US, EU economics stuck in a 'long depression'


July 24th 2010


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US, EU
economics stuck in a 'long depression'


by Patrick J. Byrne

News Weekly, July 24, 2010
"We are now, I fear, in the stages of a third depression", writes Nobel Prize-winning US economist Paul Krugman.

He argues that only two previous eras in global economic history have been described as "depressions". These were "the years of deflation and instability that followed the Panic of 1873, and the years of mass unemployment that followed the financial crisis of 1929-31".

Of the current global financial crisis (GFC) he says: "It will probably look more like the Long Depression than the much more severe Great Depression. But the cost - to the world economy and, above all, to the millions of lives blighted by the absence of jobs - will nonetheless be immense," (New York Times, June 28, 2010).

His warning comes at the same times as the Bank for International Settlements has advised of the threat of a new global credit crash and another economic downturn.

The BIS is one of the world's key economic institutions, coordinating international financial regulation, and is banker to the central banks.

In its latest report on the GFC it says the world is ill-equipped to deal with "a shock virtually of any size". This fragility risks seeing a repeat of the 2008-09 crisis.

Krugman argues that this third depression will result primarily from policy failures worldwide, as governments echo the recent G-20 meeting "obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending".

He says: "In 2008 and 2009, it seemed as if we might have learned from history. Unlike their predecessors, who raised interest rates in the face of financial crisis, the current leaders of the [US] Federal Reserve and the European Central Bank slashed rates and moved to support credit markets.

"Unlike governments of the past, which tried to balance budgets in the face of a plunging economy, today's governments allowed deficits to rise. And better policies helped the world avoid complete collapse: the recession brought on by the financial crisis arguably ended last summer.

"But future historians will tell us that this wasn't the end of the third depression, just as the business upturn that began in 1933 wasn't the end of the Great Depression.

"After all, [US] unemployment - especially long-term unemployment - remains at levels that would have been considered catastrophic not long ago, and shows no sign of coming down rapidly. And both the United States and Europe are well on their way toward Japan-style deflationary traps."

This begs the question: why are governments committed to making the same policy mistakes as their predecessors in the 1930s?

Free-market economists argue that austerity measures are needed because the bond markets (the lenders to governments, banks and big business) have already turned on the big debt nations starting with Greece and the other s0-called PIIGS nations - Portugal, Italy, Ireland and Spain.

Krugman responds by observing that Greece introduced strong austerity measures in the face of a depressed economy, and it has done nothing to reassure investors.

He says: "On the contrary: Greece has agreed to harsh austerity, only to find its risk spreads growing ever wider; Ireland has imposed savage cuts in public spending, only to be treated by the markets as a worse risk than Spain, which has been far more reluctant to take the hard-liners' medicine.

"It's almost as if the financial markets understand what policy-makers seemingly don't: that while long-term fiscal responsibility is important, slashing spending in the midst of a depression, which deepens that depression and paves the way for deflation, is actually self-defeating."

Deepening the crises in Greece and the other PIIGS nations risks pushing the global economy deeper into the Third Depression.

Worldwide, financial markets and policy-makers have become accustomed to V-shaped recessions. Whenever there has been an economic downturn, central banks have cut interest rates and injected money into the financial system, and governments have introduced generous stimulus packages like tax cuts. Then, the economy quickly rebounds.

But a new book, This Time Is Different: Eight Centuries of Financial Folly (Princeton University Press), says that this time it is different. The GFC is not a V-shaped recession.

Its authors are the University of Maryland's Carmen M. Reinhart and Harvard's Kenneth Rogoff. The book's title is deliberately sarcastic, implying that the more things change in the financial world, the more they stay the same.

Krugman and Robin Wells reviewed the book and further discussed the current Third Depression in the New York Review of Books (May 13, 2010).

Krugman says that the essential message of the book is that "too much debt is always dangerous". He says: "It's dangerous when a government borrows heavily from foreigners - but it's equally dangerous when a government borrows heavily from its own citizens.

"It's dangerous, too, when the private sector borrows heavily, whether from foreigners or from itself - for banks are basically institutions that borrow from their depositors, then make loans to others, and banking crises are among the most devastating shocks an economy can face."

Such debt crises can take various forms. Sovereign debt crises occur when investors (the bond markets and the banks) conclude that a government cannot meet its debt obligations. Inflationary crises occur when governments use the printing presses to print money to pay their bills and/or create inflation to reduce the value of their debts. Then there are banking crises, where people lose trust in the financial sector, which is vital to the functioning of a modern economy.

Reinhart and Rogoff warn that the world is now facing another "great contraction", a giant banking crisis gripping Europe and the United States with effects that have spilled over the entire world. (The previous one was the 1930s Great Depression).

Krugman says, "In the past, banking crises have often led to sovereign debt crises as well, since banking collapses depress the economy, reducing government revenue, at the same time that they often require large outlays to rescue the financial system. Greece may be only the first of many stories of troubled governments�."

He adds that, along with two International Monetary Fund World Economic Outlook reports (April and October 2009), Rogoff and Reinhart offer "a grim prognosis: the aftermath of financial crises tends to be nasty, brutish and long. That is, financial crises are typically followed by deep recessions, and these recessions are followed by slow, disappointing recoveries."

Yes, it can be argued that there have been some phoenix-like recoveries from such crises. South Korea depreciated its currency and traded its way out of the 1997-99 Asian Financial Crisis.

However, there is no hope of the US doing the same. Its currency has appreciated in value, being seen as a safe haven in the wake of the crisis in Europe and elsewhere. The US cannot trade its way out of this Third Depression, "not unless we can find another planet to trade with," says Krugman.

How long can such financial crises last? Japan's economy has been stagnant since its property bubble burst in the late 1980s. Its property market is still shedding value 20 years later, and its banks are still writing off debt.

According to the IMF's October 2009 World Economic Outlook, such crises have the effect of depressing not just short-term performance but also long-term growth.

Is there a remedy? Reinhart and Rogoff and the IMF reports provide evidence that boosting government expenditure in the face of a financial crisis shortens the downturn. They also acknowledge that there is some evidence that such policies may backfire, i.e., running up excessive debt can lead to a sovereign debt crisis, as seen today in Greece.

Support for this finding has come from Barry Eichengreen of the University of California, Berkeley, and Kevin H. O'Rourke of Trinity College, Dublin. Last year, they published a highly influential report showing that the early stages of the GFC tracked closely to the early stages of the Great Depression (see News Weekly, July 11, 2009).

Their follow-up paper found that the huge interventions by governments worldwide prevented the world economy from spiralling downwards as happened between 1929 and 1933. Recent interventions have cushioned the downturn, whereas the grim austerity measures imposed by governments 80 years ago exacerbated it.

Why have economists and policy-makers argued that this time was different? They claimed that sophisticated secondary banking markets, with new complex debt instruments held across the world's financial sector, would act like shock-absorbers in the event of any major shocks to the system. They didn't. We now know that these new structures and instruments actually magnified the crisis.

Hence, Reinhart and Rogoff argue that there is no safe path with high levels of debt. High levels of debt are dangerous for whoever holds it - governments, banks, corporations or citizens. The safest way to deal with debt crises is to avoid them in the first place.

After the Great Depression and World War II, governments worldwide cooperated to regulate the international and domestic financial markets and the world trading system. Under this arrangement, nations couldn't simply run up huge debts and imperil the financial system.

But memories of the Great Depression faded. Many universities downgraded - some even abolished - their economic history departments.

Investors and policy-makers lacking first-hand knowledge, or even any historical understanding, of that time rationalised away the looming dangers and ran up even more debt.

They forgot what economist Dani Rodrik, professor of political economy at Harvard University's John F. Kennedy School of Government, described earlier this year as the "political trilemma of the world economy".

He said: "Economic globalisation, political democracy and the nation-state are mutually irreconcilable. We can have at most two at one time. Democracy is compatible with national sovereignty only if we restrict globalisation [i.e., a replication of the 1945-80 period of regulated capitalism].

"If we push for globalisation while retaining the nation-state, we must jettison democracy [i.e., Beijing's economic model today].

"And if we want democracy along with globalisation, we must shove the nation-state aside and strive for greater international governance." (Project Syndicate, May 11, 2010).

For the past 30 years or so, the developed democracies have pursued the latter. They wanted democracy and globalisation, but instead of "global governance" of the world trade and financial markets they deregulated these markets.

The late B.A. Santamaria, from the 1980s until his death in 1998, used to describe the gathering political and economic problems even then besetting the West as a long-term "crisis of structures", a term coined by the eminent postwar French historian Fernand Braudel.

No simple remedy is available to deliver the West from globalisation's current "crisis of structures". Fundamental changes to the system are needed.

Major reforms were instigated after the 1930s Great Depression. Will similar decisive action be taken today?

Krugman says that history tells us what will happen if necessary reforms don't take place. "There will be a resurgence of financial folly, which always flourishes given a chance. And the consequence of that folly will be more and quite possibly worse crises in the years to come."

The 1930s Great Depression was followed by major reforms, but with the current GFC he warns that this time "it's not clear that anything comparable will happen".

He concludes: "In that sense, this time really is different."

Patrick J. Byrne is vice-president of the National Civic Council.

References:

Patrick J. Byrne, "Economic crisis parallels the Great Depression", News Weekly, July 11, 2009.
URL: www.newsweekly.com.au/articles/2009jul11_e.html

Dani Rodrik, "Greek lessons for the world economy", Project Syndicate (Prague), May 11, 2010.
URL: www.project-syndicate.org/commentary/rodrik43/English

Paul Krugman and Robin Wells, "Our giant banking crisis - what to expect", New York Times Review of Books, May 13, 2010.
URL: www.nybooks.com/articles/archives/2010/may/13/our-giant-banking-crisis/?pagination=false

Paul Krugman, "The third depression", New York Times, June 28, 2010.
URL: www.nytimes.com/2010/06/28/opinion/28krugman.html?_r=2




























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