The Second Great Depression Delayed?

For all the bad economic news out there in the US and Europe (I'll call them, admittedly imprecisely, "the West" or "western countries") these days, most people are at least still relieved that unemployment in most western countries has not reached the levels it reached in the Great Depression and that things are far less dire than they were back then. But are we really out of the woods?

What saved us from Great Depression II was a huge bout of monetary and fiscal stimulus. When the Crash of 1929 happened, people feared that central banks would abandon their commitments to convert paper money to gold at the promised rate. This caused a rush into gold. To attract people away from gold, and to assure them that the dollar, for example, was "as good as gold," the Federal Reserve and other central banks ratcheted up interest rates, offering to pay a lot of interest on paper money -- but obviously not on gold. In order to do this, they also had to demand a lot of interest on loans (the difference between the money a bank receives from loan interest and the interest rate it pays to depositors is how a bank makes money, so it can't raise deposit rates much without raising loan rates).

This meant borrowing money became almost completely unaffordable -- no new business ventures then. It also meant that spending money became less enticing, since you could make money by squirreling it away. This meant money flowed into gold, perhaps other commodities, and various forms of saving. It flowed out of buying stuff and investing in future business. Business that relied on the latter two (that's most business) therefore collapsed. This brought down any other businesses with it.

This "monetary tightening" as it's called was accompanied by fiscal tightening. Governments received less in taxes because people were getting poorer -- so they raised taxes and cut spending, hitting people even harder in their wallets and depressing growth further.

This time around, luckily, the reaction was the opposite. Unhindered by the straitjacket of the gold standard, central banks slashed interest rates to try to make borrowing and spending easier and to discourage saving. That's meant to keep the economy moving. In addition, governments responded to the crisis by spending more and either taxing less or at least just letting tax revenues fall without raising taxes. This is fiscal and monetary stimulus. Disaster averted.

Or at least it was. We're now getting into a sticky situation that is getting governments constrained in ways that have similar effects to those of the 1930s. Governments throughout the "West" are either cutting deficits or talking seriously about it. Fiscal tightening is therefore underway or will begin soon. This is partly because governments can't run deficits forever. At some point, the investors that lend money to governments begin to worry that these governments will not be able to pay them back as agreed. Governments have to offer higher and higher interest rates to make investors willing to take this risk. This makes government spending more expensive and less attractive.

(By the way, "investors" include anyone with a bank account or retirement fund.)

So fiscal stimulus is disappearing, at least we still have the monetary sort, right? Well, this is partly true. The Federal Reserve has said it will keep interest rates at around 0% for as long as is necessary. The Bank of England (the UK's central bank) has just announced another round of what is called "quantitative easing," in which the bank buys government and even corporate bonds to make borrowing and spending cheaper and further discourage saving.

There are some forces working in the opposite direction, too, however. First of all, with inflation lower and therefore less of a worry in the US than in the UK, we might expect the Federal Reserve to follow the Bank of England and embark on a third round of quantitative easing as well. This is unlikely for political reasons: even though core prices in particular have remained stable and are rising only slowly, Republican politicians especially are railing against the Fed for allegedly destroying the dollar. Not only that, international investors in the dollar are also protesting loudly, concerned that a decline in the value of the dollar will destroy their investment. The European Central Bank (ECB) is also constrained from taking more bold measures by similar political pressures, mostly from monetarily conservative Germany.

So central banks are being restrained. At least interest rates are not set to go up, right? The thing is: borrowing is getting more difficult, whether interest rates are rising or not (though often they are). This is because individuals and most corporations cannot deal directly with their central bank. Central banks can print money, other banks can't. This is mostly a problem in Europe. As panic spreads concerning European governments' (in)ability to pay what they owe bond investors (many of whom are banks), investors are also starting to demand higher interest rates from banks, too. The banks, in turn, are scared about what would happen if some European governments (like Greece or Italy) didn't pay them back. Their reaction is to lend less money and to raise rates on loans (remember that a bank must demand higher rates if it also costs it more money to borrow, whether from depositors or investors buying its bonds). This is gumming up the wheels of business in a way not unlike that of the 1930s, though less dramatically.

So lending is partly blocked and governments are cutting spending and raising taxes. Still, lending hasn't stopped, trade barriers haven't gone up (a big 1930s mistake that intensified the Great Depression), and interest rates are very low overall. Plus, much the rest of the world is still growing fast, pushing things forward. All grounds for some guarded optimism. But: things may get worse. If Eurozone countries were to default on (not pay back) their debts or leave the euro (which would result in much the same thing happening), panic could ensue that would be similar to 2008. The difference, though, would be that central banks can't provide much more monetary stimulus (interest rates are already extremely low), and governments are (sometimes severely) constrained in how much additional fiscal stimulus they could provide. Their reaction to round two of "the Great Recession" might be less vigorous than to round one, and this one could end up being worse.

Alarmist? Yes, but this is not ludicrous. It's also far from inevitable, however. If governments in the US and Europe can get ahead of this thing, it can be managed without panic breaking out. Good thing we're all confident in our politicians, right?


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