Archive for October 2nd, 2008

Another Great Depression?

Today I’ll try to tackle two questions that I’ve been pondering, reading all I can about, and trying to work through.  Is another Great Depression possible?  Will the bailout, if passed, avert it?

The answers are yes, and ‘not exactly.’

First, with credit markets tightening dramatically, the risk of a recession spiraling into depression is real.  Even now Auto dealerships going belly up due to lack of sales in part because of lack of credit for consumers.   Toyota and other manufactures are seeing sales down over 30%, which will have a ripple effect through the economy — and that’s only one sector.   Add that to the slow down in construction and contraction in consumer and business spending due to tight credit, and you have a very weak economy.   Pile on top of that our current accounts deficit, and the risk of a catastrophic meltdown is real.

However, it is important to remember that when the Great Depression hit, the reaction favored by most economists was for the government to tighten its belt and let the free market work things through.  John Maynard Keynes would recognize the problem with this approach — when economies fall into a spiraling recession, nothing in the free market is guaranteed to pull them out.  The business cycle can get stuck in a downturn.  The way out would be to actually increase government spending and “prime the pump” so to speak.  Two states that undertook thoroughly Keynesian approaches (though not recognizing it as such) were Nazi Germany and the Soviet Union.  Economically this helped their countries buck the trends of the Depression.

The good news is that there is no way we’ll make the same mistake as then.   Even Roosevelt’s “New Deal” was modest in comparison to what was needed to stimulate the economy.   The bad news is that while that lesson was learned from Keynes, another lesson was not.  Keynes did not want continuous and expansive government debt.   What a responsible government should do is run counter-cyclical budgets.  When the economy is booming, pay back any past debt and perhaps run a surplus.  That money (or new debt) can be used to counter act a downturn.  However, from the “stop and go” policies of the sixties and seventies to the “budget deficits are meaningless” idea promulgated in the 80s, governments have lost all sense of fiscal discipline.

The US total debt is somewhere around $10 trillion.  If we had no debt, borrowing $700 billion would seem like a big deal, but wouldn’t be much of a burden to the economy.  Given the size of the economy, we could pay it back rather easily.   With already massive debt, adding to it in order to avert a recession has a number of negative counter effects.  One that would be especially troublesome is stagflation.  Inflation could return at the same time as an economic downturn.  People would find their salaries declining while prices would be rising.  Rather than a massive and sharp depression, we’d have a continuous decline in our standard of living.  Moreover, this won’t completely avert a recession — people will be losing jobs and businesses will be failing.  The numbers just won’t be as high as in a depression.

So despite the high fives that will probably be exchanged on Wall Street when a bailout gets passed, it won’t be a panacea, it won’t “solve” the national crisis.  Rather, it simply drags out the time frame of the crisis, and expands our unsustainable debt.  It also creates a real dilemma in terms of fiscal discipline.   To battle inflation one spends less, or contracts the money supply.  This, however, feeds into a recession.   While some credit the Federal Reserve for ending the last stagflationary cycle by conquering inflation by this means, that only worked because oil prices declined rapidly in the eighties, while the US increased deficit spending.

Moreover there are wildcards out there:

1.  Oil.  Right now oil prices are down due to fears of lower demand thanks to the economic slow down.  If that continues, the decrease in oil prices will help spark some kind of recovery (or at least weaken the severity of a recession).  On the other hand, if oil production continues to decline, a decreased supply could put upward pressure on oil prices, thereby weakening the economy further.

2.  Demographics.  The baby boomers, especially the older ones, are starting to retire.  They are suddenly finding their retirement income far below what they had anticipated.   As they retire they’ll also be cashing out investments (rather than contributing to mutual funds and the like), putting downward pressure on stocks and really all sorts of investment.  They will also require social security payments, medicare, and other government services.  The new work force will be smaller.  This might help mitigate some unemployment problems, but in general could do more harm than good.   Also, this generation — the greatest benefactor of the years of economic imbalances — might suffer most, as their retirement investments won’t have time to recover, and they could be among the first laid off.  Older workers have higher incomes, and unless protected by unions, cutting them is more cost effective than cutting younger workers.

3.  Global warming.  Forgotten in this election campaign, but potentially a devastating problem down the road, is the impact global warming will have on the economy.  The Pentagon has labeled it a major security threat, and there are fears of economic catastrophe.  This was the case even when people had a more rosey view of the economy.  If the worst of the global warming predictions come true, the world economy may not be strong enough to handle it without total collapse.  On the “bright” side, a global slow down would do more than anything else to limit the production of green house gasses.

4.  Globalization.  We still don’t know the impact this will have on China, India, and other countries.  Already we see that Europe is learning that the “Schadenfreude” I talked about last week was premature.  Their credit markets may not be as “wild west capitalist” as those in the US, but in a global financial system, the contagion spreads.  European banks are also in trouble.  If the problem is contained, and countries in Asia can manage to continue to grow, that would help the US (and Europe) by assuring that global actors still exist with the capacity to invest.  This would be a shift of economic power from West to East, as they would gain controlling interest of many companies in the US and Europe, but while that would be a major decline in economic clout, it might prevent a depression.

So rather than soup lines and a sudden crash, we’ll probably see government spending maintain some semblance of economic activity.  The cost will be increased inflation and a steadily decreasing standard of living, as well as a shift of economic power to the East (unless the contagion spreads there as well).

Is that inevitable?  I think not.  I suspect smart economic minds might be able to find a way to allow the resumption of normal credit markets while fixing the economic imbalances in a manner that, while painful, might put the economy on the right track.  This would require reducing debt and government spending while finding ways to stimulate the economy, a tricky task.  Still, one can hope!  However, the dangers are real, and the bailout alone only shifts the problem from a sudden and dramatic implosion to a gradual decline.  More needs to happen.

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