Monday, October 12, 2009

One Economist's Argument For The Coming Great Depression

The mood on Wall Street and at the Fed are pretty optimistic that a recovery is ready to take place. However, Economist Thomas Palley argues that the massive deleveraging by consumers and government will soon lead to a double-dip recession which could possibly spiral into the Great Depression II. See the following post from Economist's View to learn more.

Let's hope Thomas Palley, who says "a second Great Depression remains a real possibility," is wrong. My best guess is that he is (though I don't expect a quick recovery, particularly for labor). But I suppose I "should never underestimate the destructive power of bad ideas":

A second Great Depression is still possible, by Thomas Palley, Commentary, Economists' Forum: Over the past year the global economy has experienced a massive contraction, the deepest since the Great Depression of the 1930s. But this spring, economists started talking of “green shoots” of recovery and that optimistic assessment quickly spread to Wall Street. More recently, on the anniversary of the Lehman Brothers crash, Ben Bernanke, Federal Reserve chairman, officially blessed this consensus by declaring the recession is “very likely over”.

The future is fundamentally uncertain, which always makes prediction a rash enterprise. That said there is a good chance the new consensus is wrong. Instead, there are solid grounds for believing the US economy will experience a second dip followed by extended stagnation that will qualify as the second Great Depression. ...

There is a simple logic to why the economy will experience a second dip. That logic rests on the economics of deleveraging which inevitably produces a two-step correction. The first step has been worked through, and it triggered a financial crisis that caused the worst recession since the Great Depression. The second step has only just begun.

Deleveraging can be understood through a metaphor in which a car symbolises the economy. Borrowing is like stepping on the gas and accelerates economic activity. When borrowing stops, the foot comes off the pedal and the car slows down. ...

With deleveraging, households increase saving and re-pay debt. This is the second step and it is like stepping on the brake, which causes the economy to slow further, in a motion akin to a double dip. Rapid deleveraging, as is happening now, is the equivalent of hitting the brakes hard. ...

The US economy has hit a debt iceberg. The resulting gash threatens to flood the economy’s stabilising mechanisms, which the economist Hyman Minsky termed “thwarting institutions”.

Unemployment insurance is not up to the scale of the problem and is expiring for many workers. That promises to further reduce spending and aggravate the foreclosure problem.

States are bound by balanced budget requirements and they are cutting spending and jobs. Consequently, the public sector is joining the private sector in contraction.

The destruction of household wealth means many households have near-zero or even negative net worth. That increases pressure to save and blocks access to borrowing that might jump-start a recovery. Moreover, both the household and business sector face extensive bankruptcies that amplify the downward multiplier shock and also limit future economic activity by destroying credit histories and access to credit.

Lastly, the US continues to bleed through the triple hemorrhage of the trade deficit that drains spending via imports, off-shoring of jobs, and off-shoring of new investment. This hemorrhage was evident in the cash-for-clunkers program in which eight of the top ten vehicles sold had foreign brands. Consequently, even enormous fiscal stimulus will be of diminished effect.

The financial crisis created an adverse feedback loop in financial markets. Unparalleled deleveraging and the multiplier process have created an adverse feedback loop in the real economy. That is a loop which is far harder to reverse, which is why a second Great Depression remains a real possibility.
This post has been republished from Mark Thoma's blog, Economist's View.

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