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. We wrote a separate post on inflation here, but in short, 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.
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.
Cracking the Debt Bubble
Stanley Druckenmiller recently said that he believed we had "cracked the debt bubble". What he means by this is that the long period of rising debts in the US and most of the industrialized world, as well as many emerging markets, has peaked and that we are entering a period of deflationary deleveraging.
The deflationary side of this is closely related to the deleveraging side. When debt levels are low then Central Banks have far more power to stimulate borrowing. Low debt levels also tend to coincide with higher interest rates because it is very hard to borrow a lot when interest rates have been high. So the Central Bank can simply lower interest rates and households and businesses with low debt burdens are able to borrowing. This borrowing translates into greater demand for goods and services putting upward pressure on prices (i.e. inflation).
But the opposite is happening today. High debt levels make it very hard for Central Banks to stimulate demand for goods and services because fewer households are willing or able to borrow. Many businesses are desperate to borrow, but to survive ... not to make investments in the form of buying real goods and services. These deflationary pressure are compounded by unemployment that by some measures is already around 20%. This puts downward pressure on wages which are a key driver of inflation. The result is a drop in demand which is putting downward pressure on prices (i.e. deflation).
Deflation increases the value of debt because it makes future dollars worth more than they are today. This just makes it even harder for households and businesses holding a lot of debt to pay it off. Incomes are shrinking. Profits are shrinking. But those debt are still the same. This puts pressure on those with any choice in the matter to avoid taking on debt. This is what feeds the vicious cycle of Deflationary Depressions ... a worry that incomes will fall and a belief that prices may fall as well leads many households and businesses to avoid spending...which only deepens the hit to economic growth and employment.
How Bad Might This Be?
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.
Factors to consider when evaluating the magnitude of a Depression besides debt levels include:
1) High Asset Prices including stocks, bonds, and real estate. Check!
2) Broad bullish sentiment prior to the crash. Check!
3) Long period of rising prices and economic growth without disruption. Check!
4) Stimulative monetary policy. Check!
While this potential Depression was triggered by COVID19 ... it also coincided with conditioned that looked very much like the end of a typical short term credit cycle. COVID19 also happened to cause a simultaneous supply and demand shock across the world...which can only make this a potentially worse scenario than a shock that unfolded over a longer period.
We also had elevated political tensions that were in part driven by income and wealth inequality. These inequalities are getting far worse and far faster than before. Those most effected by COVID19 lockdowns were lower income workers with service jobs that required physical proximity to other people like restaurants. Higher income workers are far more likely to have been able to work from home. Bond markets have largely been bailed out as well and far more wealth is stored in bonds than stocks.
Rising inequality and unemployment are very bad for political stability. We are also at risk of ill-informed and magical beliefs that the engine of economic growth that gave mankind the technology we have today can continue to improve the welfare of everyone without incentives to work and take risk. Capitalism is under threat from those that are more interested in forcing equality of outcomes than creating equality of opportunity...especially for young people.
The Great Depression didn't end because of the "New Deal" which began in 1933. Many very important regulations were put in place at the time such as insurance for banks which were going broke across the country. But the New Deal also included a lot of well meaning but arguably damaging laws like the "Live Poultry Code" that tried to force wages higher and put other restrictions that made life harder for business owners. The reality is that the Great Depression persisted until WWII...and may have gone on a lot longer. What quickly followed was a Cold War against communist dictators that controlled their populations in part with propaganda about the beauty of socialism.
Those ideas are starting to come back in part because of the rise of inequality ... and because our memories are fading.
What happens next?
If we are in fact headed for a Depression and we did "Crack the Debt Bubble" then its going to take a long time to recover.
Initially governments and central banks responded by making credit even more readily available. This has resulted in a surge of both government and corporate debt issuance. Many of the companies refinancing and borrowing right now are zombie companies ... meaning that they are doomed to go bankrupt at some point...its just a matter of when.
The longer it takes to restructure debts through bankruptcy the deeper the Depression will be. Economies weighed down by zombie companies do not have the full benefits of creative destruction, and that means lower productivity and weaker growth. That hurts everyone in the long run because it makes the pie smaller.
Many companies will also survive, but are heavily burdened by debt. Households burdened by debt are realizing they need to save more. That has historically been the case for countries that had low savings rates prior to a massive shock. A prolonged period of lower consumer spending is going to put pressure on businesses pay own debts...and that take a long time when you have higher debt levels than at any time in history.
We might be wrong...we hope we are. But given all the evidence it seems prudent to hope for the best while planning for the worst. Some might say you have a "patriotic duty" to go shopping. I say, don't buy things you don't need. Stay close to family if you can. Prepare for an extended period of isolation, scarcity of cash, and even higher levels of political dysfunction and perhaps even widespread protests and demonstrations of anger and frustration that tend to occur when opportunity cost of doing so is low (i.e. there is massive and persistent unemployment).