“THOSE THAT CANNOT REMEMBER THE PAST ARE CONDEMNED TO REPEAT IT”
– GEORGE SANTAYANA

Is History Repeating Itself?

Truer words have never been spoken. The financial times and circumstances we are experiencing today have occurred in the past. There were many times in the 1800’s when our country experienced severe recessions. Over the past 20+ years, the Federal Reserve (“Fed”) – especially under Alan Greenspan – managed the economy to smooth out the business cycle and avoid a recession. In doing so, the Fed allowed excess lending to occur, especially to less qualified borrowers, which has created a credit overhang similar to what happened during the Great Depression. Some lessons have been learned from this, while some lessons have been completely forgotten.

Ben Bernanke has learned some valuable lessons from the Great Depression and has applied them during this crisis. In our opinion, the low level of interest rates today versus the level of interest rates back in the 1930s is a big distinction. In the middle of the Great Depression, the Fed raised interest rates in order to preserve the value of the dollar. This was a huge mistake because it restricted the money supply which in turn slowed down the economy. This is why the Fed has kept interest rates low for a prolonged period of time and will likely continue to do so. We give Ben and the gang at the Fed props for learning this lesson. But there is another lesson we believe they need to learn.

As many people know, the Great Depression was precipitated by a stock market bubble in the late 1920’s. What is not well known is that this bubble was caused by the Fed. The economy and stock market were heating up in 1928 and the Fed, instead of raising rates, reduced them early in 1928. The Fed chairman, Benjamin Strong, pushed for the cut to help out Britain. By doing so, he created a bigger bubble in the US that ended badly. What is the history lesson here? Make sure that when helping foreign countries you don’t do it at the expense of the US economy. Our concern is with the current crisis in Europe, the Fed will feel compelled to help the Eurozone nations. We hope Ben doesn’t make this mistake.

If the Fed is doing most of the right things, why isn’t our economy turning around? The reason is our government still has several other history lessons to heed. To this point, we have managed to keep a lid on tax rates. However, the regulatory environment in the US has been very burdensome for businesses. Regulations usually do not have that big of an effect on the economy. In times of significant distress, however, more regulation causes more uncertainty and prolongs the crisis. For example, contacts we have in the banking industry are frequently informing us of the negative impact of the 848 page Dodd-Frank bill. It was sold to the American people as a means to control the “too big to fail” banks. But now, as a result of JP Morgan’s recent trading loss, we see that this bill doesn’t prevent that sort of scenario. So we have 848 pages of regulations that don’t solve the problems it was designed to address. How does that instill confidence in business?

A bigger problem is increasing tax rates in a severe downturn. President Obama was correct when he said in August of 2009, “You don’t raise taxes in a recession.” Now that is changing and there appears to be more attacks on the wealthy – i.e., occupy Wall Street – with continued talks of raising taxes. What is wrong with raising taxes? Raising taxes has the impact of slowing down the economy. In the 1930’s, the government raised taxes dramatically on the wealthy as the chart below demonstrates.

The need to raise taxes was a worldwide phenomenon back in the 1930s. The next chart shows how countries taxed stock dividends in 1929 compared to 1935. There is a direct correlation to the magnitude of GDP growth – or the lack thereof – and an increase in taxes on dividends.

Top Marginal Tax Rate on Dividends

This is a major concern going forward. If Congress and the President don’t act by year-end, qualified dividends will be taxed at ordinary income tax rates we means qualified dividends top tax rate will jump from 15% to 39.6% next year. That is a whopping 164% tax increase on dividends!

Market Implications

The stock market will continue to suffer until these uncertainties are resolved. If the lessons of the past are not heeded, and income tax rates rise and more regulations are issued over the next few years, it will drag down the economy, stock market and employment. We believe with this much uncertainty over the next few months, it is still a time to manage risk in client portfolios.