The ‘Lehman Moment’ of 1931

I’ve been reviewing the editor’s proofs of my Depression manuscript (don’t ask) and I suddenly felt a sense of deja vu.  Britain left the gold standard on September 20, 1931 (the crises are always September or October—1929, 1931, 1937, 1987, 1992, 2008, etc).  And then everything started falling apart.

But not right away.  Stocks in the US did fall on September 18-19 as rumors of the devaluation leaked out, but then stocks actually rose modestly over the next few days.  And then the US stock market crashed.

Why?  And why the delay?

Now flash forward to the Lehman failure.  Stocks fall in September 2008 due to Lehman, but nothing disastrous.  Then the stock market collapses in the first 10 days of October, and zig zags much lower up until March 2009.

Why?  And why the delay?

It turns out that the dynamic was very similar on each occasion.  The initial shock in 1931 was worrisome, but not by itself a major factor.  Then a few days after the British left gold a run on the dollar began (fear of devaluation), and massive gold and currency hoarding commenced.  Gold and currency were the dual media of account.  Massive hoarding means a massive increase in demand for gold and cash.  Econ 101 says an increase in the demand for any asset makes that asset more valuable.  But the nominal price of the media of account cannot rise.  So the only way for them to increase in value (in real terms) is for the price level to fall.  And commodity prices did plunge during this period.

In 2008 the Lehman event was worrisome, but not catastrophic.  Then it gradually became apparent in early October that demand for liquidity was soaring.  Even worse it became clear that the world’s major central banks were not willing to cut interest rates sharply enough and/or supply enough liquidity to prevent NGDP expectations from plunging. And despite Bernanke’s insistence that the Fed should never let the US fall into a Japanese-style liquidity trap, we did.  Even worse, the Fed adopted IOR in early October and stock prices crashed.  Then they raised IOR a few weeks later and stock prices crashed again.  Then they raised IOR a few weeks later and stock prices crashed again.

In both cases the delayed stock crashes and severe output declines and severe financial distress all had the same cause—falling AD caused by bad monetary policy.  The 1931 event was actually slightly more excusable—the gold standard was a constraint on policymakers.  Fiat money banks have no excuse at all. Especially fiat money central banks that continued to raise and lower interest rates over the next few years, and hence were able to avoid the zero bound trap.  I.e. the ECB.

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