Recession may ease a crash in confidence
‘Once I built a railroad; now it's done. Buddy can you spare a dime?’ ran the most popular of the songs about the Great Depression of the 1930s. To people then, it appeared that capitalism had run its course.
Pretty much anything that was needed had been built or made. That was why work had disappeared.
For the first time since, we can experience directly how it happened, and why they felt that way. But also why the song was looking in the wrong place.
Academics have known for a long time that the main cause of the Great Depression was financial. The banking system, and with it the supply of money, collapsed.
This month, to all intents and purposes, the US banking system collapsed. Only for a couple of days, of course, and it must be hoped that is all it will ever be. But it is truly extraordinary, after all that has been learnt in the past 80 years, that such a possibility could even arise.
Yet arise it has. For those couple of days, after the collapse of Lehman Brothers, banks wishing to borrow money from each other, just for 24 hours, had to pay five
per cent for the privilege, even though official rates at the Federal Reserve, America's central bank, are just two per cent. That's a collapse.
Make no mistake about it, without the actions of the Fed, the European Central Bank and other central banks, it would be the 1930s again.
Now, if a bank finds it cannot borrow on the market, its central bank will lend it money, and take assets (such as mortgages) as security.
In the past month, the central banks have lent something like €500bn in this way to prevent complete collapse.
That did not happen in the 1930s, when the authorities believed that banks should really sort themselves out.
Credit and money supply dried up, and so did the economy.
Modern methods can prevent a great depression but, after last week, it is not at all clear that they can prevent a depression of some kind.
The old joke is that a recession is when you lose your job and a depression is when I lose mine. The more serious definition is that a depression is a combination of slow real growth and falling prices.
The latter may seem a non-existent threat as central banks struggle to combat inflation. But it is, unfortunately, early days yet.
At the moment, the only commodity whose price is rising is the store of value of last resort, gold.
The final outcome depends on how successfully the bad loans and investments by the global banking system can be written off and normal service resumed.
Money supply may not have collapsed, but it is looking very sickly in both the USA and Britain. Economic growth will not recover until money creation does.
Things are a little different in the euro area, where banks in general are not quite as exposed, and property markets in general were not quite as bubbly. That is why the ECB felt able to raise interest rates in the face of the gathering storm, and rely only on its emergency lending to help otherwise solvent banks with their borrowing difficulties.
Many observers think the ECB is being far too optimistic. It is certainly a bold claim to say that Germany will lead a eurozone recovery by the end of this year, as made by both the ECB President and the chairman of the euro finance ministers.
We must hope that they are right. Or must we?
The inevitable crash in confidence from all these extraordinary events has now hit the Irish banking system.
It seems clear that some re-organisation of the smaller lenders will be required, following withdrawals of deposits and difficulty in raising funds.
Ireland is especially vulnerable in the euro area because of its property price boom and bust, and even bigger building boom and bust. And of course, now, we have been officially declared to be in recession.
Trouble is, in this extraordinary crisis, even normal bad banking becomes dangerous. Banks always over-lend in good times and then have to write off large chunks of it in bad times. Shareholders lose out, get tapped for more capital, and eventually everyone moves on.
This old-fashioned bubbling is what Irish banks did, while largely avoiding the toxic new products. But the global poison means their share falls are far worse than would have been expected, and the difficulty and expense of raising new capital far greater. Even old-fashioned banks can be caught in that trap. To get them out of it the Government may have to increase the guarantees to savers and make sure any vulnerable banks are rescued before panic sets in. What we need most, though, we cannot deliver — a cut in interest rates. One suspects that part of the ECB's apparent intransigence is to avoid looking as if it is rescuing profligate Irish, Spaniards and others who showed such financial indiscipline.
In the short run at least, a eurozone recession might be our best bet.