A Deflationless Depression?

Logic can be a bad weapon when the equation isn't finished.

Think back to the Great Depression. Long lines of unemployment, years of economic contraction, suffering, etc.

One big thing that happened during that period was deflation - a continual falling of prices. Goods and services dropped in value on a daily basis.

The problem was chronic, and policy makers at the time either didn't know how to cure it, or didn't really see it as an important issue. In hindsight it was. Keynes rightfully argued that a good response would've been for the government to expand its operations and run a deficit, thus increasing economic growth and reinflating. Monetarists rightfully argued that interest rates at the time were too high and that increasing the money supply by lowering rates would've been a good solution. Ben Bernanke, in his study of the Depression, declared that there was always the option of merely creating money ex nihilo and throwing it around until deflation disappeared (and thus was born his nickname "Helicopter Ben").

So... here we are on the cusp of yet another potential depression. Ben is doing his best to keep deflation at bay - interest rates have dropped again, a process which acts to stimulate money growth. If the problem gets any worse Ben may have to warm up his helicopter and begin money bombing.

But will this solve the problem? Will the simple process of creating more money - which is balanced out by the market's deflationary money hoarding - do the trick? Is it simply a matter of monetary policy?

The answer to that, of course, is no. It will certainly help prevent exacerbating the problem, but we need to remember that the Great Depression was not simply a failure to keep prices stable.

At present, I would argue that our current set of policy tools and economic understanding is quite capable of coping with an economic upheaval similar to that which caused the Great Depression. Yet I would also argue that the upheaval we are experiencing now is twice as worse as the share price bubble bursting in 1929.

The basis for this argument is the below graph, which I mentioned back in July and which was instrumental in changing me from an "optimistic financial doomer" into a "pessimistic financial doomer":

The graph is sourced from this article at Naked Capitalism.

There is always something terribly frightening about any graph showing exponential growth as it plots something in the real world. "What goes up must go down" is the rule - and the current market crash seems to be following this principle.

I still cannot believe that total credit market debt is equivalent to around 350% of GDP. If that isn't frightening enough, look back the great depression years - the "spike" on the left hand side of the graph. This may, of course, be simply a Propter Hoc scenario - two bits of information that appear to be linked but aren't - but I honestly doubt it since we are comparing stats from the same area of study.

(Note: an example of a Propter Hoc fallacy would be to say that the decline in popularity of Spirographs has occurred while childhood literacy has dropped - thus creating the impression that declining literacy rates could be stopped by buying more Spirographs. The two areas of study - developmental psychology and sales figures - need more to link them than just sheer coincidence. In the case of the graph above and the instance of economic downturns, the information is linked in the area of financial statistics, thus making the correlation between the two more reliable).

If the graph is correct (and I trust Yves), then we are facing a financial situation many times worse than that which hit in 1929. Debt-based asset price bubbles (such as property or shares), when they go bust, leave a trail of deflationary and expanding debt.

It is important to look at the above graph and compare the Depression years with the years since 1980. The depression years saw debt increase to around 170% of GDP before the crash. The increase of the debt to 260% of GDP occurred after the crash and is most likely due to the deflationary spiral that the world economy went into (debt levels remained the same while GDP contracted sharply, thus increasing the share of debt to GDP).

What we have seen since 1980, however, has been a build-up of credit market debt to a level representing 350% of GDP. That is around twice the comparable amount of debt that was present before the 1929 crash. This means that we have further to go.

Think of it like this: The economy is a car ("automobile" for you yanks). In 1929 the car hit the wall at 100kph and crashed. Unfortunately no one knew how to fix the car properly after the crash, which meant that the problem got worse. Moreover, it took years of research and study to determine the best methods of fixing the car properly. Now that the car has hit the wall again, it is tempting to say "well we know how to fix it now" - except this time the car has hit the wall at 200kph.

And that goes back to the title of this article - a deflationless depression. I am absolutely certain that we have learned from the policy mistakes of the 1930s and we are able to prevent the world from going into a 1930s-type deflationary spiral. But we must also remember that our economy has hit the wall harder and faster than in 1929. We cannot assume that this will be of no consequence.

Monetary policy is, of course, an essential tool for running an economy properly. But monetary policy is best used as a preventative rather than a cure. The most effective form of monetary policy occurs when interest rates are raised or lowered in response to price signals while the economy is running along relatively smoothly. Emergencies like deflationary spirals or stagflation do require monetary intervention - but they still remain emergencies. It is obvious that central banks like the Federal Reserve need to step in and provide emergency assistance to an economy that has hit the wall - but the work that monetary policy does in those cases is not a cure, but merely a bandaging of wounds and a setting of broken bones. At some point the market ends up having to cure itself with bed rest.

It is entirely possible to have a deflationless downturn - just as the 1970s showed us that it is possible to have an economic contraction and high inflation at the same time. Whatever the Fed or the US government will do in response to the current crisis will never be enough to cure it but hopefully will be enough to limit the damage. After all, the last thing we need is for policy mistakes to make the situation worse.


Noni Mausa said...

I think you haven't seen an important element. I think the deflation has happened already, and has been coming on slowly but steadily for the past fifteen years.

Salaries essentially stalled for most people. But essentials continued to increase in price, so more and more of their income went to the essentials. What happened to the rest? Some examples:

Thrift shops and second hand stores thirty years ago were not places you bragged about shopping at. (I was a poooor college student so I got in the habit very young, and would brag about really good finds, but I am not your median gal.)

Not today. Thrift shops have proliferated like mad, and everyone shops there without having to explain it to anyone.

And then there are the Wal-marts and the Dollar Stores and the cheap shoe stores and the relentless el cheapo big box stores and cheap food and Kraft Dinner and so on.

The deflation was cushioned and disguised by being slow, and by the promiscuous ubiquitous offer of credit, and by the slow dissolving of the personal and collective "fat" that Americans had built up post WWII. That fat is gone now, the houses mortgaged, the jobs precarious, the grandparents' inheritances already either used up or already dispersed among the kids to help them in their troubles, and no-one with any savings. The slimming has just jumped, this summer and fall, from fashionable gauntness to near starvation.

~looks upwards at comment~

Ooops, sorry for the doomsday pronouncements. Most people are not in this depth of bad shape.

But a lot are.


John M said...

(Hi Noni!)

OSO, I'm in a mood for attempted car metaphors after that Herbie Goes Bananas event Tuesday when VW momentarily had the world's highest market cap -- and that must have handed a bunch of the Dark Pools of Liquidity gang their heads in their hands to play with. Truly the Mother of All Naked Short Squeezes.

Anyway, think of the Fed's target rate (now at a near-ZIRP 1.00 percent) as a steering wheel. A very important component before you hit the wall, but once the fender's been caved in you need a qualitatively different set of tools and controls.

All the best!

One Salient Oversight said...

I think you're both right AND wrong here Noni.

There certainly has been a fall in costs and your story of thrift shops is not just anecdotal.

But where is all this stuff coming from? Where does Wal-Mart and other places get the bargain basement low-qual stuff?

They get it from China.

And China has a very large current account surplus while the US has a very large current account deficit. China sells goods to America, and then uses the profit to invest in America to ensure they keep buying their goods. It's a mercantilist situation that mirrors that of Japan.

But if that's the case, then the US Dollar is overvalued in comparison to the Yuan and the Yen. That means that while US prices may be going down for a lot of goods, the value of American's money is going up in relation to the rest of the world. It's not deflation, in other words, it's the inflation of the dollar.

And now what has happened? The debt market that is the US economy is now imploding. With it will be pain and suffering for international investors. But so too I believe with the US Dollar.

Which is why I think the US Dollar will crash at some point. And when that happens, you'll have an inflationary depression.

One Salient Oversight said...

once the fender's been caved in you need a qualitatively different set of tools and controls.

I don't know. Inertia is important. It can continue to drive the car forward... and damage it even more!

Noni Mausa said...

Hi John, hi OSO,

I agree Neil, two shifts happened at once: the stalling of American salaries, and the shifting of product sourcing from USA to China and other nations. The two dynamics (I don't know which led the way) circled each other downwards. At the same time Americans stepped up their hours and jobs worked, and the number of adults in the workforce.

And where is the "stuff" coming from? Excellent question. A lot of thrift shop stock literally is imported from the past, being 5 to 30 years old. This stuff, at least in my household, is purchased, serves its purpose for a span of time, and then goes back to the secondhand. I am still wearing favorite 2ndhand sweaters and jackets that I've had 15 years or so. The dozens of 2ndhand stores in my town constitute a kind of a Sargasso Sea of home furnishings.

There have been news articles hinting that the influx to that sea is beginning to thin out. Also, a new phenomenon called FreeCycle has grown hugely, whereby people just give each other things when they are tired of them. This will likely have an effect too. I expect a lag of around 5-10 years -- that's how long it takes before new goodies like computers or hand held CD players drift down into thrift shops.


John M said...


We recycle ;-)

I've reposted this article here. My blogging partner twist has put up some extraordinarily popular posts in the last 48 hours, so hopefully a few of our readers will take the time to try your effort, too.

John M said...


My grandson just turned one at NDG Montreal, and let me tell you the kids would have been in bad shape without "FreeCycle," although I don't think they call it that.

You push the kid around the neighborhood in a stroller, you meet strollers. Give to the parents of younger kids, receive from the parents of older kids. No money, no fuss -- it's a survival skill for their generation.

Noni Mausa said...

FreeCycle is a real thing, there's more about it here http://www.freecycle.org/

"On May 1st, 2003, Deron Beal sent out the first e-mail announcing The Freecycle Network™ to about 30 or 40 friends and a handful of nonprofits in Tucson, Arizona...

...Beal set up that first Freecycle e-mail group in a way that permitted everyone in Tucson to give and to get. Freecycle was off and running...

The Freecycle concept has since spread to over 85 countries, where there are thousands of local groups representing millions of of members -- people helping people and "changing the world one gift at a time." As a result, we are currently keeping over 500 tons a day out of landfills! This amounts to five times the height of Mt. Everest in the past year alone, when stacked in garbage trucks!"

Quite a successful project. Just in this past summer I received a stove, a dining room table, a funny movie on tape, a Powerpoint manual, and a inkjet printer. (There's more, but memory refuses to bring them up.) I have given away a vacuum cleaner, a lamp, a teapot and sugar and creamer, an older piece of software, a bookshelf stereo, Trivial Pursuit with two extra boxes of questions, and a gallon of ice cream. A big bookcase will be going soon.



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