Unlike ‘29, Economy Is Resilient After Crash

The recent plunge in the stock market from record highs has heightened concern over the future of the economy. Some sensationalistic writers have compared this fall to the infamous 1929 crash and have predicted that a recession or worse will follow.

The rapid fall in the stock market is indeed a cause for concern but almost certainly does not presage an economic collapse.

First, some perspective on the market. In August, 1982, the Dow Jones industrial average was at about 770 and stocks, by their usual standards, were undervalued. We were in a recession that cut inflation from the double-digit levels of 1979-80.

In the next four years (through October, 1986), the Dow rose to 1,830, an unprecedented increase that brought the usual measures of stock valuation--price/earnings ratios and yields on stocks relative to alternate assets--into line with historic averages.

Then, from October, 1986, to August, 1987, there was an additional 900-point, or 50%, rise. This raised the price/earnings ratios to one-third higher than normal.

Anticipated Correction

Economists and stock analysts cautioned that the Dow was overvalued and that a correction, or reduction in stock values, of about 20% was likely.

That would have reduced the Dow to the 2,100s, a correction most of us expected to occur gradually. A variety of factors, however, including changes in the technology of trading, created the opportunity for much more rapid movements than ever before. Even so, much of the decline was the anticipated correction. Indeed, as of Friday, the Dow was up nearly 5% from where it was one year ago.

Numerous explanations have been given for the decline in the stock market and the message this decline supposedly is sending to policy-makers. We are five years into the longest peacetime economic expansion.

Probability of a Recession

Journalists keep writing that the expansion must run out of gas, but this need not occur. There is no close statistical relationship between the length of a recovery and the probability of a recession. Recessions have occurred after short recoveries, medium recoveries and long recoveries.

In fact, many signs in the economy are quite good. Third-quarter gross national product rose at a brisk 3.8%. Inflation, which was up a tick temporarily as a result of the stabilization of oil prices and the depreciated dollar, came in at a modest 0.2% in September.

Production of steel and lumber, durable goods orders and business plant and equipment spending are all up. Wage settlements have been moderate. Thus, before the recent market fall, the most reasonable forecast was continued expansion and modest inflation. What about now, after the market collapse?

Historically, a fall in asset values has been accompanied by a reduction about 4% as large in consumer spending. This implies an annual decrease of about $30 billion to $40 billion in consumer spending. Thus, many forecasters are downgrading their GNP growth forecasts to 1.5% or slightly less from 2.5% for next year.

But two factors suggest that the historical relationship may be misleading. First, the recent fall was preceded by the big gain from October, 1986, to August, 1987. Were most consumers constantly adjusting their spending levels to the rising Dow? I doubt it.

One could easily overstate the likely decline in consumption by measuring only from the peak to the trough rather than the increase over the full year.

Secondly, substantial uncertainty remains. We do not yet fully understand the market collapse’s causes and consequences, including those for consumer and business spending.

Fortunately, many of the factors that brought on the Great Depression not long after the market crash in 1929 don’t figure to re-emerge now.

Back then, the Federal Reserve made the first in the federal government’s series of major policy mistakes: It tightened the money supply after stocks plunged, worsening the effect on spending considerably. This time, federal officials are taking the right steps.

Would Provide Liquidity

Fed Chairman Alan S. Greenspan moved in and announced that the Fed would provide liquidity, lowering short-term interest rates. Meanwhile, Treasury Secretary James A. Baker III has led the push for some sensible international coordination of macroeconomic policy, although the central banks of West Germany and Japan have not always cooperated.

A second major policy mistake in 1929 was the passage of the protectionist Smoot-Hawley Tariff, leading to retaliation abroad and a sharp contraction of world trade, worsening the recession and leading us into depression.

Fortunately, despite the protectionist legislation in Congress, President Reagan stands ready to veto any such trade bill.

More remarkably, Baker has concluded a historic free trade agreement with Canada. While work remains to be done, the Administration stands ready to prevent a repeat of the Smoot-Hawley fiasco.

Changed Course

The third major policy mistake was a tax increase once we were already into the recession in 1932. So strong was the call for a balanced budget even amid a recession that then-candidate Franklin Delano Roosevelt campaigned on a tax increase to balance the budget. (He subsequently changed course in his New Deal spending programs.)

It still is foolish to raise taxes during a recession, and the present Administration won’t repeat that mistake if a downturn comes.

There are other important differences between 1929 and today. Individuals are much better protected than ever before with safeguards such as deposit and unemployment insurance.

In 1929, many people purchased stock on 10% margin, so when the market fell by a dramatic 12% in a single day, entire investments were wiped out. Margin requirements are much higher today, and most stock is purchased with cash.

Further, it is misleading to compare the 12% one-day decline in 1929 to the 22.6% fall on the Black Monday of three weeks ago. The last time around, the market decline eventually reached 90%. Nobody expects the Dow to duplicate that feat this time by tumbling to 300.

Even the most pessimistic forecasts are for the Dow to hover in the 1,200 to 1,500 range, and most forecasters, including myself, suggest that the 1,700 to 2,100 range is much more likely for the near future.

The Administration is pushing for free trade, not protection; provision of liquidity, not restrictive monetary policy, and sensible fiscal reforms, not foolish ones.

Despite the considerable uncertainty, we should remain cautiously optimistic that the economy will continue to expand, that inflation will remain modest, that the stock market will stay at reasonable price/earnings ratios and that we may all look back on this remarkable episode thankful that we did not repeat the policy blunders that followed the 1929 debacle.