Thomas Palley: A second great depression still possible.

This is no doubt a minority view but Palley argues that there could very well be a second dip. Palley argues that deleveraging will involve saving and paying off debt which militates against spending that would stimulate the economy. Also, the government will gradually ease stimulus spending which also could increase debt. Of course as the article notes programs such as cash for clunkers just temporarily increase sales and this is followed by a huge slump during the next period.Thoms

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A second Great Depression is still possible
October 11, 2009 4:37pm
by FT
By Thomas Palley
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. Some indications to this effect are already rolling in with unexpectedly large US job losses in September and the crash in US automobile sales following the end of the “cash-for-clunkers” programme.
That rosy scenario thinking has returned to Wall Street should be no surprise. Wall Street profits from rising asset prices on which it charges a management fee, from deal-making on which it earns advisory fees, and from encouraging retail investors to buy stock, which boosts transaction fees. Such earnings are far larger when stock markets are rising, which explains Wall Street’s genetic propensity to pump the economy.
As for mainstream economists, their theoretical models were blind-sided by the crisis and only predict recovery because of the assumptions in the models. According to mainstream theory, it is assumed that full employment is a gravity point to which the economy is pulled back.
Empirical econometric models are equally questionable. They too predict gradual recovery but that is driven by patterns of reversion to trends found in past data. The problem, as investment professionals say, is that “past performance is no guide to future performance”. The economic crisis represents the implosion of the economic paradigm that has ruled US and global growth for the past thirty years. That paradigm was based on consumption fuelled by indebtedness and asset price inflation, and it is done.
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. However, the car’s trunk is now weighed down by accumulated debt so economic activity slows below its initial level.
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 only positive is it reduces debt, which is like removing weight from the trunk. That helps stabilise activity at a new lower level, but it does not speed up the car, as economists claim.
Unfortunately, the car metaphor only partially captures current conditions as it assumes the braking process is smooth. Yet, there has already been a financial crisis and the real economy is now infected by a multiplier process causing lower spending, massive job loss, and business failures. That plus deleveraging creates the possibility of a downward spiral, which would constitute a depression.
Such a spiral is captured by the metaphor of the Titanic, which was thought to be unsinkable owing to its sequentially structured bulkheads. However, those bulkheads had no ceilings, and when the Titanic hit an iceberg that gashed its side, the front bulkheads filled with water and pulled down the bow. Water then rippled into the aft bulkheads, causing the ship to sink.
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 haemorrhage of the trade deficit that drains spending via imports, off-shoring of jobs, and off-shoring of new investment. This haemorrhage 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.
Thomas Palley is former chief economist of the US-China Economic and Security Review Commission and is currently Schwartz Economic Growth Fellow at the New America Foundation

No Depression just recession.

This is the conventional wisdom but the conventional wisdom not long ago was that the securities that are now virtually worthless had great ratings. That is why all those banks now taking billion dollar writedowns bought them. How reliable are the ratings of the chances of depression by conventional economists? It is true that the conventional theology about not interfering in markets that helped fuel the Great Depression has been thrown overboard this time.The same conventional economists who in normal times trumpet the virtues of the market unsullied by government intervention are now trumpeting the virtues of government intervention to cut interest rates and to stimulate the economy. But this could very well cause problems itself such as inflation especially when combined with humungous expenditures on war and the military.


NY Times, March 23, 2008
The Nation
Depression, You Say? Check Those Safety Nets
By CHARLES DUHIGG

The stock markets are spiraling like whirling dervishes, one of the
nation's largest financial institutions has flirted with bankruptcy
and the former Federal Reserve chairman Alan Greenspan invoked the
ghost of past calamities when he wrote that the current economic
turmoil is likely to become the "most wrenching" since World War II.
Meanwhile, home foreclosures are at their fastest pace in at least 30
years and in a survey conducted by USA Today and Gallup, more than
half of respondents indicated that they had fears the downturn could
become a depression.

Some innocent bystanders might be forgiven for wondering why that
last word — "depression" — has started popping up. Is it possible
our
economy could speed past a recession into a full-blown depression
like that of the 1930s, when American unemployment reached 25 percent?

Well, the economists are here to say that you can dig up the family
silver and stop training the kids how to jump onto a moving train.
While many who study the nation's economic health agree that a
recession has probably already begun, and that it may be long and
severe, they also say the odds of a full-blown depression are almost
nonexistent.

Why? Because so many of them have spent so much time studying the
Great Depression and trying to figure out how to react more
effectively if things turn really bad again. Take last week, for
example.

"I used to give a lecture explaining that the Great Depression could
never happen now because of the regulations that emerged from that
crisis," said Barry Eichengreen, an economist at the University of
California at Berkeley. "But we're learning that there is a shadow
banking system, of hedge funds and investment banks, that are outside
of those safety nets. What happened to Bear Stearns last week looked
a lot like a 19th-century run on the bank. And that's why the Fed
reacted so quickly."

Indeed, when the government moved last weekend to help save Bear
Stearns, the fifth-largest securities firm on Wall Street, from
bankruptcy, policy makers were motivated by concerns that the
investment bank's failure could start a chain reaction of collapses
at other investment houses. Stopping those dominoes was such a
priority that the Federal Reserve helped broker the sale of Bear
Stearns to its rival JPMorgan Chase.

A century ago, such government hustle would have been unthinkable.
Even the distinction between a recession (a significant decline in
economic activity that lasts more than a few months) and a depression
(a decline that is much longer and deeper) didn't really matter,
because turmoil in the economy was often taken for granted.

Between 1857 and 1929, while regulators largely stood idle, the
American economy swung through 19 national boom-and-bust gyrations
that sometimes threatened to wipe out whole industries within months.

But in the wake of the Great Depression, American policy makers began
actively managing the economy with a handful of tools, including
adjusting interest rates and using massive government spending to
spur growth. Since 1945, there have only been 10 boom-and-bust
cycles, most of them much shallower than earlier ones, and the
unemployment rate has never topped 9.7 percent.

Much of that stability, economic historians say, stems from reforms
designed to calm consumers during downturns, like the Federal Deposit
Insurance Corporation, which guarantees most checking and savings
accounts up to $100,000 if a bank fails.

But as the Internet boom and recent housing bubble demonstrate, even
relatively stable periods can be part of a cycle of extreme ups and
downs. The prolonged expansion that just ended had an unusually long
run of more than six years. As a result, some are speculating that
the crash will be equally drawn out.

"The biggest difference with this recession is that it's starting in
the housing market," said Victor Zarnowitz, an economist at the
Conference Board who is also a member of the National Bureau of
Economic Research's business-cycle committee. For the first time in
more than 50 years, the nation faces a broad risk "that people's most
important asset, their home, will lose value," he said.

As homeowners see the value of their homes decline, they become more
likely to delay purchases of the big items — like automobiles,
electronics and home appliances — that are ballasts of the American
economy. When those purchases decline, large manufacturing firms,
suddenly short on funds, could begin laying off employees. Those
workers, uncertain about the future, might in turn stop buying
Starbucks lattes and movie tickets, and in a worst-case scenario,
that could spur coffee shops and theaters to begin layoffs of their
own.

Such a chain reaction was one reason unemployment during the Great
Depression was so persistent and widespread.

But today, say economists, fundamental changes make such contagion
unlikely. For one thing, incomes are more stable. Many more Americans
hold jobs in service sectors, like medicine or education. And more
Americans work for the government, which is less inclined to fire
people just because the economy turns gloomy.

Moreover, there are safety nets that can be traced to the Great
Depression, like Social Security, unemployment benefits, food stamp
programs. These "give people a sense of security even when they're
out of work," said the Harvard economist Benjamin Friedman. "That
establishes a floor for how panicked consumers become."

Even if consumer confidence hit rock bottom, that most likely would
not be enough, by itself, to cause a depression. For things to become
really dire, the nation's financial institutions would have to fail
at the same time that unemployment began significantly rising. Only
if banks suddenly closed, or it became impossible for companies to
access short-term lines of credit, would things begin spiraling out of
control.

A credit shortage, in fact, has played a significant role in today's
economic turmoil, and was the reason some economists began invoking
the Great Depression. But those comparisons were more to stress how
differently policy makers are behaving today than their counterparts
did in 1930, when a wave of panics started that eventually caused
one-fifth of the nation's banks to fail.

Today, the Federal Reserve is so cautious about the stability of
major financial institutions that regulators sometimes jump into
action almost immediately, as they did in the Bear Stearns case. One
goal of such an intervention, say economic historians, is to slow
down the turmoil as much as possible. In the 1920s and early 1930s,
policy makers became overwhelmed by a cascade of crises they were
unable to temper.

"In the 1920s, everyone was still reeling from the First World War,
which had realigned capital structures and boundaries and had put the
defeated countries in positions where they had much less economic
flexibility," said Peter Temin, an economic historian at the
Massachusetts Institute of Technology. In particular, one cause of
the Great Depression was that policy makers in the United States and
elsewhere were either reluctant or unable to increase their
countries' supplies of money, which at the time were often backed by
gold.

"Today, we have a lot more flexibility and we can prop up banks and
the economy to give us enough time to let things stabilize,"
Professor Temin added. Already, some lawmakers are proposing to help
refinance or purchase failing mortgages in order to slow down how
quickly other problems might spread; that approach, however, might
carry risks of its own, like encouraging irresponsible behavior and
increasing government deficits.

Of course, all of these techniques do not guarantee an easy path to
rosier times. Some economists and financiers say it's likely that the
current recession will extend for at least a year. Others think the
American economy will suffer from an extended malaise as Japan did in
the 1990s.

But whatever name economists give the current downturn, we are
unlikely to see the bread lines, shantytowns and dust bowl of the
Great Depression. More likely, these economists say, would be a
sudden increase in the number of people selling belongings on eBay.

Hollywood, which until now has largely catered to American tastes,
might begin more explicitly choosing scripts based on how they would
play in rising economies like India and China. And while exports of
manufactured goods might accelerate, the outsourcing trends that sent
some American jobs abroad might reverse. Already, Germany-based BMW
is expanding a South Carolina plant, betting that the weak dollar
will make American workers cheaper than those in Germany or Japan.

Which isn't to say that anyone is starting to hum "Happy Days Are
Here Again." Even the Federal Reserve chief, Ben Bernanke, has warned
against becoming too sanguine.

"To understand the Great Depression is the Holy Grail of
macroeconomics," Mr. Bernanke wrote in a 1994 paper, when he was a
professor at Princeton focused on analyzing the financial cataclysm
that began in 1929. While economists have made great progress, he
continued, "we do not yet have our hands on the Grail by any means."

_______________________

A new Great Depression? It's different this time.

Notice that it is an unregulated area that the problem cropped up and that one of the reason's for the Great Crash was the market theology that markets corrected themselves! There was no regulation of the greed that led to the mortgage meltdown:
"The agencies bestowed lofty AAA ratings on some extremely complex mortgage bundles even though their inherent risks were not understood. The banks and firms that packaged the securities and hawked them to clients simply accepted the rating agencies' conclusions, which were often favorable to the packagers. The dubious valuations of many of these securities are at the core of the credit crisis roiling the financial markets today"
Just what has been done to correct this problem? What has been done is to rescue those who sought to benefit from this greed using taxpayer funds.

A new Great Depression? It's different this time


The shadow of the '30s looms over every economic downturn or crisis. But unemployment reached 25% during the Depression; last month it was reported at 4.8%.
Fear is spreading with the financial system in disarray. But the global boom is ongoing, unemployment is low and the government has new tools to address the downturn.
By Michael A. Hiltzik, Los Angeles Times Staff Writer
March 20, 2008
Dysfunctional capital markets, frantic central banks, stressed-out consumers, fear and uncertainty -- all are alarming echoes of the global economic cataclysm of the 1930s.

Which raises the inevitable question: Could another Great Depression be lurking over the horizon?



TV news programs show grainy footage of Depression-era bankers as reporters tick off grim economic statistics. The Federal Reserve invokes powers it hasn't used since the 1930s. Critics of President Bush's economic policies are emboldened to use the H-word: "Hoover."

On the surface, there are disquieting parallels between economic conditions in the early 1930s and those of today. There is the popping of enormous asset bubbles -- stocks then, housing now.

And, as in the Great Depression, the financial system is in disarray. It was symbolized back then by the failure of thousands of banks, mostly small, local outfits -- 2,300 in 1931 alone.The parallel today is the crippling ofonetime giantssuch as Bear Stearns Cos., Countrywide Financial Corp. and Ameriquest Mortgage Co.

Many economists believe that the U.S. will find it almost impossible to avert a recession, if one has not started already. Housing remains mired in a deep slump,with some analysts projecting that Southern California home values could plunge 40% from their peaks last year.The Commerce Department reported this week that new residential building permits nationwide plummeted 36.5% in February from a year earlier.

Then, like now, stock prices were highly volatile. The S&P 500 index, which fell more than 56% from 1928 through 1940, nevertheless recorded four up years in that span, including a 46.5% gain in 1933.

The shadow of the '30s looms over every economic downturn or crisis, no matter how modest. Pundits were quick to invoke the Depression as a cautionary model during the stock market crash of 1987, the bailout of the giant hedge fund Long-Term Capital Management in 1998 and the dot-com meltdown of 2000 and 2001.

But there are vast differences between the 1930s and today. U.S. unemployment reached 25% during the Depression; last month it was reported at 4.8%. The international industrial economy was a shambles in the '30s. Today it is coming off a global boom.

"I've been asked many times whether we will have another Great Depression," said David M. Kennedy, a Stanford University history professor and the author of "Freedom From Fear," a Pulitzer Prize-winning history of the Depression and World War II. "My standard answer is that we won't have that one again -- I'd be surprised to have one of that seriousness and duration. But that doesn't mean we wouldn't have a catastrophe we haven't seen before."

Economists and historians say the most important difference between today's economic environment and the old days is the government's role.

"There's a perception now that you don't stand around at the central bank and whack people with a ruler for making bad decisions," said Robert Brusca, chief economist at New York-based Fact and Opinion Economics. "Instead, you do something."

Nothing demonstrates that as vividly as the Fed's orchestration of the takeover of Bear Stearns by JPMorgan Chase & Co. over the weekend. The deal staved off a possible Bear bankruptcy, which the central bank feared might traumatize financial systems worldwide.

The resolution drew a stark contrast with the Fed's role in the 1930 collapse of the Bank of the United States, a New York institution largely serving Jewish immigrants. The failure was then the largest in U.S. history, and the Fed's inability to arrange a rescue by Wall Street banks -- including J.P. Morgan & Co., the predecessor to the "white knight" in the Bear Stearns case -- caused a cataclysmic loss of confidence in the entire national banking system. That fueled a panic that historians regard as a key cause of the Depression.

The Fed's relative powerlessness in 1930 led directly to New Deal reforms that vastly expanded its authority. Some of the agency's new powers, such as its ability to lend directly to brokers and investment banks, were seldom or never used until the current crisis.

Fed Chairman Ben S. Bernanke, an expert in the central bank's Depression-era history, is also knowledgeable about the instruments at its disposal in a crisis.

In a 2002 speech -- he was then a member of the central bank's Board of Governors under Alan Greenspan -- he outlined a number of drastic steps the Fed could take in extreme conditions and still remain within its legal authority.

Among them were buying up foreign government debt to influence dollar exchange rates, and even lending, if indirectly, against private assets. The subject of Bernanke's speech was how to combat deflation, a broad decline in consumer prices that is not currently a problem on the Fed's agenda. Still, the powers he described could apply in a wide range of dire scenarios.

But as Fed Vice Chairman Donald L. Kohn conceded in testimony before a Senate committee this month, the most serious challenges generally arise not from scenarios that can be forecast but from the unforeseen.

Alluding, in effect, to the tendency of regulated industries to burst at their weakest seams, Kohn blamed "the most sophisticated banks" for allowing credit rating agencies such as Moody's and Standard & Poor's to paper over the unsoundness of mortgage securities on their books.

The agencies bestowed lofty AAA ratings on some extremely complex mortgage bundles even though their inherent risks were not understood. The banks and firms that packaged the securities and hawked them to clients simply accepted the rating agencies' conclusions, which were often favorable to the packagers. The dubious valuations of many of these securities are at the core of the credit crisis roiling the financial markets today.

Brusca, the economist, says the most dangerous behavior often occurs just beyond regulators' reach -- in the exotic strategies of the hedge fund industry, to use a contemporary example. "We have a far more extensive regulatory network now," he said, "but it's always the unregulated sector that pushes change."

Does it make sense to require banks to maintain adequate capital relative to their obligations, Brusca added, "but let them have an unregulated hedge fund?"

There are also limits to what monetary policy -- the Fed's responsibility -- can achieve on its own to forestall a drastic economic downturn. The Franklin D. Roosevelt administration not only reformed the Fed but also experimented with stimulative fiscal policy, such as unemployment relief.

New Deal programs aimed at staving off a wave of home foreclosures may be especially relevant today. Among the most important was the Home Owners Loan Corp., or HOLC, which is one of several models for homeowner relief being considered by Congress.

HOLC took over 1 million mortgages in default starting in 1933, worked to keep the owners in their homes and made new loans to strapped mortgage holders. When the agency was finally liquidated in 1951, it even returned a small profit to the U.S. Treasury.

The Fed's recent actions were "a temporary palliative" to the fundamental problem in the economy, which is the rapid fall in home prices and its ripple effect on mortgage bonds and other securities, said Barry Eichengreen, a professor of economics and political science at UC Berkeley. "You have to reorganize the system, but the discussion about that has only begun."

michael.hiltzik@latimes.com