History does not repeat, it echoes. In the present crescendo of global asset price inflation there are strong echoes from Wall Street in the late 1920s. That earlier episode culminated in a devastating sequence of financial crashes. The danger of a repeat is widely evident, albeit that the Federal Reserve has taken a crucially different policy step from back then.
The echoes stem from an essential similarity in historical circumstance. After the Great Recession of 1920-21, the recently created Federal Reserve embarked on a course of fighting deflation dangers whilst countering incipient cyclical downturns. In fact the technological revolution unfolding in the 1920s meant that prices had a natural and benign tendency to fall. The Fed, in resisting this, in effect kept monetary conditions very easy, fostering a powerful asset price inflation which encompassed the market in stocks, real estate, and foreign loans (most of all to Germany).
Hence in 1927 when the US economy floundered in a mild recession, with speculative temperatures moderating across the globe (the Dow Jones index faltering very slightly through late 26 and first half 27) and in some cases falling sharply (in particular a German stock market crash in May 27 and the bursting of the Florida land mania in Winter 1926/7), the Federal Reserve led by Benjamin Strong resolved to give a “shot of whisky” to the stock market. Fresh monetary stimulus, which incidentally helped Strong’s friend Norman at the Bank of England defend Sterling, “succeeded” in breathing new vigour into global asset price inflation which became growingly apparent through 1928, especially in Wall Street equity prices.
In like manner, the Yellen Fed responded to the US growth cycle downturn through 2015 and the first half of 2016 (explained by the energy price slump and a pull-back in global trade originating in a China slowdown) accompanied by some decline in speculative temperatures (US and global equities faltering especially on news of China currency shock) by cancelling all its planned mini-rate rises through the first three quarters of 2016. The US monetary stimulus (accompanied by the ECB and the BoJ extending their radical expansion policies alongside a China state lending boom) culminated in the present powerful coordinated global economic upturn and sharp rise in speculative temperatures across global asset markets. This is where the difference sets in.
Into the second half 1928, following Benjamin Strong’s death, the Fed embarked on a policy of fighting speculation, even though prices of goods were falling slightly. Herbert Hoover, elected as President in November 28, had been a vocal credit of US monetary policies which nourished a “speculative craze” on Wall Street. Milton Friedman and Anna Schwartz in their epic monetary history fault the Fed, arguing that it would have done better to ignore the speculation and focus instead on sustaining rapid economic growth and fighting the downward tendency in prices. Instead, it fell between two stools – lacking the punch to end the speculation but exercising enough restraint to cause the next pause in economic growth to develop into something much worse.
Almost 90 years later the Yellen Fed has put Friedman’s contention to the test. It turned back from any serious monetary restraint through 2017 because inflation was undershooting its target of 2% p.a. largely on account of the so-called “Amazon effect”. The new occupant of the White House is extoling not cursing the rise in the stock market, furnishing indeed a new speculative narrative based on a big business tax cut.
History will not judge Yellen or Friedman well if this continued monetary stimulus ends in an even more devastating sequence of crashes from a higher peak level of speculative temperatures. The true lesson would then be that monetary regimes which seek to stabilize the price level or the inflation rate despite strong benign downward pressure reflecting technological progress eventually collapse under the weight of crisis.