Panics and Booms, a lesson from 1897

Panics and Booms, a lesson from 1897
March 11, 2009 – 4:24 pm

by Rolfe Winkler, CFA

Thanks to Patrick for an absolute gem. Earlier this week, he linked to a fantastic newspaper article written in 1902. That article actually reprinted a paper written five years previously, entitled “Panics and Booms” by L.M. Holt. When Holt wrote the paper, the economy was at the tail end of a depression. Holt argued that booms always follow busts, so folks should anticipate the return of flush times. Fast-forward five years, a new boom was in full swing, and the newspaper republished Holt’s paper as a warning that the next depression was due around 1910, give or take. The Bank Panic of 1907 arrived a bit ahead of schedule.

It’s a great read, particularly now when most observers remain conflicted about what kind of economic funk we’re in. Mr. Holt described quite clearly the economic conditions we face today, a depression created by over-indebtedness. And he offers a prescription for how to dig ourselves out: pay back debt. It’s a prescription I endorse wholeheartedly.

The paper is so good, for posterity’s sake, I have reproduced it here in full. Another reason: Irving Fisher generally gets credit for having created the “debt deflation theory of depressions,” but Holt beat him to it by 36 years. Enjoy!

“Panics and Booms”

L.M. Holt

Ever since the establishment of the human race on this planet there has been a gradual increase of population and a more rapid consumption of wealth.

Wealth is the result of labor, and without labor there can be no wealth.

Men live and pass away, but as they cannot take their wealth with them a large percentage accumulates for the benefit of their successors. Hence the wealth of the world today, per capita, is much greater than ever before, and it is continually on the increase.

The transfer of wealth, or property, from one person to another creates business. Under favorable conditions, transfers are numerous and business is brisk. Under unfavorable conditions transfers are few and business is dull.

During periods of business activity there is work for all, and this of itself makes greater business activity. During periods of business depression there is not work for all, and this of itself makes business dull and unprofitable.

The existence of either one of these conditions leads necessarily to the other. It is an impossibility for either prosperous times or depressed times to continue permanently.

This is where it starts to get good…

During prosperous times, there being work for all, all are supplied with the means of accumulating wealth, and thus all are enabled to provide themselves, and families with all the necessaries, and many of the luxuries, of life; and hence, during the prosperous times the demand for goods and property increases and soon the demand exceeds supply, and then prices advance.

This rule, which is applied to the laborer, is also applied to the business man. Prosperous times induce business men to branch out in their several lines of trade….The volume of trade being large, each gets a corresponding proportion of it. Many business men find that they can do more business than is allowed by their limited capital. They then buy on credit.

Prices are continually advancing, therefore they are able to make margins of profit not only on the capital furnished by themselves, but on the capital furnished through their credit.

This rule also applies to people dealing in real estate. The country is growing; money is easy; the times are good; business is prosperous and therefore speculation is favored. A man worth $5000 can buy four times that amount of property using his credit, and sometimes he buys ten times that amount or more. While prices are advancing he not only gets the benefits of the advance in the price of the property represented by the capital furnished by himself, but also on the capital furnished by his credit.

When prices of property and goods during a period of business depression are falling, the loss does not come on the entire property, but only on that portion of it represented by the cash capital the man has invested in it. The debt never shrinks until the real investment is all gone.

A fantastically simple description of leverage, that is, investing with borrowed money as a way to amplify potential gains at the risk of greater losses. How quaint that Holt seems impressed by “ten times” leverage. He would blush at the leverage ratios permissible today.

A quick tutorial on leverage for the unfamiliar. The more money borrowed to buy an asset, the higher the buyer’s return on equity when times are flush. If you buy a $100,000 house with only $5,000 down and the price increases to $125,000, the return on your equity investment is 400%. ($25,000 increase in price / $5,000 initial investment = 400% return). A cash basis investor who pays the full price of the house up front has a much more meager return, 25%. ($125k / $100k = 25% return). The flip side is that when prices fall, the leveraged investor sees his equity wiped out quickly. The guy who paid cash has lots of cushion.

All people in a given section of country use their credit at the same time because they are all governed by the same local conditions. Hence, there is a fictitious stimulation of prices which must come to an end. This end brings a financial depression which must necessarily follow a period of business activity.

A “fictitious stimulation of prices.” We have our own word for that: “bubble.”

When the people arrive at a point where their credit limit is reached there is necessarily a decrease in the demand for goods and property, and soon the supply becomes greater than the demand and prices begin to decline. This stops speculation. Thousands of people engaged in manufacturing or producing articles of general use are thus thrown out of employment, and this causes a still further decrease in the demand for goods and hence a further decline in prices. Those who have purchased on credit find themselves subjected to heavy losses because they are compelled to sustain the depreciation on goods they do not own—that is, goods bought on credit. Because of this decrease in valuations all are compelled to economize in order to adjust their expenses to the new order of things, they being compelled to pay off the accumulated indebtedness with the decreased income. This economy of the masses still further decreases the demand for goods and property and this still further increases the supply over the demand, and decreases the prices, throwing more people out of employment and increasing the depressed condition of business.

Fisher, eat your heart out!

The business man feels the change in conditions as well as the laborer. Doing business largely on borrowed capital he loses all the capital employed in the business, not alone on the money furnished by himself. The value of the business shrinks, but the debt remains the same or increases. Bankruptcy stares the business world in the face. The weaker go under while the stronger pull through, and sometimes make fortunes at a little later date out of the misfortunes of others.

Here is a condition of hard times. A large percentage of laboring people of the world are thrown out of employment. Every time a man stops work—stops producing—his purchasing ability is impaired, the demand for goods becomes less and prices are lowered.

During the period of depression—the debt-paying period—the people at large are forced to economize. The earning capacity of all classes has been decreased. A large percentage of people are thrown out of steady employment and wages are reduced for those who do secure labor. Some earn enough to pay expenses of living economically, while others do not and are compelled to live in part on the limited accumulation of former more prosperous years.

Holt notes that depression coincides with the period during which debt gets paid back. Economic expansion coincides with the expansion of debt, with the period during which debts are rolled over rather than paid back. [I made this point in my post on The Great American Ponzi.] The bigger the debt hole we dig for ourselves—via bailouts, stimulus, etc.,—the longer our payback period. More debt, in other words, will only exacerbate the depression.

Many business men continue in business: some are able to meet running expenses, while others prefer to lose a little each month, awaiting a return of better times rather than to lose more heavily by retiring entirely from business. Many cannot stand the pressure and quite business, forced to lose the accumulation for years.

During the years of depression, values of all kinds of property shrink. In the case of incumbered property this shrinkage falls entirely on the margin and not on the debt. Sometimes it wipes out the margin and a portion of the debt also. Sometimes the margin is so nearly wiped out that the alleged owner of the property transfers his interest in the property to the one who holds the claim against it, and another debt is paid. Sometimes the holder of the debt declines to thus take the property and releases the owner.

More on leverage. Assets “incumbered” with debt leave their owners very vulnerable. What Holt refers to as “margin” we refer to as equity. Equity, “during the years of depression,” may be substantially “wiped out.”

A person who does business on a partial credit basis, on borrowed capital, makes larger profits during periods of prosperity when the prices are advancing than he who is on a cash basis, but he sustains larger losses during periods of depression when prices are dropping.

If a man could change quickly from a credit system to a cash basis as soon as the period of prosperity closes he would be all right, but he is in debt, and the debt must be paid, and hence it is not usually practical to make the change. If it were he would not be in debt.

Gradually the surplus debts of the country are paid and the people breathe easier again. People live within their incomes and temporarily learn economical habits. Men smoke fewer and cheaper cigars and ladies purchase fewer ribbons and occasionally fix over a bonnet and dress instead of getting new ones.

A time is finally reached when people begin to get out of debt and they begin to live a little better, buy more of the necessities of life and some of the luxuries. As the number of people in such improved condition increases, trade begins to pick up, larger orders are sent to the factories, more wheels are set in motion, more operatives are employed and more people are placed in position to buy more goods, which in turn starts more mills and gives employment to still more men.

Note how the pre-existing condition for healthy economic growth is first getting out of debt.

Deficit spending won’t stimulate anything. It will just sow the seeds of an even deeper depression. The sooner we get out of debt, the better off we’ll be.

Thus the business of the country is forced into an active condition, and thus business activity increases in geometrical progression until wages reach their maximum point, factories are running to their utmost capacity, prices of all kinds of goods and all kinds of property advance, and people begin to purchase again more than they have the money to pay for—some because they want profits on increasing valuations and others simply because of extravagant ideas of living.

Money is plenty, credits are good, and the masses are good pay because all kinds of property are convertible into legal tender. Improvements, public and private, are pushed to their utmost extent, fancy prices are paid for real estate because it can be sold readily again at still more fancy prices. Individuals of limited capital hold thousands and hundreds of thousands of dollars worth of property on which only a small payment has been made. An advance of five per cent on the price of the property is an advance of 50 or 100 per cent or more on the cash investment. Another transfer is made and another soul is made happy. In short a speculative boom has struck the country again gradually but surely. This speculative boom is not the result of any movement on the part of the people or any portion of them to create a boom, but it is the result of natural laws of business and is just as certain to materialize as a good crop is sure to be the result of favorable climatic conditions.

It is not, perhaps, in order here to discuss the millionaire question or inquire into the trust combinations which threaten to disturb so seriously the business interests of the country. It is, however, safe to say that those who think during a period of business activity that such activity will always continue are just as much mistaken as are those who believe during a period of business depression that such business depression will never come to an end.

Good times will follow bad times and bad times will follow good times just as surely as darkness follows day and day follows darkness. Those periods always have followed each other and they always will.

The seeds of prosperity are sown during the periods of financial depression and the seeds of hard times are just as surely down during the period of business activity and speculative boom. There is not question as to the soundness of this conclusion. There is no question that these changes will come. The only question is—when?

At the close of a speculative boom the change comes like a thief in the night. In fact a thief in the night would be a welcome visitor to many instead of the change which puts in an appearance, but the change from a financial depression to better times comes gradually—so gradually that for months there is a difference of opinion as to whether a change for the better has actually commenced or not.

Glance for a moment over the financial history of the century just closing, and see what has been the condition of the country. During 1837 the country was in the midst of a financial panic. Again during the year 1857—twenty years later—there was another panic. In 1837 a financial crisis struck the eastern states and the great banking house of Jay Cook & Co. was found among the financial wrecks scattered throughout that section of the country. In 1875 that same panic reached the Pacific Coast, closing the doors of the Bank of California of San Francisco, together with many other banking institutions, including the then popular banking house of Temple and Workman in our own Los Angeles—a bank that failed for over a million dollars and never paid a cent on the dollar to the many unfortunate depositors.

In 1893 the next panic struck the United States after having wrecked so many banking institutions in South America, Australia, and other parts of the world.

During the year 1886, when the late speculative boom was getting under good headway in Southern California, Hon. D.C. Reed, now mayor of the City of San Diego, gave a banquet at the Horton House in that city, to which he invited business men from all points in Southern California. In response to the sentiment, “The Prosperity of Southern California,” the writer, among others, briefly reviewed many of the principles herein laid down and following the line of thought that waves of prosperity and depression follow each other with more or less regularity, predicted that somewhere between the years of 1892 and 1895 this country would again enter upon a period of business depression that would be very severe on the business activity of the country. The local speculative boom of 1886-7 broke long before this predicted period, but the universal panic which swept over the civilized world did not appear until the time predicted—1893. It appears to require, under present business conditions, from eighteen to twenty years for the country to pass through a complete cycle from one business depression to another.

After the panic of 1875 it took the people of Southern California five years to get ready for business again in 1880. A similar period after the panic of 1893 ought to place this country again in line for business activity. The panic of 1893 was more widespread in its operations that that of 1875; but locally, it was not so severe, as comparatively little money was lost by depositors by falling banks in Southern California four years ago, whereas in 1875 the loss was heavy.

Again so far as Southern California is concerned the past five years has dealt very kindly with our people. Southern California increased its population from 200,000 in 1890 to over 300,000 in 1896. Los Angeles city has increased in population from 50,000 in 1890 to 103,000 in 1897, more than doubled.

In actual wealth, Southern California has kept pace with the increase of population, although on account of the business depression of the country and the decrease in valuation all over the world, this increase in wealth is not so apparent. With the extraordinary increase in population and wealth in Los Angeles city during the past seven years, nothing short of a financial depression all over the country could have prevented that city from experiencing a speculative boom of great magnitude.

If Southern California in general and Los Angeles city in particular can make such a showing during a period of financial depression, what will be the result when the clouds roll by and prosperous times are enjoyed again throughout the country at large?

It is a difficult matter to make the people believe that our country is now entering upon another period of prosperity. Each one has a remedy for hard times. And each one sticks firmly to the proposition that better times cannot come again until his remedy has been applied. These remedies are mostly of a political nature. One man believes that a high protective tariff is all that is necessary to restore prosperity to the country, and another thinks the free coinage of silver and gold on a basis of 16 to 1 without making any suggestion to any other nation about the matter would bring good times. There is no question but the legislation on both these questions or either of them would affect the main proposition. Wise legislation will always assist in bringing prosperity, and unwise legislation will always retard the coming of better times, but no legislation, no matter what it be, can prevent the incoming tide any more than the little child on the sandy beach with its little shovel can, by piling up a ridge of sand, stay the incoming surf.

“The statement that, except for the temporary depression in prices the volume of business transacted is now larger than it was in 1892—the year of the greatest prosperity—has been questions by some. But a comparison of prices this week in the leading branches of manufacture, not only confirms that view, but shows a remarkable similarity to the course of prices in the early months of 1879, when the most wonderful advance in production and prices ever known in this or any other country was close at hand. The key of the situation is the excessive production of some goods in advance of an expected increase in demand. So, in 1879, consumption gradually gained, month by month, until suddenly it was found that the demand was greater than the possible supply. All know how prices then advanced and the most marvelous progress in the history of any country resulted within two years. Reports from all parts of the country now show that retail distribution of products is unusually large and increasing.”

This is a remarkably clear statement of the facts of the case, and is evidence from unquestionable authority that the position taken herein is correct.

Local conditions in Southern California will affect the issue here, and they appear in our favor. The building of the breakwater at San Pedro by the government will insure another transcontinental railroad from the east to Los Angeles via Utah. Then a 1 cent a pound tariff on citrus fruits, the building or more beet-sugar factories and the improvement of the vast water power of the mountain streams, and the setting of that power to work building up and enriching the country—all these and more will help along the good work.

Capitalists are now active, laying the foundations solidly for future operations in this, God’s corner of the universe; and while we would not advise people to stand still and see the salvation of the Lord, still it is pretty certain that those who stand will see it, although they will not be benefited thereby so much as they would be if they didn’t stand still.

The coming boom is not here today and it will not be here tomorrow, but he who has no faith that a period of very busy business activity, accompanied by a speculative boom is close at hand, would do well to place himself under the fostering care of a good, reliable guardian.