In 1933, the US Federal Reserve Bank began massive ‘open market operations’. It bought $2 billion of government bonds, and flooded the system with liquidity. $2 billion in 1933 was a massive amount. It’s about $35 billion in today’s money, but of course, the ‘real’ (inflation-adjusted) economy was much smaller then. For example the population of the United States was only 122 million, compared with over 310 million now. ‘Real’ incomes are much higher now. In fact the ‘real’ economy now is 17 times bigger than it was in 1933, the CPI price level 17.5 times higher. Between the great crash of October 1929 and early 1933, ‘real’ GDP had fallen 25%, and ‘nominal’ GDP even more, because prices fell. Not just low inflation, negative inflation. Industrial production fell 46% from peak to trough. Unemployment had risen to 25% (it was even higher in Australia) from 3% in 1929. The Federal Reserve is currently undertaking open market operations of $800 billion. They’re calling it ‘quantitative easing’ (QE2), because theycan’t cut the cash rate any more, since it is already zero. But it’s exactly what the Fed did in 1933, when the discount rate was also zero. Then they called it ‘open market operations’. Did it work then? Yes, emphatically. Within days of the Fed buying government stock and flooding the system with liquidity, the stock market bottomed, within a couple of months, industrial production bottomed and started to rise, within six months, unemployment started to fall. The Great Depression was over. Well, mostly. In 1937, worried about inflation, the Fed raised interest rates and the Federal government cut many support programs it had initiated in the dark days. There was a very deep, though short-lived recession in 1937. Only with the advent of WWII and the huge spending on armaments using borrowed money did the depression finally end. And when the war ended, there was another sharp downturn, though that also didn’t last very long. Allowing for the rise in the real level of output and income, and the rise in the price level, this $2 billion in 1933 would be about $600 billion today. The $800 billion the Fed is spending now is more then they spent then, in comparable terms.
On the other hand, the Fed isn’t doing it as a one-off injection but as a sustained monthly injection until conditions improve, which is both good and bad. Good because it can be stopped before a runaway boom develops, bad because each individual injection of liquidity may not be enough. Is it working now? It seems to be. Recent data suggest that after a slightlydeeper- than-normal pause over the last few months, economic activity is reaccelerating. Retail sales have been surprisingly strong, industrial production also. Unemployment indicators such as the weekly series of initial unemployment insurance claims show that unemployment is starting to fall again. The broad stock market indices have surpassed recent peaks and have started to rise again. Our conclusion is that world growth will accelerate next year. Commodity prices will continue to rise, and resource shares continue to outperform, and overall share indices will advance over the next 12 months. After that the picture is a great deal murkier. The structural problems of excessive debt in the West, both individual and government, remain to be dealt with, and the risk remains that just as in 1937 a downturn in 2013 is probable. Until then, however, it is our belief that share portfolios should be fully invested, where consistent with your personal risk parameters. As always, if you have concerns, please contact us.
Nigel and David
