Look: I am eager to learn stuff I don't know--which requires actively courting and posting smart disagreement.

But as you will understand, I don't like to post things that mischaracterize and are aimed to mislead.

-- Brad Delong

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Tuesday, February 24, 2009

More on Smoot Hawley

In a comment to the last post, Ironman takes exception to my critique of his Nov. 13 post at Political Calculations, titled "A Tariff Sparked, Long Running Deflationary Event." My take was flippant, bordering on smarmy, and for that I apologize. But nothing so far has made me reconsider the content. There are two issues in dispute: the relationship of the Smoot-Hawley Tariff Act (SHTA) to the stock market crash that started in October, 1929, and my take on his graphs.

Here we will consider SHTA, vis-a-vis the stock market. Though it was one of many straws on an overburdened camel, SHTA is not generally considered to be a significant contributor to the Great Depression. Ironman mentions the roll of expectations in driving stock market prices. Fair enough. If SHTA was affecting expectations in the fall of 1929, there ought to have been reporting on that topic, especially in the financial press. This appears not to have been the case.

This quote from the Erasmus School of Economics provides a more typical interpretation, specifically rejecting SHTA as a cause, though they get the SHTA date wrong. (Emphasis added.)

"More important for the monetary policy tightening was the gold outflow, mainly from the United States to France. The Fed raised the discount rate during January-July 1928 from 3.5% to 5% and in August 1929 to 6%. Because prices were falling, real interest rates were much higher than nominal interest rates. Additional bad news was the failure of the business and financial empire of Clarency Hatry in Britain in September 1929. In October 1929 regulators denied the utility company Boston Edison a request for a stock split, fearing further price speculation on a price considered already higher than justified, and accusing the company of earning monopoly profits. On October 28, 1929 the Smooth-Hawley tariff was enacted. However, although surely bad news and although frequently mentioned as a major cause of the stock market crash and subsequent economic depression, the decision on the tariff came actually after the peak and the first panic in the stock market. US exports were also only 7% of GNP, and no evidence exists that import-export companies suffered more than other companies during the crash."

The following paragraph from the same source provides a traditional explanation for the decline:

"Many investors had bought stocks on margin, with borrowed money using stocks as collateral, and were liable for both interest rate costs, loan repayment and additional margin calls when prices decline. When stock prices started to drift downward during September/October 1929 the volume of trade increased. When prices declined and hope of a speedy recovery faded, the number of margin calls increased. Many were forced or attempted to sell their shares, and through sheer size of volume brokerage firms were swamped and prompt reporting of prices became impossible. Large scale or panic selling disrupted the market on a number of ‘black’ days in October 1929. Information on transaction prices was unavailable. Furthermore, speculators had a perverse incentive to stay away from the market in order to benefit from the distress sale and free fall in prices."

Now let's look at the Dow Jones Industrial Average over the relevant period. In the above chart of daily closing values, pink lines indicates times of significant SHTA events. From early September through October, a senate coalition opposed to to the tariff broke down. After peaking on Sept. 3, the market tumbled sharply for a month (wave 1), then rebounded into a 50% retracement by mid-October (wave 2.) It then fell of a cliff (wave 3). Alternating days are indicated in red to show the day to day trajectory of the move. The DJI then bounced short of another 50% retracement (wave 4) of this decline, and finally hit a major intermediate bottom on November 13th (wave 5.) From that point, the market gradually retraced 50% of the entire loss, topping again in mid-April of 1930. On March 17, Congress passed SHTA. The market crept up for another month before entering the next phase of decline. Finally, just prior to the June 24th low, President Hoover signed the bill into law on June 17th. The market then made a slight recovery over the next three months.

The coalition breakdown coincided with the beginning of the stock market decline. Correlation is not causation. But this is not even correlation. This is a coincidence. Passage of the bill preceded the next down phase by a month. Signing into law shortly preceded a moderate recovery, retracing about 38% of the most recent decline. There is no coherent connection between SHTA and market movements.

There is a more fundamental question. Does the stock market relate in any way to exogenous factors, or does it move to its own specific and unique rhythm? One manifestation of the latter view is Elliott Wave Theory. The stock market movement through this period is close to a text book example of an Elliott wave sequence. Robert Prechter and his colleagues at Elliott Wave International have repeatedly argued and demonstrated that news events, wars, and assasinations have, if any, only a transitory effect on stock market movements.

Elliott wave theory suggests that movement in a primary direction takes a five wave shape that is generally easy to discern. Counter current moves occur in overlapping sequences that might or might not be easily resolved into a three wave pattern, and often achieve a retracement of 38%, 50% or 62%. Here, you see downward moves (the primary direction) in fives and the counter-current waves in threes, completely consistent with an Elliott wave explanation.

We'll take another look at Ironman's graphs in a future post.

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