What the Great Crash can tell us about the likely outcome of this one

By Tim Price Jan 16, 2009

Tim Price

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According to the Spanish philosopher and essayist George Santayana, those who cannot remember the past are condemned to repeat it. Indeed, many high-profile investors, not least hedge funds that have strategies such as systematic trend-following (one of 2008's rare positive performers), owe their very success to the essentially unchanging aspects of human nature. Circumstances may vary, and the fortunes of individual businesses may rise and fall, but we are all ultimately vulnerable to the same overwhelming psychological impulses of greed, hope and fear.

To put it another way: different circuses, same clowns. That's the fundamental message of Carmen Reinhart and Kenneth Rogoff in their recent study, The Aftermath of Financial Crises [pdf file], presented at this year's gathering of the American Economic Association in San Francisco. In an earlier analysis, Reinhart & Rogoff edited out references to emerging market crises in order not to spook the horses. This time round, the assembled economists were sufficiently realistic and cowed by circumstance to hear the unvarnished truth, emerging markets included. Reinhart & Rogoff find much in common between financial crises in developed economies and those in developing ones, as you might expect – we're all only human after all. But the implications for investors are alarming.

According to Reinhart & Rogoff, big financial crises invariably end up sharing three key characteristics:

First, asset-market collapses are severe and long-lasting. Price falls in residential property amount to some 35% after inflation in a bear market that typically lasts for six years. And the prices of equities fall by an average 55% in a bear market that typically lasts three and a half years.

Second, large banking crises tend to trigger big declines in output and employment. From peak to trough, output tends to fall by more than 9% over two years. Unemployment tends to rise by roughly 7% over more than four years.

Finally, the real value of government debt tends to go through the roof – rising, on average, by 86% during the major post-World War II crises. This seemingly uncontrolled surge in debt – under the conditions of a 'normal' financial crisis – has (ordinarily) little to do with the cost of bailing out the banks, and more with the collapse in tax revenues you get in severe economic downturns.

But the reference to 'normal' crises is precisely the point: we are not in a normal financial crisis, but arguably the gravest banking crisis of the post-war era; one which flies off the charts because it is global in scope. So comparisons with major localised blow-ups have less relevance, as previous financial emergencies tended to stop at national borders. So Reinhart & Rogoff's 'average' recessionary data are, if anything, likely to understate the pain to come this time round. The wild card in 2009, of course, is the extent of government support for the banking sector – support which was lacking in, for example, the 1930s.

Another study from history which has many pertinent conclusions for our own time is Barrie Wigmore's The Crash And Its Aftermath: A History Of Securities Markets In The United States, 1929-1933 (Greenwood Press, 1985). As Wigmore makes clear in his analysis of the 1929 Great Crash, many investors caught up in the Crash were able to get out relatively early and to salvage much of their equity portfolios. Just as many were then lured back in to what seemed like a newly stable (and evidently cheaper) stockmarket in 1930, only to be drowned by the second brutal downwave.

Just as ominously, for those investors anticipating a strong bounce from the wreckage of the Crash of 2008, here are Wigmore's comments about those investors burned in 1929: "Each time during the Crash when stock prices improved, however, the banks sought liquidation [of margin loans]. Individuals or partnerships who saw most of their equity in stocks wiped out needed little encouragement to sell out when prices rose..." Needless to say, there were plenty of false dawns, as the Dow Jones Industrial Index ground remorselessly lower, until it finally bottomed in 1932, having lost some 89% of its value. That's not to say that markets will fall so far this time round – but rather to ask, since human nature fundamentally barely changes, why the 1930s experience couldn't possibly be repeated in 2009, or 2010? The severity and global scope of the crisis today would certainly seem to warrant extreme caution.

But it is not given to us to see the future. Santayana also remarked that character is "an omen of our destiny, and the more integrity we have and keep, the simpler and nobler that destiny is likely to be". Integrity has been in short supply within the financial markets these last years. Our destiny is unlikely to be overly noble.

• Tim Price is director of investment at PFP Wealth Management. He also edits The Price Report newsletter.

Published in Economics | More articles by Tim Price

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