The Dow Jones closed down more than 4 per cent. The crisis is now being widely compared to the great American pre-war depression. The American stock market crashed in 1929 and took more than 20 years to recover after hundreds of banks collapsed. Developments over the past few days have dashed hopes that the credit crisis may be drawing to a close and consumers are now being warned that the economic turmoil could continue for at least another year.
That really rather depends upon what you think caused the first depression.
If you go all Keynes on us, and think that it\’s an absence of demand that caused it then perhaps. If you\’re more Friedmanite and think that it was the contraction of the money supply then perhaps not. It depends what he central banks do to counteract the unwinding of leverage that is going on.
Judging by that latter metric, the Fed is doing the right thing, flooding the place with cash (no surprise, as Ben Bernanke is a leading economic historian of that first depression) the BoE a little more restrictive and the ECB doing the wrong thing in not lowering interest rates.
As Tim Congdon has pointed out recently, the current burst of inflation has been driven by oil and food prices (and the extra shock of biofuels) and those pressures are dropping rapidly. Looking 12-18 months ahead, deflation, not inflation, is the problem. Given that interest rates affect things 18-24 months out, then we should all be, as the Fed has, cutting interest rates.
This latter view is based on the thought that the first depression wasn\’t caused by the collapse in share prices, but by the collapse in the money supply (and the associated shrinking of the banking system). Not some inevitable consequence of raging markets, but the reaction to them.
Thus what happens next depends upon the central bankers.