Ray Dalio mentioned several months ago that he is seeing parallels in the world between 1937 and 2018, is he right?
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For those unaware (who perhaps have other ways to spend their time than looking at the events of 80 years ago!), during 1937 the stock market fell about 40 per cent as a result of a swift but severe recession. Hence if there are parallel’s between then and now – perhaps it’s something we should pay attention to.
My major source for this blog is the academic paper “The recession of 1937—A cautionary tale” written by F Velde of the Chicago Fed back in 2009.
The 1937 recession was difficult to predict. There was little in terms a debt crisis which we could point to. There were no shocks in unemployment, no inversion of the yield curve, no wars or other issues which could be said to be a direct cause.
Reasons as to why the recession occurred range from a contraction in the money supply to changes in bank reserve requirements, reductions in government expenditures, reductions in loans by banks and even wage increase pressures. Some of these have been debunked whilst still persist in being theories.
From the research I’ve read, the recession appears to have been caused by monetary tightening whilst the economy was very weak (i.e. hadn’t recovered post the Great Depression). Tightening was thought to be required because of inflationary concerns.
And to be fair, these inflationary concerns weren’t unreasonable. The below chart shows ‘excess reserves’ of financial institutions in the US during this period (upwards of $3b in 1935/1936, well in excess of the circa $2.3b-$2.4b required). Note that excess reserves are defined as capital deposited on behalf of these institutions in excess of their regulatory requirements.
Why would they deposit so much? – clearly, memories of the Great Depression were well imprinted on banker’s minds. Yet the Fed was concerned that these excess reserves would be put to work once bankers risk tastes changed, creating significant inflation which would create more problems.
The tightening consisted of two forms;
i) The US treasury sterilised inflows of gold into the US economy.
Recall that at this time, the world was on a gold standard. Up until late 1936, when foreigners brought their gold to the US (an increasing trend in the 30’s due to geopolitical/social pressures in Europe) it would increase the gold (money) supply. Sterilisation meant paying for the gold by the Treasury and taking it out of circulation – as such this contracted the money (gold) supply.
ii) Raising capital requirements.
As noted above, with the Fed being concerned about excess reserves, it raised capital requirements significantly such that much of these excess reserves became required reserves. Banks responded by offering less credit to some private institutions, participating less in new bond offerings and offloading securities such as stocks, existing bond issues and other securities.
As a result of these actions, there was a contraction in the money supply which was enough to crash what was a recovering but still weak economy.
Now you may rightly think, isn’t this what we have now? I.e the Fed is taking actions which would contract the money supply – so isn’t it time to panic? No, I think we can relax a little (and as an aside, even if a depression occurred in the next hour, next week or next month, I’m not sure how panicking would help!)
Firstly, the Fed has been well aware of the 1937 issue since it began tightening in 2015. The economy in 2015 was much more normalised (i.e. had recovered from its last crash) than it was 1937. Hence the raising of rates is in accordance with the Fed’s mandate given the present economics.
The Fed’s view is that the monetary contraction actions of 1936/1937 were premature and this is what caused the recession. In light of the evidence, this appears correct and the Fed has done well in ensuring the mistake hasn’t occurred again (rates have been rising gradually since 2015 and there has been no recession).
If we look at what Dalio was saying in the rest of his statements, he went on to talk about wealth disparity and its impacts on society and the general political environment. Dalio actually said that he believed a downturn is about a couple of years away (although if asked, I’m sure even he’d admit he can’t forecast this with much accuracy).
Notably, this is also the consensus of the market – i.e. a recession starting in late 2019 or 2020. I believe I’m unlikely to offer a better forecast but would say that if consensus believes there will be a recession in those years, it’s probably going to happen sooner than this or later. That said, if the multiplier effect begins to build, Vega’s algorithm will notice and begin to position the portfolio differently.
But whether this is next month or in the next decade, I can’t yet be sure.