How to cope with an economic depression

As the Great Depression demonstrated all-too-clearly, banking collapses have to be taken seriously. Arguably bank failures were more important than the 1929 Crash in explaining the huge loss of output and jobs in the 1930s. As the monetary system froze, so the links between savers and investors broke down. And, as the economy weakened, so people sold their risky assets. Demand for cash exploded but the Federal Reserve did not respond. Deflation took hold and even more banks failed.

For a moment, September 2008 looked as though it might be the month to mark the beginnings of another great depression. Fortunately, policymakers know their history. Ben Bernanke, the Federal Reserve Bank chairman in particular, is one of the world's leading authorities on the depression and its associated banking crises. We have now gone well beyond the standard liquidity injections favoured by textbooks. Nationalisation, socialisation and taxpayer bailouts are all on the agenda. These are extraordinary times for both the world economy and for capitalism.

The initial euphoria associated with plans for a Resolution Trust Corporation (RTC) Mark II was hardly surprising. If bad assets are removed from banks' balance sheets, the banks will feel happier lending to each other again and counterparty risk should decline. To suggest, though, that financial problems are over would be a step too far. More, though, will need to be done.

First, as households choose to, or are forced to, pay down debt, the household saving ratio will rise. Unless there is reduced saving elsewhere, the US economy will encounter the paradox of thrift, whereby rational decisions by individuals to save more lead to a lower level of economic activity and, hence, a lower level of overall savings.

Second, if the downside risks to economic growth are to be limited, a borrower will have to be found to provide the demand no longer coming from households. Foreign nations might provide some help - US exports have held up well in recent years - but that is unlikely to be enough. The alternative is to run a very large budget deficit, perhaps heading to 6 or 7 per cent of GDP (and even higher if the bad assets of the banks were to be included).

Third, although the proposed RTC Mark II is a step in the right direction, it is no magic bullet. The first RTC came into being in 1989 and, four years later, people were still talking about the credit crunch and the so-called "jobless recovery". Perhaps the RTC helped ameliorate the impact of the savings and loans crisis but it certainly did not lead to an abrupt turnaround in investor sentiment.

Fourth, the trade-off between growth and inflation in the developed world has not been easy in recent times. In the 1930s, there was not a whiff of inflation. Over the last 12 months, however, inflation has surprised considerably on the upside, a result which has left central bankers reluctant to cut interest rates to emergency "anti-credit crunch" levels. As a result, market interest rates have remained very high in absolute terms, arguably making the credit crunch worse than it needed to be.

Fifth, one of the overriding conclusions associated with the Great Depression was that the Federal Reserve was simply unwilling to increase money supply to meet the demand for liquid assets and, as a result, was partly responsible for the onset of deflation. What is less clear, however, is what would have happened had the Fed boosted money supply. According to some authors, had money been provided, GDP might have fallen by 6 per cent in total. Moreover, with continued injections of liquidity, banking crises might have been limited and, hence, the loss in output might have been smaller. All of this supports the actions of US policymakers over the last 12 months but still suggests that output could easily surprise to the downside compared with current consensus estimates, which suggest growth this year of 1.8 per cent followed by a 1.4 per cent rise in 2009.

Sixth, it is a mistake to think that a US bailout would, on its own, deal with the world's credit problems. The rapid growth of mortgage securitisation may have been based in part on the booming US housing market but housing markets also boomed elsewhere. Vulnerable borrowers are not just confined to the US: they exist in, among others, the UK, Spain, Ireland, Australia and New Zealand. Banks with high exposure to bad assets are manifestly not confined to the US, as the experience of the UK demonstrates all too clearly. Then there is the thorny issue of the identities of the investors who own the mortgage-backed securities issued over the last few years: the US balance of payments data show clearly that foreign investors were very happy to buy these pieces of paper, particularly between 2004 and the first half of 2007. They are now presumably nursing their losses, but uncertainty remains over the scale of the losses and their geographical location.

With lots of household de-leveraging still in the pipeline, an uncomfortable trade-off between growth and inflation for the time being and the likelihood that, even with the best policies in the world, the Great Depression might only have been limited to a deep recession, we are not yet out of the woods.

This report was compiled by the marketing department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.