The Depression Will Not Be Televized…

…because there will be no depression!

Reference to the Great Depression are quite in vogue these days (Sen. Harry Reid just cited Fed chair Bernanke’s academic expertise on the subject during a press conference), but they are off the mark. The Great Depression was the sharpest and deepest economic contraction in modern history, and its damage was global and long lasting. We are in the midst of a global economic slowdown, a possible domestic recession, and a massive credit seizure. But we’re not headed for a depression–not yet anyways. 

The only thing that can cause a depression to occur in a financial (i.e., money and credit driven) economy is for the marginal cost of a new unit of money to rise well above the expected return on  marginal investment in the real economy.*** A high degree of leverage (i.e., debt) can amplify the effects of a depression, but it cannot directly cause a depression.

For a depression to occur, Congress would have to dramatically raise taxes, regulations, and trade barriers, and the Federal Reserve would have to significantly hike interest rates. While Congress is clearly trying to pull us in the direction of lower returns on economic activity, the Federal Reserve is absolutely not in deflationary territory, even though the value of domestic assets are falling. We may be in for a stubborn recession or contraction, but at this point, a depression is not going to happen.

*** There have been two major depressions in U.S. history, the Great Depression of (roughly) 1930-1942, and the Long Depression (previously known as the Great Depression) of 1873-1896. In both events, the cost of money rose well above the rate of return on profit seeking activity. In the Great Depression, it happened very abruptly, when high trade barriers and higher taxes lowered expected returns on economic activity at the same time that several major central banks tried to forcefully reimpose the pre-WWI parity value of gold, which raised the real cost of money and credit dramatically. They basically tried to force the global economy into a much smaller box overnight, and tax and trade burdens made the box that much smaller. In the lesser known Long Depression, the marginal cost of money rose when a large part of the world moved onto the global gold standard in 1873; this raised the demand for (and thus relative value of) gold, but monetary authorities did not raise the parity value of gold accordingly. The deflationary effects persisted as, in the ensuing 20 years, a dearth of global gold discoveries caused the real value of gold to move further and further above its nominal parity; that caused money, which had its value tied directly to gold’s, to also rise in value against all assets, goods, and services (William Jennings Bryan’s famous ‘Cross of Gold’ speech was given in 1896, the same year of massive gold discoveries in South Africa that eventually alleviated longstanding deflationary pressures). However, unlike the Great Depression, the Long Depression unfolded during a period marked by dramatic expansion of global trade, low barriers to investment and productive activity, and rising incomes and wealth. This helped make it a more drawn out but less destructive affair than the Great Depression.