The Looming Depression

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The Kremlin still frowns on the use of the word "crisis" to describe Russia's financial markets. But no such taboo exists in the United States. As the election campaign enters its final days, Democratic front-runner Barack Obama appears to understand the seriousness of the situation. He has proposed measures to boost government spending and to stimulate demand in the spirit of President Franklin D. Roosevelt's New Deal. It is a good thing, since the words "Great Depression" have started to echo in the financial press.

Federal Reserve Chairman Ben Bernanke spent much of his academic career studying the causes of the Depression. He shares the view of the late Nobel Prize economist Milton Friedman -- that the Depression occurred because the Federal Reserve not only failed to pump money into the financial system after the 1929 stock market crash, but it raised interest rates to boot. In 2002, at an event marking Friedman's 90th birthday, Bernanke assured the father of monetarism that the Federal Reserve understood its mistakes and that another Depression would never happen again.

The current financial crisis gives Bernanke a chance to test this theory. The Federal Reserve has slashed interest rates and provided hundreds of billions of dollars to U.S. banks. But sell-offs on Wall Street continue, and a major recession seems unavoidable.

In reality, the Depression had less to do with lack of liquidity and more with economic fundamentals and imbalances between supply and demand. Starting in the early 1920s, the U.S. economy was driven by a post-World War I burst in consumer demand. This boom benefited from the introduction of new products such as automobiles and radio sets. The economy also thrived by providing infrastructure for those new products. This is when electric utilities and the oil industry experienced explosive growth.

Productive capacities expanded rapidly. Just as companies geared up to produce more by the late 1920s, the market became saturated. When the economy spiraled downward, the magnitude of the crisis intensified with a snowball effect. Shrinking demand led to layoffs, which in turn reduced consumers' ability to buy even basic necessities. Economic activity in the United States shrank by 8.6 percent in 1930, then by 6.1 percent in 1931 and 13 percent in 1932.

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The authorities found that existing tools for reviving demand no longer worked. A depression is not merely a severe, prolonged cyclical downturn. It is when the old growth model fails in such a way that the economy cannot be revived with fiscal and monetary stimulus. A fundamental shift in the economic paradigm was the only way out of the Depression, and Roosevelt's New Deal filled this role. It entailed instituting new government programs, public works, pensions, unemployment insurance and other measures to increase aggregate demand.

In this analysis, the Wall Street crash was a leading indicator of impending doom, not its cause. The stock market is a fine barometer of future economic trends, and the current bout of selling on global stock markets reflects the fear of a coming economic slump. Just as in the early 1930s, the existing model of economic growth has suddenly started to disintegrate. This is why even consumer goods companies and oil conglomerates -- both of which are currently profitable -- have been dumped by investors.

Over the past 15 years, global economic growth has been sustained by the U.S. consumer. U.S. imports measure almost $2 trillion and the trade deficit totals some $850 billion. The sheer volume of U.S. imports and the pace of their expansion provided a boost to other countries. The dollars the United States sent abroad have spurred consumption and investment in China, Russia and dozens of other emerging economies.

This burst of consumption was sustained not so much by wage growth but by borrowing. Actually, there have been three mutually reinforcing credit bubbles. The U.S. housing boom was built on a mortgage bubble, as home mortgages grew by more than 50 percent from 2003 to 2007. Rising home prices led to a consumer credit bubble, with homeowners using their appreciating houses as collateral. Government debt also ballooned as Washington refused to raise taxes to close the federal budget gap. These three types of debt amount to more than $10 trillion each, which means that together they measure more than twice the size of the U.S. economy.

The housing bubble has popped, but this is only the first stage of the crisis. The second bubble, consumer spending, is starting to pop as well. Banks are starting to lend to each other once more and the credit crunch may be at an end. But it will be a very long time until they resume lending to the U.S. homeowner. Americans will have to stop living beyond their means, which could shrink consumption by as much as 20 percent.

Falling U.S. consumption has already been felt by countries that sell goods, services and oil to the United States. They will, in turn, curb their own consumption and production. The situation has a downward spiral written all over it, and foreign countries will suffer even more than the United States. In the Depression, the U.S. economy shrank by almost 50 percent. But the impact on the rest of the world was more severe, as the global economy contracted by 65 percent.

The third bubble, the U.S. government debt, will burst when countries like China and Russia stop running enormous current account surpluses and their central banks are no longer able to buy dollars. On the contrary, some central banks have started to sell their dollar reserves to support their currencies, economies and financial markets.

The crisis is at its early stages. No bottom is yet in sight, and it is unclear how deep it will go and how long it will last. Just as in the Depression, a new economic paradigm will be required to pull the economy out of the slump. It is testimony to the flexibility and resilience of the U.S. political system that, just as the economy started to tank, a president is about to be elected who understands what needs to be done.

Alexei Bayer, a native Muscovite, is a New York-based economist.