A recent article from Paul Krugman in the New York Times argues that the world is already in a depression. He points to high unemployment in the United States and Europe, austerity packages and the decimation of economic growth.
It’s familiar territory for Krugman. Back in 2009, he posited that the world economy’s economic indicators showed we were half way towards the 1930s depression.
Krugman notes – correctly – that depressions experience ebbs and flows. They are not linear phases of constant decline. They have periods of growth. In 2010, Krugman argued we were in the “early phases of a third depression”, which may threaten democratic governance itself. In 2011, have we turned the corner, or are things getting worse?
How did we get here?
Glad you asked. In his seminal 1973 work, The World in Depression 1929–39, the great financial historian Charles Kindleberger outlined his theory of hegemonic stability as a counterpoint to Keynesian and monetarist explanations of the Great Depression.
Essentially, it goes something like this: international financial, economic and political stability requires a dominant, hegemonic power to provide international public goods. These goods include an international security system (the Royal Navy and Britain’s position as a “balancing” power, whose decision to intervene in a military conflict would prove decisive); a stable and efficient monetary system and central banking authority (pound sterling backed by gold, in combination with the Bank of England); and a free trade system (zero tariffs in Britain from 1860) that encouraged other countries to reduce trade barriers. Recent research even suggests the UK ran its colonial empire at a loss.
This worked out just fine until 1914. Then the Great War took over, Britain floated the world’s first-ever billion-pound loan, driving up its burgeoning sovereign debt (sound familiar?), then promptly went broke when the war ended.
In 1919, Britain was willing, but unable to remain the world’s provider of international public goods. The US – now the world’s largest creditor – was able, but not willing, to step into the breach.
Kindleberger argues that the 1919–39 period is characterised by a lack of hegemonic stability. This means no country was willing and able to assume the role Britain had played from 1815–1914 throughout the pax Britannica.
What transformed the 1929 crash into a full-blown international financial crisis in 1930 were bank runs. The Bank of England, together with other European central banks, guaranteed an Austrian 50 million schillings ($US7 million) loan. This bridging loan worked for several months until France began swapping its sterling into gold (in effect, its own run on the Bank of England’s gold assets). Meanwhile, German depositors began raiding the major banks. The cumulative cause was lack of confidence, resulting in contagion and, ultimately, collapse.
The seeds of the depression were discernible in 1919. They just took 10 years to develop into a global financial crisis. In the 1920s, the US was unwilling to act as a global creditor (“they hired the money, didn’t they?” was President Coolidge’s unsympathetic response to British and French war debts), while Germany, as Keynes famously complained in The Economic Consequences of the Peace (1920), was effectively cast out of the global economy by a combination of exhausted gold holdings, punitive reparations and hyperinflation as the Reichsbank simply printed marks to pay debt.
Monetarists versus Keynesians
Why do recessions turn into full-blown depressions? For both Keynesians and monetarists, the length and depth of a downturn is wholly attributable to government policy.
For monetarists, depressions are the result of excessively-contractionary monetary policy, allowing the volume of money in circulation to shrink. For Keynes and his disciples, deep interest rate cuts (monetary policy again) are needed to encourage consumer spending, rather than savings. In short, corporate profits, driven by consumption, will spur growth.
Kindleberger offers a third explanation: the necessity of a single power willing and able to lead and take responsibility for long-term credit lending; to act as a lender of last resort; to coordinate macroeconomic policies; and to maintain an open trading system. From 1944 until 2008, the US assumed this responsibility, providing non-excludable international public goods to the global economy.
Arguably, in 2009 Washington was no longer able to assume these responsibilities. Instead, the US saturated its own financial and manufacturing sectors with over $US8.5 trillion in bailout commitments in 2008–09, double the inflation-adjusted cost of World War II to the US economy.
These loans to major US banks by the Fed were enacted covertly and were repaid with virtually no losses. This sum dwarfs the $US700 billion devoted to the Troubled Asset Relief Program (TARP) and the $US787 Obama stimulus combined. And these rescues and stimuli have kept the global economy alive, but comatose.
Are we in a depression?
Well, no. Not yet. Unemployment in the US isn’t 25%, it’s under 9%. US GDP has not slumped 33%; in fact, there is now modest growth. The Dow Jones and Nasdaq are bearish, but the 34% loss in value of the Dow in 2008 palls in comparison with the 89% collapse of Wall Street prices in 1929–1932. The Dow is well above 10,000 points – in fact, nearly 12,000 as of mid December. CPI is flat as price deflation feeds into cars, computers and petrol.
True, at the margins, workers have seen their jobs vanish and estimates suggest two million Americans have fallen through the cracks, leading to a rise in homelessness and the opening of more soup kitchens. The US auto industry, whose virtual collapse in 2008 promised to turn manufacturing centres like Detroit into ghost towns, is still very much in recovery mode. This is not a jobless recovery, but new jobs are still slow in coming.
Meanwhile, the situation in Berlin is serious, but not hopeless. German unemployment isn’t 15%, Moreover, German exports are still going gangbusters. Bundesbank reserves are over 300 billion euros. Inflation is not an issue.
Unlike 1929–33, government and central bank action is now coordinated. An orderly dollar credit swap took place between the US Fed and the European Central Bank early in December. China and Taiwan cut their bank reserve ratio requirements, while Beijing has allowed the yuan to appreciate slowly to avoid importing excessive inflation.
Ghosts of 1929
The lessons of the Wall Street Crash and the Great Depression are seared into the mentalities of European and American central bankers and economic policy makers. After World War II, billions of dollars in Marshall aid bankrolled European reconstruction, in stark opposition to what had happened after World War I. The prescription was Keynesian and the watchword was – and remains – liquidity, liquidity, liquidity. Rinse and repeat.
The Black Monday stock market crash of 1987 saw the hard-earned lessons gleaned from 1929 applied: the US Federal Reserve intervened in the largest one-day fall on Wall Street and ensured there was adequate liquidity in the system. Each time the US Fed has done this (in 1987, 1998, 2003 and 2009), there has been a sluggish rebound – just enough to keep markets trending in positive territory.
Compare this with 1929–33. In 1929, everyone dumped shares on Wall Street on Black Friday (J.P. Morgan bought up briefly on Day Two to instil confidence in the market, then shamelessly profited following the brief stock rally). The Hoover administration slashed its budgets savagely, raised the top tax rate significantly, and allowed the Smoot-Hawley tariff act to pass in 1930, which decimated global trade for the next 10 years.
Subsequently, US foreign trade fell by an astronomical 70% by 1933. Figures for Britain, France and Germany were similar. Even US–Canada trade collapsed as countries engaged in retaliatory tariff measures. Trade, the life-blood of the international economy, was rudely cut off.
Fast forward to 2011. True, there’s still no Doha Round World Trade Organisation (WTO) deal in sight (negotiations commenced in 2000, but have been dormant since 2008), but world trade has functioned fairly efficiently since the conclusion of the Uruguay Round in 1994. What has really caused a trade and financial imbalance (and a significant proportion of US, Japanese and EU indebtedness) has been China’s rapid emergence as the world’s largest exporter since its admission to the WTO in 2001.
Indirectly, China’s productivity, export boom and willingness to purchase swathes of debt in the form of sovereign bonds fuelled the credit boom and deficit spending of the US, EU and Japan.
Commentators who charge that China needs to stop saving and start consuming are right, because while structural disequilibrium in the global economy persists (meaning China saves and the West consumes), the sovereign debt issue threatens to drive the world into depression if markets get spooked and start to punish governments and banks savagely for their former profligacy.
If that happens, start stocking up on tinned soup. Because there isn’t any money left in the kitty to engage in any more massive bank rescues.
A China that spends would go some way towards alleviating this imbalance, as well as possibly rescuing the global economy from an extended recession. Beijing would win as well, as it prevents its own export markets from sinking into oblivion.
But to return to hegemonic stability theory, Kindleberger is right: the system needs a leader, a hegemon, that is willing and able to provide international public goods. China is neither willing nor able to fulfil this function. Its economy is scarcely larger than Japan’s. The US Fed, and its ability to extend long and short-term credit to ensure liquidity in global markets is our best – possibly our only – bet.
For those groping for ways to save the moribund world economy from depression, take some encouragement from Keynes. While on his deathbed, he despaired of the British economy in 1946, questioned his own solutions, and returned to a concept he had rejected throughout his career: the self-equilibrating power of the “invisible hand” of the market.