Are we Facing Another Great Depression

The big question now is what kind of downturn are we now facing?  A short sharp recession with recovery in 2010?  Or a much long Japan-style slump? Or, the worst case scenario, a repeat of the Great Depression during which living standards fell dramatically?

To answer this question we need to study the 1930s more carefully.  The Times newspaper provide an accessible comparison with the Great Depression here. The article quotes Nick Crafts as saying

Until very recently I would have definitely said yes to the question of whether we can avoid a repeat of the Great Depression . . . The trouble is that these things can go horribly nonlinear.”

Banking failures and debt deflation may be what Professor Craft's is referring by 'horribly nonlinear'. Ben Benanke appealed to similar fears in justifying the Paulson plan. 

But are we really in danger of repeating the 1930s?

The Great Depression was a unique event. In general, I am influenced by Joseph Schumpeter's view that business cycles as endogenous to a market economy and thus I therefore do not think that regulatory ailure, greed, or expansionary monetary policy can fully account for the current crisis though all were undoubtedly contributory factors. 

The it was not the initial downturn that made the Great Depression great. Rather it was the fact that it was so prolonged.  And this was largely the result of catastrophic policy decisions. Though my confidence in policymaking has certainly fallen during the last three weeks, I don't think the US economy will experience a downturn on the scale of the 1930s. 

Moreover, as Arnold Kling observes financial markets were much thiner in the 1930s; once local banks failed depositors had nowhere else to go.  The debt-deflation - and banking failures that Benanke documented in his famous 1983 article were so devestating because  America had highly inefficient laws that made it impossible for banks to merge across state lines.  We live in a different world now. Credit markets are much broader and deeper than they were in the 1930s.

This does not mean that the recession will not be deep and painful.  Barry Eichengreen notes that unemployment is not going to reach 25% but that it may reach 10%. 

The comparison to the Great Depression is more relevant when it comes to accessing the global effects of the crisis in American and European banking systems.

William Easterly notes that the most damaging long-run consequences of the crisis may be in developing economies. The current crisis is undoubtedly going to influence policy debates in the developing world for years to come.  Development economics was born in the aftermath of the Great Depression and as a result the subject as a whole was predicated on the idea that markets do not work.

'That gave development economics a bias toward relying on governments, rather than markets, to create growth. The early development economists ignored a century and a half of European and North American development through individual enterprise, remembering only that their governments forcefully intervened to stimulate output during the 1930s.'

Whether or not something similar happens now depends on the length of the recovery. The world did not recover from the Great Depression until after WW2. Most economic historians now agree that prolonged nature of the Great Depression was largely a result of poor policy: a failure to abandon gold once it had become deflationary, misguided government interventions like NRA, and a movement towards international autarchy.  Nevertheless, the length and severity of the Depression were accepted as an indictment of capitalism. It seems to be that in the aftermath of the crisis it will be imperative that the same mistakes are not made again.

Comments

[Frank Miller]

Good read. Glad someone is starting to take this issue more seriously. Now, the big banks are fighting each other in a break neck race to consolidate which is being done for business survival rather than business gain. Sadly, the bailout will not help them much. They are hurting and when they hurt, we all suffer. Everyone should start looking for ways to protect their money. This basically comes down to either taking your money out of the market and cutting discretionary spending or diversifying and investing some overseas. I personally use offshore bank accounts and they have helped me with diversification and asset protection. If you want to read more on why offshore investing is smarter, feel free to visit my website.

Best,
Frank Miller
http://www.theoffshorebankaccount.com