A Comparative Analysis of the Two Great Debt Crises in the United States

A Comparative Analysis of the Two Great Debt Crises in the United States

There are many studies on the two major crises in the United States, so I will not repeat the main process of the crisis, but will discuss some key points from them. There is nothing new under the sun. The study of the history of economic development is very important. What is happening today that astounds you can always find a highly similar situation somewhere at some time in history. For so long, people will still be the same madness and panic, the bubble will still be inflated and burst, the government and the market will still be the same struggle and cooperation.

Detailed case analysis of the deflationary debt cycle

This book details the two Great Depressions in the United States from 1928 to 1937 and 2007 to 2011. It tries its best to restore the scene at that time in detail. The key stages are accurate to the daily information and data, even regardless of the framework of the debt cycle. In-depth understanding of these two crises is very valuable material. The selection of these two crises is typical, but not representative.

First, these two debt crises are both the bottom of the long-term deflationary debt cycle, and the data trends and the use of policy tools at the bottom of the short-term debt cycle are quite different. For individuals, there are far more cases where the bottom of the short-term debt cycle is encountered. At the bottom of the long-term debt cycle.

Second, the United States has been the world’s largest economy since the early 20th century. After World War II, the U.S. dollar has become the world currency. Therefore, the United States’ economic stability is high enough and its ability to withstand external economic shocks is strong enough that it is almost impossible to cause currency factors. While most other economies are very vulnerable to external shocks, the degree of autonomy of monetary policy is much lower, but the difficulty of solving economic crises is not simpler but difficult because of smaller scale.

However, these two cases are still very valuable for reference. Although the situation of different countries is very different, there is always something to be learned from the outbreak and handling of the two debt crises. Below I will talk about a few things based on the description in the book. Know and think.

One is how to identify bubbles . The sources of bubbles that led to the two crises are different. The crisis in the 1930s originated from the bursting of the stock market bubble, while the crisis at the beginning of this century originated from the bursting of the real estate market bubble. However, the basic characteristics of the two types of bubbles are Consistently, Dalio summed up seven points, namely: high asset prices, market expectations that the current high prices will continue to rise rapidly, widespread bullish sentiment, using highly leveraged financing to buy assets, and buyers buying long in advance , The entry of new buyers into the market and the stimulative monetary policy further contributed to the bubble (or the austerity policy caused the bubble to burst).

This description is very comprehensive. Just remember it in three words: high, rising, and high leverage, that is, the price is already high, buyers are still generally bullish, and leverage is common; this is for any kind of bubble asset The recognition is universal. However, from a macroeconomic perspective, identifying bubbles requires structural dismantling and analysis, and sub-sectoral inspections, because the degree of bubbles between different assets is often inconsistent, and the ultimate cause of the crisis must be the most serious type of asset.

Second, the balance sheets of financial institutions looked healthy during the bubble. This is because of the positive cycle between asset prices, credit scale, and purchase intentions, leading to the fact that most of the macroeconomic data during the bubble period looked very good. The higher the leverage ratio, the more inclined financial institutions are for high-risk investments, the better their profits will be.

Because bubbles are always caused by uneven development, the average value will completely cover up the problem, which causes the regulator to actively or passively ignore the problem. However, not solving the bubble problem is like carrying an untimely bomb, or to put it mildly, there is a gray rhino nearby.

Third, it is extremely unreliable to use limited historical data to predict future conditions. For example, the VaR (Value at Risk) method commonly used in risk analysis is either based on historical data or based on a normal distribution. This leads to the better the recent situation and the lower the volatility, the better the predicted future situation. Investors The more you dare to increase your risk appetite, this is completely “garbage in, garbage out”, which is an extremely stupid method, but the similar VaR method still seems to be one of the most important methods for risk analysis by financial institutions, and it has not been baptized by crisis. It is indeed difficult to change people’s thinking behavior habits.

How should risk analysis be done? In addition to using VaR, be sure to perform the necessary stress tests . For example, in January 2009, the Federal Reserve conducted a stress test on the ability of all important banks to withstand a sharp economic contraction. The standard for a sharp economic contraction is a 3.3% decline in GDP, a rise in unemployment to 8.9%, and a 22% drop in house prices. Because financial institutions generally operate with high leverage, net assets of 1% of asset losses will be emptied at 10 times leverage, and the inter-institutional relationship is getting stronger, so I think that not only banks, but also the important non-banking banking industry Institutions, insurance, brokerage firms, etc. must pass strict stress tests. The Basel III requirements for capital in the banking industry are based on this consideration. Any questioning or circumvention of capital constraints will be dangerous.

Fourth, the credit that fuels the bubble always comes from shadow banks outside of supervision. Although the form is different each time, the substance is similar, such as the investment trust in 1927 and the subprime mortgage institution in 2007. Some people say that such financial institutions are a necessary part of the financial industry. Without them, who would invest in high-risk assets and who would provide funds to cyclical enterprises and small and medium-sized enterprises characterized by high risks? I cannot refute this statement because bank credit itself has limitations in coverage. Such institutions have indeed played a role in balancing the distribution of credit during the period of rapid economic development, and have also obtained corresponding profits.

But any financial institution has the inertia and impulse to grow bigger, especially for companies that are developing rapidly before the top of the debt cycle. Therefore, all types of shadow banks must be covered under supervision. They must not be overwhelmed, and they must have room for survival, and they must not be ignored and let them slip through the net without lawlessness.

The fifth is to choose to believe in data rather than the media, and to choose to believe in evidence-based inferences rather than compromising on wishful thinking. Judging from the two crises in the United States, the decision makers will not recognize the crisis until the last moment, or even vote for votes, either to preserve their position, or because of lack of knowledge, or because they are unwilling to face it, or to avoid panic among the people. And make all kinds of “false promises.” At the moment when crisis sentiment is spreading, the government always tends to appease market sentiment through various means. Many investors in high-risk fields also choose to believe in these seemingly exciting policies and ignore the implicit ones because of confirmation bias . risk.

However, we must be clear that the reason for the crisis is that the bubble has been brewing for a long time. If the fundamentals of the economy do not undergo fundamental changes, it is inevitable that the prices of major assets will turn downward at the top of the bubble. Therefore, if you want to be a successful market participant, you must avoid being emotional, you must also avoid reading all kinds of non-objective commentary articles, and you must make judgments based on data and using logic. Which data is most important in this process? I will express it later.

Sixth, we must try our best to get rid of the perspective of the insider. The seemingly significant stock index rises in the depression are not worth mentioning in the larger cycle. We need to know what information is really worthy of attention . The volatility of the stock market and the rate of return are significantly negatively correlated. The stock market volatility in the depression stage is huge, and the mentality of stock investors is extremely divided. The stock price is easily affected by various news. The stock price rises and falls sharply. During the crisis, the stock price appears to be overall or continuous. Significant rebounds are not uncommon. For example, from 1929 to 1933, the Dow Jones Industrial Index rebounded more than 15% on 7 occasions, and there were also twice more than 30%. However, it fell step by step from 2007 to 2011. The decline has been even more rapid, but there have been many sharp rebounds.

The rebound in these declines has also given some media or ulterior politicians and business leaders to exaggerate the actual economic situation. They deliberately amplify the importance of these smaller events and make predictions of turning points again and again. What I said in this way is not to show how hindsight I am. I just want to point out that it is normal for the stock market to fluctuate sharply in the depression phase. When the real turning point comes, the condition that needs to be met is that all necessary policies are in place, the benefits are exhausted, and the business situation For the better, debt is in a state of net reduction, and the actual economic growth rate has begun to rise. Only when the stock market rises at this time is supportive and sustainable.

Seventh, policy makers must bear huge “moral pressure”, because in the process of resolving the crisis, people’s interests will inevitably be damaged, and the negative economic growth will be superimposed on this pain. If policy makers are dominated by turbulent public opinion and take the perpetrators to bear the cost as the core of their governance, and only adopt deflationary measures such as fiscal austerity, and the transfer of wealth between industries or classes, it will not only be difficult to achieve the goal, but the pain will become more intolerable. In most cases Downfall will also cause the situation to deteriorate further; the reason why inflation measures can solve the problem is that the cost of solving the problem is shared over a longer period of time and on a larger scale. For example, when the government injects funds into risk agencies, it is actually shared by taxpayers. With funding difficulties, the government has adopted inflationary measures such as money printing and quantitative easing to allow all currency holders to share the debt burden.

But the policy makers have no way, because the debt burden has already formed, either let it bring the domino effect and cause a wider impact, or everyone can carry it together. Some people also say that domestic debt is not a debt because the government has enough room to resolve it. This argument is very one-sided, because even the best way to resolve debt will cause passive damage to the interests of certain groups, and every time the economy The decline requires greater growth to make up for.

Decision-makers who successfully manage a crisis must be wise, knowledgeable, and empowered to take necessary actions, that is, they know what to do and have the power to do so. From the comparison of the two major crises, the 2008 crisis passed faster. This is because the main decision makers in the United States at the time had sufficient sense of responsibility, withstood “moral pressure”, tried their best to preserve systemically important institutions, and even more at critical moments. Sufficient inflation measures were quickly implemented.

Eighth, the government’s invisible guarantee is a double-edged sword. It is a key means to solve the trust problem during the crisis period. In the normal stage, it conceals the market’s judgment of risk and promotes the accumulation of leverage and bad debts. In resolving the crisis in the 1930s, Fannie Mae was a powerful support to help the economy enter the re-inflation stage, but in 2008, Fannie Mae and Freddie Mac had reached the level of “big but not falling”. It has become the culprit of the crisis.

For debt denominated in local currency, government credit is a security guarantee. Even invisible government guarantees can distort asset pricing and cause high-risk assets to deviate from market prices. This will create arbitrage space and accelerate risk accumulation and bubbles. accumulation. Therefore, the government’s guarantee boundary must be clear, and the government’s credit cannot be abused. Although the government can prevent market rules in the short term, it must be prepared to pay.

After this article, the author has two questions:

First, although China’s GDP has been growing positively since 1979, did China’s experience in the late 1990s count as a deflationary debt crisis? Does it have any reference significance for analyzing the current situation?

Second, the two major crises in the United States are both deflationary. Will there be an inflationary debt crisis in the United States?

Further reading:

1. “The Must-Know Debt Cycle”

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