Economic Depressions

Originally published on March 15, 2020.

Many notable economists are suggesting that we might be headed for a Depression. As such, we thought it would be helpful to explain what a Depression is and what implications it may have for employment, inflation, and other notable economic and social effects. While the nature of Depressions varies over time there are many parallels we can draw from history to better understand what we may be experiencing in coming years.


What is a Depression?


Depressions are commonly defined as a severe and prolonged downturn in economic activity as measured by gross domestic product (GDP) and elevated unemployment. Depressions are longer and deeper than recessions ... lasting three or more years with a fall in GDP of at least 10 percent within a given year.


Employment and asset prices fall and stay lower for longer during depressions. During the Great Depression, the stock market fell 50 percent within just a few months in late 1929. Many believed the correction was over, driving a rebound going into 1930. Evidence of a prolonged fall in corporate earnings had not yet materialized. Prior downturns in 1907 and 1920 had had quick recoveries, creating an anchoring bias toward the recent past. But the initial shock to the stock market set off a chain reaction of bankruptcies that continued to cripple the economy and employment for years to come.


There are basically two kinds of Depressions...inflationary and deflationary. Inflation is defined as a general increase in prices and fall in the purchasing value of money. When prices are falling we call that deflation. Both can cause problems when unexpected and in large magnitudes.


Deflationary depressions tend to occur in countries that control their own money, have high debt burdens, and have very low interest rates. This is the more likely Depression scenario for the United States and other countries that make up the world's reserve currencies like Europe, Japan, and even China. The reason is that, unlike in Recessions, the Federal Reserve is not able to lower rates to the same degree that they have in prior downturns. As a result, businesses and households facing lower incomes are not able to get the same relief in terms of cheaper credit. Large debt burdens and shrinking incomes incentivize saving instead of spending. As a result, demand for goods and services fall and unemployment rises. The drop in demand and downward pressure on wages creates downward pressure on prices that typically exceeds the inflationary pressures from money printing unless that money is put directly in the hands of consumers in large enough quantities that the result in spending exceeds the capacity to produce goods and services.

Inflationary depressions classically occur in countries that are reliant on foreign capital flows and so have large debts denominated in foreign reserve currencies. This is the more likely Depression scenario for countries in Latin America, Africa, and the Middle East....notable larger countries facing this threat right now include Mexico, Brazil and Saudi Arabia. Pressure on their currencies is making their dollar denominated debts rise in value...making it harder to pay back. Foreign investment is at risk of drying up which could result in severe credit contraction. Central banks in these countries cannot simply print money to pay back the dollar denominated debt, but printing money is often one of the few options available to stimulate demand and support communities and businesses hit by the Depression. As a result...the local currency becomes debased.


Long Term Debt Cycles (LTDCs) are often linked to Depressions. We discussed this in our earlier post on the Economic Machine, but in short...LTDCs are debt burdens that build over a lifetime. This buildup in the USA is depicted below and includes the debts from Households, Corporations, and the US Federal Government. This is actually an underestimate of the size of US debts because it ignores pension and healthcare liabilities which are enormous.

Source: Bridgewater


Usually the LTDC process starts with challenging events that cause a tremendous amount of wealth destruction. The most common example is war. The destruction of wealth corresponds with the destruction of debts because much of the world's wealth is invested in credit markets. The destruction of debt leaves households and businesses with much more room to borrow...but the destruction of wealth also means that interest rates are higher. Only over many decades of peace and prosperity do wealth levels build back up to the point we are at today...at the end of a LTDC.



Will the COVID19 Crisis lead to a Depression

Depressions very in magnitude due to many factors...the most important of which being the amount of debt in the system. Unfortunately, the amount of debt both in the United States and Globally has never been higher and it is growing rapidly. Other factors also point to this being a potentially bad Depression. However, a "Great Depression" like that experienced during the 1929-1941 period seems unlikely in large part because we know so much more about how fiat money works, have much better technologies, and hopefully don't turn to socialist policies that would turn our deflationary depression into an inflationary one.

Artificially low rates and government spending have helped to alleviate the immediate crisis, but increased debt levels in the process. As a result we run the risk of becoming dependent on cheap money that could be unhealthy for future productivity. There is also good reason to think that massive government support combined with slower growth could lead to stagflation...a period of falling growth and rising inflation. Such a scenario would threaten the ability of central banks to keep supporting high debt levels and this is the key threat we face today.


There is no way of knowing how likely this scenario is, but understanding the nature of the problem can provide clues. To do this I answer three questions.

  1. Why do we have so much debt?

  2. Is the debt a problem?

  3. What happens next?


1) Why do we have so much debt?


Globally we have never had as much debt as we do today relative to the economy. This includes government, business, and household debt; which are the big three types of debt which together make up all the ways in which one entity owes another entity money. I'm talking about global debt because it is a global phenomenon. Debt levels are high generally across not just the USA but developed and emerging economies around the world.


There are essentially two reasons why we have so much debt. The good reason...and the bad reason:


The good reason is that lots of debt is the flip-side of wealth. Since the 1980s we have had a remarkable stretch of global stability and moderate inflation. Prosperity brings wealth, albeit unevenly distributed, leading to an ever greater supply of cash relative to investable financial assets. All that wealth has to go somewhere...and debt is the largest asset class. This scarcity of assets as led to a bidding up in prices; which is a big reason why interest rates are so low, stock prices are so high, and just about any entrepreneur with a potentially good idea can get funding.


The bad reason is that some central banks have allowed governments, businesses and households to borrow money for free. Free money creates problems, mostly because it incentivizes bad investments. A huge global supply of cash drove down benchmark rates (government bond interest rates) to zero...essentially removing any "hurdle rate" for investment. As a result...over the past decade we have seen absurdities like negative yielding junk bonds and people getting paid to take out a mortgage. This creates bubbles and price distortions because no one can value a financial asset properly without a reasonable discount rate.


Many blame central banks for causing zero interest rates, particularly those on government bonds. But the reality is that the zero interest rates have been largely caused by the good reason ... lots of wealth chasing few financial assets. Inflation has been very low despite zero rates because of technological innovation, demographics, digitization, and other reasons that have nothing to do with central banks. Central banks were never going to create an artificially high hurdle rate...in the face of low inflation...even if that would have been the right thing to do.


Regardless of the causes...many of the worlds governments, businesses and households are now dependent on very low interest rates. Some are insolvent ... meaning that they are unlikely to ever pay back their debt. This problem has been allowed to grow during COVID19 as central banks rushed to force rates down so governments could dramatically increase deficit spending, businesses to refinance, and households could keep spending.


If rates were to rise and stay higher, many governments, businesses, and households, would be in big trouble...and so would the rest of us.

2) Is the debt a problem?

Yes.

The size of global debt is a problem because a large chunk of it is dependent on very low to zero interest rates. This has led to increasingly risky investments and a dependence on debt financed consumer spending.

But the size of the debt did not seem like a problem because it is still largely being "serviced". In other words, governments, businesses and households were generally paying their debts. Low and negative rates allowed for higher debt...and if rates stay low forever then theoretically debt levels never becomes a problem.

COVID19 illustrated the fragility caused by the large debt build up. For example, as we discussed in real time right here on Evolutionomics...corporate bonds in particular have become a key point of weaknesses. Even the most liquid investment grade corporate bond funds lost 20% of their value in just a few weeks...wiping out five years worth of interest payments. Until central banks stepped in.

Central banks had a choice. They could have let heavily indebted businesses fail and get forced into bankruptcy, or they could backstop these market and allow debts to grow even larger. Just about every central bank around the world opted to backstop these markets believing that allowing mass defaults would send us into a global depression...and they were probably right.

As a result...the world's debt markets are more dependent on central banks than ever before. Unlike in January...most prices are being directly pushed by central bank actions. If central banks came out tomorrow and said they would stop buying sovereign bonds, corporate bonds, and giving out subsidized loans to private businesses then these markets would freeze up again and yields would skyrocket.

The longer this goes on the longer the global economy becomes dependent and artificially low interest rates. Many governments need artificially low rates to fund deficit spending. Many businesses need artificially low rates to refinance. Many households need artificially low rates to commit to buying a house or car given all the uncertainty.

In short, the debt is a problem because it is becoming increasingly dependent on artificially low interest rates...and if rates rise then large swaths of the economy may default at the same time.

3) What happens next?

Central banks can ultimately control interest rates. That is why markets have responded to vigorously to central bank support. But artificial support cannot remain indefinitely.

Central banks have a duel mandate: price stability and maximum sustainable employment. Central bankers have learned from experience that it is helpful to lower interest rates and support government spending during recessions. The reason is that recessions run the risk of becoming deflationary...as rising unemployment reduces consumer spending which in turn can cause even higher unemployment. Lowering rates and government spending help fill the gap in spending...so businesses can avoid slashing prices and laying off workers.

But there are limits to how far this can go.

Inflation did not take hold in response to QE from fighting the Financial Crisis for several reasons...


  1. All the money printing went to wealthier people..because only wealthy people held the treasury bonds the Fed was buying with printed money.

  2. Government spending to fight the downturn was limited. The “bazooka” was a $700 Billion package that failed the first time it was voted on.

  3. Reasons 1 & 2 were too small compared to deflationary pressures...namely falling home prices, and falling consumer spending due to high unemployment.


Central Bank and government responses to The COVID19 Crisis have been and continue to be, dramatically different both in scale and mechanism.

  1. Central banks are buying not just treasury bonds...the are also buying corporate bonds, including junk bonds ETFs, which contain debt from companies that have little hope of ever paying it back.

  2. Helicopter money ... a term coined by Ben Bernanke because it is not unlike the Fed simply flying over people and dumping money out the window ... has been a key part of the relief package. On top of this... Enhanced unemployment has given many an incentive to stay unemployed.

  3. The combined effect of 1 & 2 has actually left households with higher incomes than before the crisis, while dramatically reducing GDP.

Clearly this response is far larger than during the Financial Crisis.


Conclusion


Central banks are now stuck between a rock and a hard place. The entire corporate debt market is dependent on their support. They can’t let interest rates rise much or they risk triggering an ever greater wave of defaults. They will continue to prop up financial markets because it is the path of least resistance...unless artificially low rates combined with helicopter money and stagnation lead to inflation.


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