I don’t claim to be an expert when in comes to economics; in fact, all that FTSE and Dow Jones stuff is just meaningless numbers to me, and I expect it’s the same for many other people. However, the recent economic turmoil in China is rather worrying, not least because of some striking similarities to the run up to the 1929 Wall Street crash. Firstly, back in the 1920s a huge number of rural Americans emigrated to the cities, in the hope of finding a more prosperous life in the ever growing industrial sector. The same thing has happened in China over the last decade or so. Secondly, during the latter part of the 1920s the American economy grew at an amazing rate, and hundreds of thousands of Americans bought stocks and shares. It’s been the same in China recently. Thirdly, in the 1920s these small, inexperienced investors borrowed heavily to buy more stock, thinking that the boom would continue indefinitely and they couldn’t lose. It’s been a similar story in China. This kind of speculative borrowing to buy stock is known as ‘margin trading’. By August 1929, brokers were routinely lending small investors more than two-thirds of the face value of the stocks they were buying. Over $8.5 billion was out on loan, more than the entire amount of currency circulating in the US at the time. Today, in China, when you open a stock market account chances are it’ll have a margin facility built in. Margin lending is a huge business. Upwards of 90 million households are in the Chinese stock market, most of them buried under margin debt. Among them, they hold about 258 million trading accounts (here).
So, for our inexperienced investor everything is hunky dory, as long as the market continues to expand at a fast rate – an ever growing bubble. However, as soon as there’s a slow down, and the price of stock falls, it will trigger what’s known as a ‘margin call'; ie, the margin lender asks for their money back, money lent on the original higher price of the stock. For many small investors, the only way to get that cash is to sell some of their shares. Of course, a lot of margin calls causes a lot of selling, forcing prices down even more; and that triggers still more selling, forcing down prices further still, etc, until: CRASH! That’s what happened in Wall Street in 1929, and although there were other factors involved, most economists agree that it was the myriad of small investors that were the primary cause of the crash. That said, I’m not going to speculate about what might happen in China in the weeks and months ahead (I’ll just say that the gun is loaded and the hammer is cocked).
The 1929 Wall Street crash led to the worldwide 1930s Great Depression. Some countries, those with a mostly agricultural economy, were barely effected (such as France, Spain and Ireland). It was the industrialised nations that got hit the hardest, countries like Britain, Italy, Germany (and we all know what happened in Germany!) and of course the USA. In Britain the government’s reaction to the Great Depression was exactly the same as it now is to the 2008 crash: austerity. At the time of the Wall Street crash a minority Labour government headed by Ramsay MacDonald was in power. Under pressure from its Liberal allies, as well as the Conservative opposition, the Labour government appointed a committee to review the state of public finances. The ensuing report urged public sector wage cuts and large cuts in public spending (notably in benefit payments to the unemployed) to avoid incurring a budget deficit. The sense was that the deficit was dangerous and had to be reduced. In 1931 an election was held which resulted in a Conservative landslide victory, although a National Government was formed with Ramsay MacDonald still at the helm. This Conservative dominated government immediately instituted a further round of cuts in public spending and wages. Public sector wages and unemployment pay were cut by up to 15%, and income tax was raised from 22.5% to 25%. The pay cuts did not go down well, however, and resulted in a mutiny in the Royal Navy. It’s notable that 3 million people emigrated from the UK during the 1930s, seeking a better life.
On the other side of the Pond things panned out a little differently. Herbert Hoover was president when the crash happened. Hoover, a Republican, reacted to the economic downturn by raising tax rates and initiating a large public works program, including the Hoover Dam on the Colorado River. Hoover also raised trade tariffs, in an attempt to encourage the purchase of American-made products. However, Canada, France and many other nations retaliated by raising tariffs on imports from the US. The result was to contract international trade, and prolong the Depression. To make matters worse, in the early 1930s there was a persistant drought in America’s agricultural heartland. Businesses and families defaulted in record numbers and more than 5,000 banks went bust. Hundreds of thousands of Americans found themselves homeless, and began congregating in shanty towns, dubbed ‘Hoovervilles’. By early 1933 the unemployment rate hit 25%. That same year, President Franklin Delano Roosevelt and the Democrats came to power.