When to Expect a 1937 Style Crash

James Juliano Insights

Ray Dalio is the founder and CEO of Bridgewater Associates, the largest hedge fund in the world. He is one of the greatest money managers of our time, so when he speaks about markets we listen. Dalio made headlines last week worrying that the Federal Reserve is currently at risk to repeat a policy error that caused the 1937 crash. He blames the 1937 economic recession on the Federal Reserve’s policy of raising interest rates and warns investors that Fed policymakers could induce the same scenario all over again.

Dalio Warns of 1937 Market Risk with Rates, FT

The Fed’s 1937 monetary policy actions could have been the wrong policy, and we won’t remove the possibility that the current Fed could enact policy that creates a large market crash/recession. However, we think Dalio misses one crucially important part of history that leads him to incorrectly extrapolate Fed policy mistakes of the past into policy mistakes of the future. Dalio only blames Fed policy for the 1937 crash when, in fact, the bigger and more credible ingredient was bad fiscal policy.

Fiscal, monetary and regulatory policies are the three pillars of economic policy that drive economies and markets. While monetary policy receives most of the press, fiscal and regulatory polices have had the same, if not greater, impact on economic history. Let’s take a quick look at some of that history through a policy lens.

US government economic policy in the 1920s embraced lower taxes and lower regulations spurring a boom decade referred to as the “Roaring Twenties.” By 1929, however, those pro growth polices were being undone. The stock market crash of 1929 was followed by a series of fiscal and regulatory policy errors that launched the Great Depression, the largest of those mistakes being the Smoot Hawley Tariff Act enacted by President Hoover. Hoover also doubled the inheritance tax from 23% to 45%, doubled the income tax from 23% to 45% and initiated a 15% corporate tax rate. Franklin Roosevelt, elected in 1932, accelerated the tax “wedge” that Hoover began. Roosevelt hiked taxes in 1935, 1936 and 1937 pushing the top marginal tax rate to 92%, yes ninety-two percent. Not only did the Great Depression worsen, these tax policy mistakes spurred the 1937 recession and market crash known as the “Recession within the Depression.” The 1937 Fed inspired market crash that Ray Dalio warns about repeating was actually more inspired by these horrible tax policy mistakes than what the Fed was doing.

The biggest risk we see today is not a monetary policy error. In fact, not only is current monetary policy not a problem, it is actually improving. Remember, the only job of the Federal Reserve should be to stabilize the value of the US$. They should do so by continuously matching the supply and demand for US dollars. The best way to gauge the success of their efforts is by watching the price of gold in US$. Gold prices have recently been flat or slightly falling which means the US$ has been stable to slightly stronger. The Federal Reserve may not know or intend to do so, but they have been correctly matching the supply and demand for US$, with a slight preference for a stronger US$, for well over a year. This is excellent news and a favorable monetary policy backdrop for attracting global capital. A Fed mistake is always possible, but one is not presently happening. If one does occur gold markets will notice quickly, and we can follow the “Footprints.”

A much more dangerous risk to the current US stock market/economy is a fiscal policy error, like raising tax rates. Democrats likely will not be the party to implement such a mistake since they have steadily been losing power. Instead, newly appointed Republicans from recent midterm elections are at serious risk of not delivering on their election promises of more pro growth fiscal policies. Republicans could incorrectly focus on balancing the budget or negotiating tax hike deals with Democrats instead of focusing their efforts on reducing marginal tax rates.

Tax hikes are not the only fiscal policy mistake to fear. As our good friend and excellent economist John Tamny recently wrote, “In our present state, government spending and usurious rates of taxation are both barriers to production. But it says here that government spending is the bigger barrier.”  Tamny’s recent article correctly identifies government spending as a major economic growth killer.

What Stimulates More, Tax Cuts or Spending Reductions? by john Tamny

Remember, government spending IS taxation. The tale of the past several years has been one of decreasing government spending and, therefore, a lowering of the economy’s tax burden.

Another friend and our “go to” economy/market thinker, Scott Grannis, points out on his blog Calafia Beach Pundit that, “Over the past 5 years, the federal budget has improved dramatically. But the best part of that improvement—a zero net increase in spending which translated into a significant decline in spending relative to GDP—looks to be reversing. Federal revenues continue to boom, thanks to rising jobs and incomes, but federal spending over the past year is once again growing. We’re no longer likely to see a significant, further decline in future expected tax burdens, unless and until Washington embarks on a more aggressive reform of tax and spending policies.”

Receipts and Outlays

Recent headlines about Senators lifting spending caps enacted by the 2013 sequester are troubling. The possibility that defense and non-defense spending will be relieved next year if a group of Republican and Democratic senators get their way sets up the possibility of a serious fiscal policy mistake that would derail the already weakest US economic “recovery” in history.  We remain bullish on US equities, but fiscal policy mistakes are dangerous.  Investors must remain on high alert for history’s fiscal policy blunders repeating themselves.

Senators Talk About Lifting Spending Caps

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