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The lessons of two evils

“Those who cannot learn from history are doomed to repeat it,” said philosopher and essayist George Santayana.

As the global financial crisis began to unfold several months ago, I was struck by the unusually pessimistic tone adopted by certain commentators who had until then been somewhat balanced and perceptive, not prone to exaggeration or melodrama.

It shocked me that more than a few claimed that the fall-out from the US sub-prime crisis could lead to a financial meltdown that would be “the worst since 1929”.

That started me thinking. What was it about 1929 that made certain individuals draw parallels with that experience? What were the salient lessons from that momentous period in US and world history that could still resonate?

I am no historian but I do enjoy researching the history of investment, so I could see some advantages to finding out a little more. What amazed me was how many parallels there are between what we have seen unfolding in 2008 and what went on during 1928.

First, let me share two quotations with you (see right). Incredibly, these are not the words of Obama or McCain, nor are they from the Bishop of York. They are lifted word for word from the inaugural speech of President Franklin D Roosevelt who was tasked in 1933 with picking up the pieces. The resonance is palpable and the words could have been written this morning.

By autumn 1929, the New York Stock Exchange was 112 years old. As the central focus of the burgeoning US capitalist empire, it learnt much from the older bourses of Europe but then took those lessons and rewrote the guide book. Wall Street was an institution like no other and its reputation for creating fortunes sat perfectly with the American Dream. In those 112 years, the NYSE had seen turmoil, of course. Crashes, bubbles, acts of terrorism – all had occurred previously. As recently as 1907, a major financial crisis that could have developed into a global contagion had been averted by the co-ordinated efforts of several US bankers acting in harmony to prevent a stockmarket rout. It had worked under the careful auspices and stewardship of one JP Morgan the elder.

Since then, there had been a Franklin D Roosevelt, 1933damaging world war replaced by a feelgood decade. The 1920s promised everyone opportunity and achievement. Aspirations and goals were set much higher than previously. The US was at the forefront of the new positive mood. The seeds of World War Two had been sown at Versailles, of course, so the outcome was anything but positive for the world.

Returning to today, it is easy to see that things are incredibly different in 2008 but it is the essence of human nature that has such commonality to both events. Then, like now, people had seen the acquisition of wealth through the ownership of assets and were happy to secure them against increased borrowings without feeling any poorer for it. There was a new global sense of investment opportunity for all that was difficult to speak against. The US led the way and the world followed.

The 1920s’ stockmarket boom was a natural result of this mood. It began in May 1924 when the Times’ index of 25 industrial stocks (the equivalent of the Dow Jones today) stood at 106 points. By the end of that year it was at 135, growing to 181 by the end of 1925. In only a couple of months was no gain seen – very welcome if you were one of the many new investors benefiting.

By the summer of 1927, as Henry Ford moved from Model T to Model A, the index was at 245. The market grew steadily, talked up by the great sages of the time. In the same way that the US property market benefited during the 1990s’ boom by comments such as “demand led” and “fundamentally sustainable based on demand”, many leading lights saw the value of stocks as reflecting the growth of corporate earnings and escalation of general inflation. It was enough for the speculators to amass.

The investment trust as we know it was largely unknown in the US until this time and the US version bears a spooky similarity to the securitised loan products that facilitated the 2008 sub-prime crisis. Essentially, investment companies or trusts had existed in European bourses for some time. What US speculators saw quickly was that in a rising market which was blessed with great confidence, the opportunity for leverage was too good to miss.

By issuing new investment trusts using debentures and preference stocks, they could gain hugely from market gains for relatively little capital outlay – a bit like lending money against a property that will always rise in value so the risk of non-payment is covered by the capital gain. You could even sell on shares within shares for even greater leverage – a bit like selling on securitised loans as investments trading on the low-risk nature of property.

What commentators have called the Twilight of Illusion occurred in the summer of 1929. There was no summer lull, I discovered, but nor was there one single precipitous plunge in stock prices either. By the last day of August 1929, the Times’ index stood at 449 points. What was more worrying was the appetite for speculation on this rising tide. Broker loans increased at a rate of $400m a month. The investment trust vehicle allowed for borrowing at 6 per cent to be lent for an immediate return of 12 per cent against a security that was rising fast.

To anyone but the most optimistic observer, it was an accident waiting to happen. Even President Herbert Hoover spoke of “worrying levels of speculation”. Yet people spoke positively of the situation.

We remember President George W Bush talking up US homeownership in his re-election campaign and describing the robust health of the mortgage market. In 1928, it was a Yale professor, Irving Fisher, who proclaimed that “stocks have reached what looks like a permanently high plateau”.

Continued on p30


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