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This set of circulars began with the surmise that because we are three generations removed from it, and perhaps also because the images it evokes are so unpleasant and discomfiting, the Great Depression seldom intrudes explicitly into our thoughts. At the same time, however, and in ways that are rarely recognised, certain beliefs and habits that most of today’s investors hold dear were moulded during the late 1920s and 1930s. Perhaps most importantly, beliefs about the proper role, benevolence and general efficacy of government economic management have been strongly influenced if not determined by ideas and actions which gained currency between 1933 and 1945.
Alas, much of what we think that we know about the Depression may be false and many of the lessons we have learnt from it may be mistaken. Sean Corrigan (Six Myths of the Crash) recently reviewed six key planks of contemporary market participants’ intellectual framework. Each is unshakeably mainstream; each derives much of its pedigree from the Great Depression and its aftermath; and each is probably mistaken:
| Myth #1: |
The consumer comprises two-thirds of the economy: as long as she is spending, we can avoid recession. |
| Myth #2: |
Lower interest rates and easy credit will promote recovery. |
| Myth #3: |
Government spending can promote growth. |
| Myth #4: |
All tax cuts are good, and those on dividends will drive equities higher. |
| Myth #5: |
We are staring deflation in the face. |
| Myth #6: |
Stocks always rise in the long run. Accordingly, the rally will start next quarter, or the quarter after that, or the quarter after that. |
Given the tragic and enduring errors committed during the 1930s, Corrigan’s injunction is apposite. Today is “a time for the careful and conservative stewardship of [capital] and for those charged with this to display a willingness to challenge prevailing myths, whether these arise from economic sophistry or from institutional prejudice and intellectual inertia. If we can all become convinced that these are aims well worth achieving [then] this recession might actually turn out to have been fully worth the cost.”
Yet it is vitally important that one’s challenge to prevailing myths does not overstep its mark. James Grant reminds us that politicians and central banks are not responsible for the existence of the business cycle. Slumps, downturns, recessions and depressions occurred during the nineteenth century heyday of the rule of law, free trade, classical gold standard and small government; no set of institutional arrangements, in other words, can generate uninterrupted prosperity. For reasons other than those set in motion by a central bank, investors and businessmen occasionally act like sheep, sometimes like mules and at still other times undertake extreme behaviour. “This is true in specific sectors or financial markets generally. That’s the nature of the market; it gets things wrong and self corrects.” Accordingly, to rethink the Great Depression and to clarify its contemporary implications for value investors is firstly to comprehend the measures that are intended to obviate (but alas, cannot prevent) the errors that the market’s price signals detect and eventually correct. Grant has dubbed certain of these measures and institutions the welfare state of credit. This is a “structure of regulators, lenders, and borrowers, and the system is dedicated to stability, the greatest good of the welfare state of credit … The system is established to avoid runs, panics, depressions, financial turmoil and other upsets. The idea is to head off the contractions before they happen. It is the financial counterpart of the more familiar welfare state of income and of labour. The welfare state of credit is built to resist a repeat of the events of 1907 and 1931.”
The major consequence of these measures is to create moral hazard, i.e., to “promote great bull markets and excessive risk taking in the financial and investment market. The fiscal and labour welfare states generate the perverse effect of feeding the very diseases they are supposedly trying to cure. In a similar way, the welfare state of credit feeds speculative frenzies and excessive risk taking in the financial and investment markets, while attempting to prevent the losses associated with excessive risk taking. It creates the boom that causes the bust, but it attempts to abolish the bust. The long-run consequence is to subsidise instability and economic stagnation in difficult-to-predict ways. The boom-bust can appear in specific sectors and at other times in whole industries. But it doesn’t often appear in extreme ways at the macroeconomic level. The system is designed to prevent that from happening, and it usually does.”
Secondly, to rethink the Great Depression and to clarify its contemporary implications for value investors is to realise the absolute importance of coherent and justifiable frameworks through which to view and render comprehensible economic and financial developments. Benjamin Graham’s ideas, which crystallised during the Depression, constitute a framework for analysing businesses and undertaking investment operations that has demonstrated its worth for seventy years (see in particular Security Analysis: The Classic 1934 Edition, McGraw-Hill, 1996, ISBN: 0070244960 and What Has Worked in Investing). Subsequent successful application of Graham’s principles by a variety of value investors demonstrates that these principles are as relevant during today’s bust as they were in yesterday’s boom and the sequences of boom and bust that preceded them.
So too, as a framework for comprehending economic phenomena, are the insights, analyses and conclusions of the Austrian School of economics (see in particular Israel Kirzner, The Driving Force of the Market: Essays in Austrian Economics, Routledge, 2000, ISBN: 0415228239; Alexander Shand, The Capitalist Alternative: An Introduction to neo-Austrian Economics, New York University Press, 1982, ASIN: 0814778364; and Alexander Shand, Free Market Morality: The Political Economy of the Austrian School, Routledge, 1990, ISBN: 0415041899). In Grant’s prescient words, uttered in 1996, “in the boom cycle, people are not so much interested in a message that says: a bust is simply a necessary part of the business cycle. In a false prosperity, good economic ideas are marginalised. That’s why Austrians should prepare right now to offer the best explanation when the tide turns, as it always does. Who knows? Maybe well find ways to make the bust intellectually profitable. In time, Austrian economics could be again seen as the mainstream theory. It should be.”
 
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