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2: How Bad Will It Be: Another Great Depression?

All through the present economic crisis, there has been constant reference and comparison to the Great Depression of the 1930s, which has largely been disregarded as melodrama and panic mongering - but it is entirely worthwhile to take a more sober and calculated look at past economic crises in America and abroad to see what lessons may be learned from past crises, and what actions might be borrowed from past recoveries.

The Myth of Economic Cycles

There have been economic fluctuations of sorts throughout human history, and even christian scripture speaks of cycles of seven fat years being succeeded by seven lean. In the agrarian era, there were fluctuations brought about by the quantity and quality of the harvest, and the belief in the capriciousness of supernatural powers that caused it to be so.

And while we no longer put faith in the supernatural, there are ample present-day pseudoscientific theories of natural causes that are no less capricious than the ancient gods: the dust in the atmosphere, sunspots, volcanic activity, the temperature of the ocean, and so on, that seek to explain some things by linking them to causes that themselves are inexplicable.

The common thread in all of this is that disasters are attributed events, supernatural or natural, that are beyond the power of human beings to prevent or correct. We are the victims of circumstance we cannot change, but can only watch and hope.

And the same sort of helpless despair carries over into economic analysis in the present day. In spite of the fact that the markets are entirely comprised by human activity, there is still the sense of a capricious and powerful force beyond our control or perception that causes it all to happen. Poppycock.

Since industrialization and globalization, the developed economies are no longer subject to the whims of a capricious deity, and markets are clearly the aggregation of voluntary human behavior. Natural disaster can cause temporary fluctuations in supply, but markets are driven by demand: there is a way to get whatever is wanted to whomever wants it, provided they are willing and able to pay the costs to have it.

A downturn in the market is not caused by the destruction of crops or buildings, but because demand does not rise to the level at which goods can be supplied. Given the efficiency of production and distribution, which yield the ability to produce and transport goods from anywhere they can be had to anywhere they are wanted, it seems puzzling that prosperity is fleeting, and the reason it should be so is lost in the complexity - feeding the superstitions of those who prefer a more mystical explanation.

That is to say that even while fluctuations in markets are man-made, they are caused by behavior of those whom we cannot see and over whom we have no direct influence. Moreover, the behavior a single individual is subsumed into the aggregate behavior of a market.

Subjected to statistical analysis, market behavior is given the appearance of clusters and waves that follow patterns and trends. Largely, this is because statistics is designed to identify clusters and waves that follow patterns and trends, and has a funny way of showing exactly what is designed to show.

That side, there's considerable doubt that patterns and cycles ever existed at all in the economy, or are merely the byproduct of an analytical paradigm that manipulates the evidence to prove its own premises.

But even in instances where there exists a plausible explanation for an economic cycle, such as the seasonal pattern of agriculture dictating the availability of raw materials, such cycles are largely defeated by the mass and scope of the economy.

For example, cotton is harvested in the fall in the northern hemisphere, but it is harvested in the spring in the southern, and can be grown and harvested year-round in the tropics. Not to mention that it can be accumulated in inventory to mitigate grander fluctuations, such that there is no time at which it cannot be had if it is in demand.

Beyond the annual variations in prosperity, there is the claim that there exist super-cycles that span many years, some as long as 60 or 80 year cycles of growth and retraction. This, too, seems to be a trick of mathematics without a plausible explanation in fact.

There is one aspect of this notion that is appealing: when major shocks occur, people learn from their mistakes and adapt their behavior (and change their institutions) in reaction, sometimes in overreaction. But in time, complacency sets in, theory forget the lessons of the past, and repeat its mistakes. This seems entirely plausible and sensible - and is born out in the examination of historical evidence.

In all, the notion of a predictable cycle - ordinary or super - has received far too much attention from economists. There are times of prosperity and times of disaster, but they do not follow a predictable trend or pattern, and occur as a result of human behavior that is not in lock-step with the alignment of the planets.

As such, the parallels drawn between the present crisis and the Great Depression are in fact repeating some of the mistakes of the past - but not because we are tied to an inexorable cycle of success and failure, but simply because memory fades and lessons are forgotten, only to be recalled after we have made the same mistakes yet again.

The Impact of the Great Depression

There is some conjecture about the precise beginning and ending dates of the Great Depression, but in general it is accepted to have been during the 1930s. It is highly significant that this was immediately after the period of rampant and unsustainable economic growth of the "roaring twenties" - just as the present economic crisis follows on the heels of the roaring nineties.

Described statistically, the economic disaster of the Great Depression was far more cataclysmic than the present recesson: GDP fell by 30%, unemployment rose to 25%, process dropped by 25%, housing slumped by 30%, and the stock market lost 80% of its value. In terms of magnitude, the present situation has not (yet) produced the same degree of devastation.

But recovery was equally swift. By 1941, two years after the end of the nominal depression, output regained the level at which it had stood in 1929, though the stock market did not recover its losses until 1954.

The depression was not solely an American phenomenon. Statistical indications are worse in Germany, and slightly less severe in Austria, Italy, France, Britain, Sweden, and other developing economies.

There are various reasons for the differences in impact. Chiefly, the economies that did not have a massive build-up in the decade prior were less impacted. Countries that had a floating currency, not married to a gold standard, were better able to mitigate. Various economic policies that are inhibitive to growth in times of prosperity also ameliorate loss in times of crisis.

(EN: The author acknowledges, but seems to understate, something I believe to be significant about the economic "disasters" - that in each cases the consequences are exaggerated by ignoring the period of hyperactivity prior. This is often best illustrated by the real estate example of a property worth $100K before the boom, $400 during the boom, and $150K afterward - if you look from the peak forward, you see a devastating drop in value, but if you look to the period before the crisis, there has actually been reasonable growth. The same is true of many economic indicators.)

What caused the Depression?

As with any major historical event, there is widespread speculation and no universally accepted answer as to its causes. The "arcane disputes" are often skewed by ideology, as each theorist focuses on the aspects that best correlate to their preconceptions, such that the argument is more indicative of the philosophy and psychology of the author than what actually happened. It's simply too multifaceted a problem to be analyzed from a single perspective.

From the author's own perspective, which may be as subjective as any others, four explanations seem to best describe the driving factors: falling asset prices, bank failures, fiscal policy, and protectionism. None of these were sole to blame and there were certainly other factors that contributed, but these seem the most prevalent and seem to have resonance today.

Falling asset prices

The stock market crash of 1929 was not a single moment: shares fell 30% in the fourth quarter of that year, and continued to fall over the next three years until the total loss was on the order of 80% - which in terms of magnitude was about 70% of one year's GDP.

It's still unclear how the crash contributed to the collapse of the economy.

In itself, a securities market is the effect rather than the cause of economic activity: the price of a company's stock does not cause a firm to be profitable, but rather the profitability of a firm is one factor that drives the price of its stock.

However, there is a feedback loop in which the value of a stock causes a firm to be regarded as more or less desirable, impacting its ability to borrow capital to finance its operations and the willingness of other firms to do business with it. If one stock in a market falls in value, the decreased valuation compounds its difficulties in recovering; but where all stocks in a market fall, there is no strong or reliable alternative to the single failing firm.

In terms of the financial markets, a crash in the market diminishes the capital held by investors. Aside of destroying personal fortunes, this means that there is less capital to invest in growth, and retrenchment causes atrophy.

A dramatic loss of investment capital echoes through markets: the inability to obtain a consumer loan for the purchase of a house means fewer people can buy homes, which leaves suppliers with a surplus of inventory in the face of low demand, which then causes prices to drop. Therefore we see that during the eight years between 1925 and 1933, housing prices fell by 30%

In the industrial sector, commodity prices also fall because of decreased demand. During the decade of the depression, oil and cotton prices fell by 80%.

Of course, this is all the market adjusting and attempting to find balance: decreased demand causes prices to fall to a level where goods become affordable again, but there is considerable damage along the way, particularly to those who have diminished income and diminished assets, meanwhile their contractual debt obligations have not diminished.

As a result, there was widespread default on long-term debt instruments, such as the mortgages on homes and farms, that could not be services once asset prices fell.

Monetary contraction due to bank failures

A great deal of importance is also given to the collapse of banks, as over half od US banks either went out of business or were taken over by other banks. Banks hold a significant amount of wealth in terms of consumer savings and working capital of businesses, and as there was no deposit insurance, the debacle reduced the money supply by 25%.

Then, as now, the perspective of the federal reserve was that this was culling the herd, weeding out the weaker banks was necessary to economic recovery, and so it took no action to support banks that failed. The current perspective of the Fed is that taking action could have significantly changed the outcome, reducing the depression to an ordinary recession.

There is the counterpoint that the failure of banks was a symptom rather than a cause: it's clear that banks had liquidity problems and could not meet their financial obligations - but one can also look at the credit side of the equation, to suggest that the contraction of the economy led to less demand for loans, not to mention less interest in extending loans at a fixed rate when interest rates were unstable, both of which reduced the ability of banks to earn income to meet their obligations.

Fiscal policy errors

A brief mention is made of Presidents Hoover and Roosevelt, who myopically considered that a balanced budget for the federal government was to be maintained - and as such, while they minded their own books, they undertook no measures that might have relieved the stress that would have negatively impacted government budgets.

It is widely imagined that Roosevelt brought the country out of the Great Depression, which is entirely mistaken. It did not really end until the US geared up industrial production to prepare for the second World War; and while Roosevelt enacted various programs, they were funded by raising taxes, placing an additional burden on a struggling policies.

It must be conceded that what could have been done, or should have been done, is speculative - but considering that government has since stepped in to ameliorate financial crises, it is fair to claim that failure to act exacerbated the crisis of that time.

The lurch toward protectionism

Economic protectionism, specifically in legislation such as the infamous Smoot-Hawley Tariff Act, was intended to protect the domestic economy from predation by raising tariffs on imported goods, thinking that it would make domestic products more competitive and spur production (jobs and trade).

The problem with this scheme is that it does not consider that other nations will retaliate with tariffs of their own, resulting in a decrease in international trade in any direction. Historical evidence provides support for this: between 1929 and 1932, world trade fell by almost 30%.

Trade restrictions are not a zero-sum game: cutting off the supply of cheap foreign goods does not create an increased demand for domestic goods in equal measure, and the amount extracted as taxes is not returned to the economy in equal measure. It is a war of attrition in which both sides lose.

The term "autarchy" describes an economic vision in which nations are entirely self-contained and consume domestic product, neither importing nor exporting. It is a significant step backward that loses the advantages of sourcing goods from locations that produce them more efficiently and selling them to locations that are willing to pay more.

That is to say, protectionism is always economically counterproductive to buyers, sellers, and producers of goods in both domestic and foreign economies, and was another exacerbating factor for the Depression.

The "Long Depression"

Governments and people in general have been highly attentive to economic data after the Great Depression, and paid little regard to it beforehand. As such, there is a great deal of economic data gathered after that event, but little data before it.

It seems reasonable to assume that there were economic highs and lows before data was gathered and analyzed, though historical evidence is scant. For example, there was the Long Depression that began in 1873 and continued for a period of 24 years, about which little is know, but much speculation is made on scant evidence.

The Long Depression is best seen as a prolonged period of decreased economic activity: output decreased and prices receded, currencies were devalued and gold was in short supply. Deflation in prices led to decreases in wages, and the resulting pay cuts and wage freezes fueled the rapid unionization of the workforce.

In the US, consumer prices fell by 30% during this era, and farmers were particularly hard-hit due to their lengthy production process (loans were taken to plant, based on forecast revenue from harvest, but falling prices caused the harvest to produce far less than expected).

In spite of this, the late nineteenth century is the period in which the US surpassed Britain to become the world's largest economy, such that the effects of the long depression in the US was merely a period in which increased production brought diminishing returns, but growth was still occurring.

Earlier recessions

Even less is known about earlier recessions (or depressions), though anecdotal evidence makes it clear that they had occurred.

The collapse of British banking in the 1820s is well known, and is generally described as the aftermath of excessively loose monetary policy and widespread investment in dreadfully ill-conceived business ventures.

The 1840s also saw the bursting of a speculative bubble in railway stock, akin to the IT boom of the 1990s. When railroad stocks and bonds turned sour, many personal fortunes were ruined, and the subsequent panic led to a series of bank and commercial failures.

In nineteenth century America, all but two recessions were associated with financial panics and bank failures. An investment boom in cotton, land, and canals in the 1830s was followed by a crash; and the US stock market lost 66% of its value between 1850 and 1857.

Postwar economic cycles

The author is dismissive of postwar recessions: they have generally been "fairly tame affairs" with single-digit impacts and a duration of only about ten months.

Large-scale military endeavors such as the first and second World Wars had significant impacts on the American economy, and a lesser impact on the economies of other countries, but there has not been any event of comparable size since.

Postwar recessions were generally associated with rising inflation and significant increases in interest rates due to an increase in demand for consumer goods as soldiers return home and rejoin the domestic economy.

(EN: I suspect that not all postwar experience conforms to the American pattern, particularly for the nations who were on the losing side of a conflict.)

Given that military conflicts since WWII have been relatively small scale, the economic aftershocks have been barely a tremor - and while it is popular to propagandize the present military conflicts as a contributing cause of economic woes, they are far too paltry to have an impact.

As such, the current crisis is "more nineteenth century in character" and the military factor is virtually irrelevant.

Japanese lessons

It's suggested that the Japanese experience during the "Lost Decade" of the 1990s provides a more recent and relevant example of economic turmoil.

While the GDP of Japan did not suffer a significant loss and consumer prices remained stable, asset prices were disastrous: land prices fell by about 70% and asset values diminished by 80%. Of course, these catastrophic drops followed equally dramatic growth in the decades prior - a bubble in multiple asset markets that drastically inflated both property and equities.

It's widely held that Japanese authorities were woefully incompetent in managing their economy. They were slow to recognize the problem and hesitant to implement policy measures to mitigate it. Authorities followed a Keynesian philosophy, cut interest rates to zero, and expanded the money supply, none of which were very successful.

But little hope can be taken from the Japanese recovery: it pulled itself out of the slump in the context of a world economy that was generally strong and was helped enormously by the "miracle on its doorstep" in the form of the economic growth in China. Neither of those can be counted on to reverse or mitigate the present crisis.

Scandinavian lessons

Another lesson might be taken from the Scandinavian experience of banking-induced recession in the 1990s - it is suggested that the crisis could have been much worse but for the "speedy, sensible, and bold" reaction of the governments and central banks of Norway, Finland, and Sweden.

Specifically, the central banks moved rapidly to persevere liquidity while governments intervened to manage the troubled assets of banks that were nationalized to prevent them from failing.

The cost of doing so was significant, consuming 9% of the Finnish GDO, though it's noted that the governments were able to recoup this cost through the sale of assets after the crisis had passed. While it resulted in short-term hardship, the estimated net costs to the taxpayers who funded the bailout are reckoned to be lower than if the action had not been taken. In fact, the Swedish government nearly broke even and the Norwegians actually made a profit.

Governments in America and other European countries followed a similar pattern - but again, their situations were somewhat different. The Scandinavian economies are very small and easier to manage, they had the ability to devalue their currencies to gain competitive advantage in manufacturing and exports, and the world economy was generally strong otherwise.

Comparisons with the Great Depression

All things considered, it does seem that the Great Depression is the most accurate historical event to which the present crisis can be compared. While there is a significant difference in the degree of the consequences, both occurred during times of peace, had their root in asset price bubbles, involved serious issues in the banking and finance sectors, and are global phenomena.

The author briefly mentions the risk of a resurgence of protectionism, which will exacerbate the problems: the Doha trade talks have balked at lowering trade barriers, there is a prominent return of "buy American" rhetoric, there are protectionist stirrings in China and the EU, and banks and investment firms are shying away from foreign markets.

But from today's perspective, the traditional paradoxes prescribed to stimulate economic activity - cutting interest rates while increasing the money supply, decreasing government spending while reducing taxes - seem superficial and oblique to the causes of the problem. Interest rates are virtually nothing worldwide and the means for "quantitative easing" are largely tapped out. It would seem that more of the same would ultimately become counterproductive.

Differences from the 1930s

While the Great Depression is the closest historical event to the present crisis, there are some significant differences that should not be overlooked.

Primarily, the market itself is much larger and more mature than it was in the 1930s, which has proved to be stabilizing. If some firms fail, there are many others to step into the void to fulfill their function; if some customers retract their spending, there is still enough spending in aggregate to provide sufficient demand to sustain suppliers.

Policymakers have also been far more proactive in the present crisis. The governments in the world's largest markets (US, Europe, and China) have all been attentive, if not perfectly effective, to mitigate the crisis. Central banks have cut interests rates aggressively, and have maintained near-zero rates in spite of the panic, and have protected the assets of depositors against bank failure.

More to come

The most worrisome questions are about the future - how deep and how long will this downturn be? Truth be told, no-one knows what the future may hold. "Common opinion, both expert and popular, may be just as bad at anticipating the recovery as it was in spotting the downturn in the first place."

In recent years, there is some indication that the world economy is recovering, and in spite of this there are those who believe it to be a temporary reprieve and that the situation will get worse. This is possible if those who are acting to mitigate the crisis (world leaders and the common consumer) change their behavior.

Because the crisis began in the housing market, it is tempting to believe that market will be the harbinger for economic recovery, and given that it has stabilized, this indicates the crisis itself will stabilize. However, this is simply an assumption. Housing prices were only one factor in the crisis, and just as this market did not alone create the crisis, neither will this market alone solve it.

The infection has spread throughout the economic system. Soaring real estate prices, coupled with easy credit, created a massive of debt that was not repaid. Poor liquidity and tight credit cause a decrease in loans and investment; the disappearance of capital caused a decrease in consumer spending; and the two together caused unemployment to rise, weakening consumer income and consumer confidence. This lead to reduced demand for goods and services, and so on.

There are ample signs that there is more to come:

There is no reliable way to predict how each of these problems will be addressed, if at all, and the attention seems to be focused on damage control rather than planning for the future. So whether there is more to come depends on how each of the precipitating systems is addressed or neglected.

So while it seems that the actions taken to date have mitigated some of the symptoms, we cannot be sure how effective those policies will continue to be, or if they will be abandoned, and there s still ample opportunity to make more major mistakes.

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