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.