Is this a depression?

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.

8 thoughts on “Is this a depression?”

  1. Just as Bernanke and Greenspan apologised, on behalf of the Fed, for the Great Depression I am sure future Chairmen will apologise for this current crisis.

  2. Don’t interest rates also have a current impact in that they help to forge inflation expectations? The expectation of future commodity price falls is unlikely to be a main consideration for wage negotiators in the present. The BoE has to be careful not to allow second round wage inflation to take off.

    My understanding is that some argue that the Fed has a stronger reputation for dealing with inflation (due to its greater history in this regard) and, as such, has greater scope to cut interest rates without raising expectations of future inflation in the economy at large.

  3. Oil and food prices may well be driving the current burst of inflation, but was the large increase in their prices unpredictable? Why did the central banks not hike interest rates two years ago to stop the price inflation happening in the first place?

    I don’t want Bernanke, Greenspan, BoE, ECB et al to apologise for the bust, I want them to explain why they allowed an unsustainable boom in the first place.

  4. What was the dictum? “A recession is when someone else loses their job, a depression is when you lose yours”

    This isn’t a depression. This is what capitalism does as part of the cycle – remove the overleveraged and the insolvent, collapse the paper profits and refocus everyone on the concepts of return of investment, risk and real value.

    The downfall of Lehman demonstrates that surviving previous downturns does not mean that you’ll survive the next one.

    The depression that followed the Wall Street Crash was caused by the Fed tightening fiscal policy, raising interest rates. That may have helped the remaining savers, but it meant that no-one could afford to borrow in order to invest.

    The real danger to the financial markets, and hence the economies of the western world is that the unwinding of the derivative markets causes a severe contraction in the money supply caused by a cascade of bank failures.

  5. The crash was way overdue. I found myself wondering how long the current state of affairs could continue.

    It’s not the end of capitalism. It’s just what happens when all you’re selling is debt. As for alternatives, Keynsian solutions are a really crap idea. They never really work.

Leave a Reply

Your email address will not be published. Required fields are marked *