Sunday, 19 October 2008

Recession or depression?

It is entirely superfluous to argue here that Britain, the US and Europe are heading into a recession - every media outlet proclaims it. But the issue is whether this is going to be an economic recession (a cyclical downturn of moderate length followed by a recovery taking the economy to a higher level - as seen most recently in 1973, 1979, and 1991) or whether there is going to be a depression (an economic downturn which is not followed by recovery taking the economy to a higher level in a medium time frame - of the type seen most severely in the world economy after 1929, or, on a lesser scale, in Latin America in the 1980s).
Although the beginning of the financial crash is genuinely on a 1929 scale nevertheless the overall balance of probabilities is that this will be a very nasty recession and not a depression. The reason is that in 1929 the world economy had been severely weakened by World War I. The percentage of investment in GDP in most countries, and above all in the world's most dynamic economy of the time, the US, had never recovered to pre-war levels. The financial crash of 1929 kicked in the door of a structure that was already rotting.
The world economy today is in a different state. The Asian economies are genuinely dynamic. Therefore recession followed by recovery is the most likely scenario.
There is, however, an important risk. The outcome of this financial crisis will see a major reduction of the weight of the US in the world economy and therefore in world politics. It is possible that the US, in an attempt to stave this off, will engage in irrational actions that can prevent world economic recovery.
After 1929 the decisive role in making it impossible to recover from the financial crash was the US Smoot-Hawley Tariff Act - which very sharply raised tariff rates. This sundered the world economy into a series of competing economic and/or political empires protected by tariff barriers - US, British, German, French etc. The combination of the 1929 crash and the Smoot-Hawley Act led to a 66 per cent fall in US imports and 61 per cent fall in US exports. Unable to operate on a world scale, economies remained trapped behind these barriers with the world locked in depression. Only World War II overcame this fragmentation of the world economy and created a new framework in which growth could take place.
It is unlikely, although possible, that in this recession the decisive issue in the US will be tariffs - but to date even the most protectionist current proposals are mild compared to the catastrophic consequences of Smoot-Hawley. But in the financial sphere actions by the US that could shatter the unity of the world economy, and produce depression, are not inconceivable.
The real content of financial globalisation in the last twenty years has not only been greatly increased financial and capital flows between countries but a large net inflow into the US.
The United States' $700 billion a year balance of payments deficit requires an inflow of almost $2 billion a day into the US to offset it. This build up of huge international holdings of US debt is one of the main features of the present international economic situation.
As long as the capital inflows were into the United States US governments were content with that situation. If, however, confronted with decline in the price of dollar assets, the net financial and capital flows became out of the US then there might be, in extremis, intervention to try to limit this - through capital controls, partial defaults/bankruptcies, or other measures.[1] In that case the resulting fragmentation of the world economy could produce a depression - other measures that could produce the same effect are also conceivable.
For these reasons, while sharp recession is the most likely outcome of the present economic situation, desperate attempts by the US to stave off the inevitability of its relative decline are the wild card that could threaten something worse. Strengthening co-ordination of the non-US economies, in particular the major economic centres of Asia and Europe, co-operating with Latin America and Africa, is necessary to counter-balance this risk.


[1] The city of New York was on the verge of bankruptcy in 1975. Several US states, led by California, are under severe financial pressure already before the recession has seriously begun.


Bemused Economist said...

Yes, the US has recently been using its enormous military to try and make up for its economic decline - the oil grab in Iraq is the obvious example.

As you say, the last time we had a crash on this scale it took a world war to sort it out. Fortunately another one is unlikely. The US would have to confront both Russia and China - but both have nuclear weapons, and despite Bush's attempt to build an anti-nuclear shield, M.A.D. still applies.

Alun Griffiths said...

A good example of the interelations between the war in Iraq and their economy being the Financial Times reporting today that Haliburton is doing well!

Bernanke comments give lift to Wall St
Oct 20 2008 21:47
An easing of strain in money markets, better-than-expected figures from Halliburton and testimony from Ben Bernanke helped Wall Street stocks begin the week in upbeat fashion