as 6 percentage points of fiscal drag. Any way you slice it, if estimates for economic growth in 2011 range from 2 to 3 percent, these tax increases could result in flat to anemic growth and elevate the risk of recession due to the slightest bit of economic turbulence.

In addition to the expiration of the Bush tax cuts, there is the additional cost of healthcare reform. While some would argue that healthcare reform is just a transfer payment program, the fact remains that there will be no incremental healthcare benefits available in the next three years. Therefore, the transfer payments, which are intended to be revenue neutral over the next 10 years, actually create a fiscal drag between 2011 and 2013 before becoming modestly stimulative when the benefits become available from 2014 to 2020.

So what does this imminent change to tax expectations mean for investors in practical terms? Very bad things, especially for those who anticipate a run up in stocks into the mid-term elections: "One clear consequence of the repeal of the Bush tax cuts will be an urgency to accelerate taxable income into 2010. This will have a number of impacts on the market, the most direct being a desire to liquidate positions in equities and other financial assets to realize capital gains before the New Year. This will continue to put downward pressure on equities and increase volatility."

That's right: equity liquidations, meaning the long expected second major leg down in stocks is at most 4 months away.

There's more:

Last week, Bernanke also referenced the importance of a “baton pass” from the economic boosts of government spending and inventory replenishing to the more sustainable support of consumer spending. If equity prices decline in conjunction with the renewed pressure on the housing market as tax incentives are removed, the net effect is likely to be an adverse impact to already fragile consumer sentiment and spending. In essence, the economy is in danger of a fumbled baton pass from 2010 to 2011.

In the face of this uncertainty, and in light of the Jackson Hole remarks, it appears Chairman Bernanke and the FOMC will find it necessary to increase their holdings in long-term securities and increase the size of their balance sheet. This will ultimately lead to lower interest rates and a need to maintain low long-term rates for several years in a hope to prop up the housing market by maintaining record low mortgage rates (see my recent commentary on “The Story in Housing”). What remains to be seen is how severe the economic headwinds will be as a result of the fiscal tightening going into 2011, and how dramatically the Fed will move once it reaches the decision to continue to grow its balance sheet.

In the short run, given the amount of purchases that the Fed will have to make, quantitative easing will most likely swamp the amount of incremental borrowing required by the government, which means that financing the deficit won’t be a problem. Ultimately, however, the U.S. economy will come to the end of the road and inflation concerns will reemerge.

Once the market collapse has transpired, then, and only then, once we enter the proverbial revulsion stage in equities, will the stage be set for an actual bull market:

I believe further quantitative easing is likely to take place in the near term. I also believe there is a strong probability that there will be some form of additional fiscal stimulus passed by the government as it yields to mounting pressure to address the nation’s historically high unemployment rate. After these two events take place, the stage should be set for the green shoots of recovery to reappear in 2011. Once these harbingers of economic health appear, the Fed will come under pressure to convince the market that it has a sound exit strategy to unwind its massive balance sheet. Simultaneously, pressure will reemerge for fiscal austerity and deficit reduction.

As we approach the presidential election of 2012, monetary and fiscal policymakers will be faced with their greatest challenge: whether to reverse the emergency policies applied up to that point, and if so, at what pace and timing to conduct such measures. The risks surrounding these decisions are even greater than the risks that surround the near-term policy decisions about further fiscal stimulus and quantitative easing – taking away support is always more difficult than giving it. The dangers will be strikingly similar to the risks that faced the economy in 1936. Remember, it was Roosevelt’s dash to fiscal discipline in 1936 – combined with the Fed’s misguided decision to tighten monetary policy by doubling the required reserve ratio for banks – that resulted in the severe fiscal drag on aggregate demand and economic output that pulled the economy back into a deep recession.

While I remain optimistic that the current economic “soft patch” will not unravel into a full-blown recession, my concern increases when I look ahead to the challenges the economy will face once it regains its footing. The parallels to 1936 grow increasingly striking the closer one looks to 2012, especially if the green shoots of economic recovery take hold between now and then, which I believe they will thanks to additional policy actions later this year and in early 2011. Oddly enough, the foundation for the recession of 1937-1938 was laid in the election year of 1936. The question remains, will the presidential election of 2012 lay the foundation for a parallel series of events? Given the unprecedented monetary and fiscal policies enacted in recent months, as well as those that are likely to be enacted in the near term, the opportunities for future errors of policy judgment loom large. In light of this, whether it’s in relation to 2010 or 2012, the lessons of 1936 are stark and disturbing.

And while America in 1938 and onward was a different country, whose manufacturing industry and thus real economic output potential, was only starting to stretch its wings, further having the rather tragic benefit of World War II as an unprecedented attractor for record economic activity, the current outlook is far more bleak. The US consumer is on average far older, the pension system is on the verge of bankruptcy, the US' chief export (at least on a relative basis) is services, and the spectre of a war at this juncture would have far more dire ramifications: a small regional conflict that avoids the participation of the superpowers may have a marginal boost to the economy, but likely nowhere near enough. A full blown collapse into another world war leads to consequences too dire to even imagine. Which is why we agree with Minerd, that while the intermediate steps that occurred in the immediately preceding 1937 period are all in line, and which the government will only have itself to blame if it screws up on the transition to a smooth glide slope, the events on the other end of the tunnel look far bleaker.

Full must read paper from Guggenheim.

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Citizen of an IKEA World's picture

Run, don't walk, to your local book purveyor for a copy of The Forgotten Man, by Amity Shlaes.

weinerdog43's picture

"Run, don't walk, to your local book purveyor for a copy of The Forgotten Man, by Amity Shlaes."

And then run even faster the other way.

HonestJohn's picture

that book was as dry as toast...I prefer Devil take the Hindmost: The History of Finacial Specualtion by Edward Chancellor

jwthomps's picture

That book is seriously good for a

real understanding of that period of


cossack55's picture

To get a solid "feel" for that period, I highly recommend Studs Terkel's  "Hard Times".  An oral history compiled in 1970 when many or the players and victims were still alive.  A damn fine read with some intersting perspectives on Goldman Sucks and JP Morgan.

New_Meat's picture

and Roth's "Depression Diary:"


and for serious readers, Milton Friedman and Anna Schwartz (kinda the basis of his Nobel).

- Ned

Crisismode's picture

I prefer people who don't read books at at all.


BOOKS are sooooo Old-Timey.


Can't you people find what you need to know online?


WHY do you WASTE you time reading BOOKS????


Oh, right.


They're not electronic.


And they say "you're" instead of "your", correctly.


Pardon me.



New_Meat's picture

you and Kathy should hook up. - Ned

kathy.chamberlin@gmail.com's picture

And they say "you're" instead of "your", correctly.

never thought about that, mode.

your = your're  =  you are. right?

books are hard for some, to just sit down and read in/on a chair. i try. i like picture books, art books. clouds, artists are up in the clouds, with pictures.

Unscarred's picture

Picture books are so benign and callous.  Color by numbers is where the REAL action is at!

palmereldritch's picture

Can we possibly use this opportunity to advance a potential standardized (albeit atavistic) Internet grammar virus?:

Your = You're = Yore (wtf, it could be used on some of those re-enactment parts of the web) => new standard: Yor

There = Their = They're (personally, this one drives me crazy for so many reasons...but I digress) => new standard: Ther

Fuck it.  At the very least, it will drive the grammar nazis mad.  And make drunk typing waaaaaaay eazier.

island's picture

And they say "you're" instead of "your", correctly.


And they put the commas correctly inside the quotation marks. :-|

sgt_doom's picture

While I am NOT suggesting anyone discount your reading suggestion, I would like to point out the abject ignorance among all these self-styled economics scholars (especially those with a concentration on the Great Crash & Great Depression era).

First, they almost always ignore Prohibition (1920-1933), which had two colossal, gargantuan effects at that time:

(1) A massive tax cut, as taxes no longer could be collected on something which it was illegal to sell (alcoholic beverages); and,

(2) Where was all the illegal, and incredible sized monies laundered?

Why, the stock exchanges, naturally.

(They also seem uniformly ignorant of a process today called "securitization" -- but was at that time practised under different names, but effectively the same process.)

We are observing parallel processes today: massive tax cuts for the super-rich, funded by borrowed monies from foreign countries; securitization run wild, of course, and the sudden and dramatic growth of hedge funds, beginning in 2002.  (Now where do you suppose that growth originated?  2002?)


New_Meat's picture

and Joe Kennedy was trans-shipping scotch whiskey over horseneck beach, then he became the first chairman of the SEC.

Sheila, you have such great progenators in yoiur past--keep up the good work.

- Ned

sgt_doom's picture

Let us not forget that Prohibition lasted from 1920 to 1933, and that three processes ended in 1933:

(1) securitization

(2) Extreme tax cuts resulting from untaxed liquor, and

(3) Unregulated dark pools laundered through the stock exchange.

Sound familiar????

Sudden Debt's picture


we should kill a Austrian Prince and blame a group of people associated with most bankers.

we can't do it ourselves... maybe we should let it look like a assassination?

After that, we pick a fight with the Germans!

They also have money!

And when we win, we let them pay for it all and TAKE ALL THEIR GOLD!!!


I could work...

and if not, we can try again a few years later!


Treeplanter's picture

Let's pretend we do all that cool stuff, but take the gold for real...  

Azannoth's picture

I agree in principle, but let's assasinate a Mongolian goat herder, we blame it on the Chineese and pretend to defent democracy in Mongolia by invading it, than we stage a border crossing by a few Chineese soldiers into Mongolia and start a fight with the Chineese, after we win we take all their Rare Earths and null our debt with them 

Almost Solvent's picture

Tibet. They want to be free. Lets free a people that actually want to be free.



Commander Cody's picture

You idealist.  No economic benefit in freeing Tibet.

Wallace Hartley's picture

I agree that it has to be the "Chineese" that we villify.  They have the most valuable resources.  They've been stockpiling raw materials, have vast natural resources, and let's not forget...they own a ton of US debt.  But what could be the spark?  Anyone see the home page blurb on MSNBS a few days ago about a Chinese satellite capable of taking out other orbiting satellites?  The US could discontinue transmission from one or more major communication satellites and blame the Chinese for it.  A direct threat to the infrastructure of the US and a threat to our "freedom".  It's the modern day equivilant of sinking a passenger ship and much harder to prove/disprove.  We're so dependent on electronic communication that the gullable US public would be demanding someone's butt!  Bonus...they could wipe out the Zero Hedge satellite and spread their propaganda just like in the good 'ole days!!! Any comments?

A Proud Canadian's picture

Not to mention all the Capital equipment and technology that has flowed there funded by Western Corporations....probably dwarfs the amount of USTs.

Jason T's picture

who do you think you are, the british empire??

palmereldritch's picture

And by that of course, you mean The German Black Nobility

Black Forest's picture

After that, we pick a fight with the Germans!
They also have money!
And when we win, we let them pay for it all and TAKE ALL THEIR GOLD!!!

You won't win. We'll drop Iraqi Dinar all over the States and let you pay reparations in Chinese Yuan by 2099.


Let's do Panama instead. They got plenty of mucho fine weed.

Johnny Bravo's picture

There's way better weed grown right here in good old Colorado.  California too.
It's legal for medical purposes, and for a 200 dollar fee, you can buy the best weed on the earth from any number of stores.

Pretty soon, it'll all be legal for anybody over 21.

DoChenRollingBearing's picture

Yet another point I agree with JB on.  Excellent.  And that is another lurch to freedom and liberty to do as we want.


Still going to buy Gold though.  5000 years and all that.

Even a superstar Johnny Bravo might want to concede that one (as a wealth preserver).

Johnny Bravo's picture

Do you live in Colorado?  Or do you just agree that the weed is good here?  Or that it shall be legal soon?

About the gold... weed is worth more than gold.  It's a lot more liquid, anyway. 

DoChenRollingBearing's picture


No, I live in SE USA.

Because of my cantankerous conservative/libertarian nature, I want it ALL!  Re Liberty and Freedom.

Gold?  That is my way to insure that my 24 year old daughter comes out of whatever happens OK.

Johnny Bravo's picture

I personally believe that after looking at somebody who is drunk side by side with somebody who is high, there's no contest!  People have to make the weed legal.

I actually came back to this site because I found this article, and thought it may be of interest to you.  

You have a 24 year old daughter?  Yowsa!  Of course, I only say that because that's close to my age!

jomama's picture

Dr. Jekyll,

Nice article. You gotta respect a guy who is the self proclaimed oil and gold expert, and makes a .ico of his face for his web address bar.

DoChenRollingBearing's picture

Fuggetaboutit JB!

Our daughter has her boyfriend, an electrical engineer working with Eaton.  And, flash news, my niece (her cousin) announced her engagement to a rich NYC youngster...!

She has a job as a paralegal with bankruptcy lawyers!  Secure job, LOTS of overtime...

Re stoned vs. drunk, well yes I agree.  But the laws BAN the weed, que pena...  That may change, as you point out.  Shi'ite!  They make weed easy to get, and I am a goner...!

Course, like Freewheeling Frankling said in the 1970s:

"Drinking and getting stoned is like pissing into the wind."  I never got clarification on to whether that was good or no.  Worked out well enough when I was in college...

Best of luck to you, Sr. VP at JPM trying to screw me re gold!    :)

zoomer's picture

You're too late:

1. US Millitary sinks S Korean patrol boat.

2. S K blames N K

3. N K & S K start throwing rocks at each other across the DMZ

4. China "Backs Up" N K(as US M is already in S K), more rock throwing ensues

5. US declares China "Enemy"

6. China assets (T/MBS/ASB Bonds) seized.

7. Trade stops and unemployment/trade deficts "Fixed"

   No One hurt(except the poor sailors-"they were expendable"),

    Problem solved.

Getagrip's picture

Didn't that already happen? Think they called it WWI... 

Oswald Spengler's picture

What happened to blaming the Jews? It always worked in the past.

Getagrip's picture

Israel has nuke's-and Divine providence..? They are and have been the center of world attention since I can remember (and I'm old) . Why is this little country the center of so much controversy and attention? Why do they matter?? I know and think all will in time...standby...    

Rebel's picture

Oh, I know, I know too . . . wonder if we are thinking the same thing?

old_turk's picture

A fine plan, SD, but it will not be popular with the Austrian Prince crowd.  Or the anti-war crowd.  Or the bankster crowd.  Or the Bilterbergers.  Or the Tripartite Commission.  Or the UN or the International War Crimes Tribunal. 

Wait a minute, this plan just keeps getting better and better. :-)

kathy.chamberlin@gmail.com's picture

just in credible and I are playing golf. he is a chemical engineer working schumberger in WY. and really likes atlas strugged ayn Rand. well he is only 22 years young. I am wising him up the back nine