Wednesday, October 08, 2008

What Lies Ahead: Recession or Depression?

There is an old aphorism that when your friend loses their job, it is a Recession but when you lose your job, it is a Depression.

In fact, the term “Depression” has almost gone out of use now, except for referring to a psychological state, or, in historical reference to the “Great Depression” of the 1930’s.

Prior to 1929, there were a number of “depressions”, but since the Great Depression, we don’t even use this “D” word anymore. In fact our governments and economists have mostly avoided the word “recession” as well. However, now everyone concedes that we are experiencing a full-blown global recession, at minimum.

But might we be plunging into something worse than a recession?

Since the 1930’s governments have used three methods to contain economic downturns:

· Fiscal stimulus based on the theory developed by John Maynard Keynes, a British aristocrat-economist who advocated major government intervention to manage recessions and depressions. He recommended tax cuts and/or more deficit spending to give consumers the ability to spend and thus to restore a general sense of confidence in the economy.

· Monetary stimulus which also was strongly advocated by Lord Keynes, but later considerably refined by University of Chicago economist Milton Friedman, who greatly influenced the development of Macroeconomics. Milton Friedman argued that monetary growth needs to carefully pace productivity growth and consumer demand, or else inflation becomes rampant, since excessive expansion of the money supply is inherently inflationary. His theories enabled developing world countries suffering from hyperinflation to stabilize their currency and to achieve balanced growth. Now Friedman’s officially enshrined concepts guide the European Central Bank in setting their monetary targets.

· Managing consumer and market psychology. This is the favourite technique of all modern governments. I would love to attribute this populace control method to Machiavelli, but there is considerable evidence that spin control was already well understood thousands of years ago by Chinese and Roman emperors.

If I were an academic, I would love to write a book on the thesis that American governments since the 1980’s have been trying to stamp out recessions permanently, but regrettably without success.

Instead, they have created an unhealthy economy where excessive monetary and fiscal stimulus produced unnaturally high growth of the housing and stock markets. This paved the way for the current global financial meltdown. (This ill advised policy was more fully described in my blogs last January and February.)

We are now likely plunging into a global depression. Time will tell if it will become a great depression on the scale of the 1930’s, rather than like the more ordinary-sized depressions of the 19th Century.

From my experience as a banker and CFO, I doubt that the global capital markets and financial institutions can be fully repaired in less than three to five years. Meanwhile, companies will have little access to either credit or to new capital. Industrial production will soon suffer drastically, as is already evident with automobile sales declining for lack of credit.

This crisis has now become much, much more than a “subprime mortgage” problem, although that may have been the trigger. Banks are starting to fail worldwide and central banks are desperately offering billions in fresh credit (printing money) to stave off a complete financial shutdown. So fasten your seat belts. This may be the mother of all bumpy rides.

Far too little has being written about this impending depression in the mainstream press, but I suggest reading an article published October 5, 2008 by Tony Jackson, in the Financial Times of London “Parallels with 1929 highlight need for radical thinking” (http://www.ft.com/)

But don’t panic. Our ancestors lived through worse crises successfully many times. We currently enjoy a standard of living unparalleled in world history. If necessary, many of us could cut our expenditures by a quarter, which is probably what we will need to do for several years. Communities and families need to work together to alleviate suffering for those hit the hardest.

We must find ways to restructure our economy on a more reasonable basis. The recessions that were avoided during the past few decades by excessive government intervention would have made industrial and financial restructuring more gradual. However, now we need to do it aggressively, depending on massive government guarantees. Our challenge is to put our financial and business structures back together right.