Economy

This is NOT the Great Depression

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Written by Joachim Fels at Morgan Stanley London   
Thursday, 20 November 2008
Morgan Stanley says don't compare the current recession with Japan’s in the 1990s or the Great Depression of the 1930s.

The base case for the global economy remains pretty grim.  

Morgan Stanley (NYSE:MS) think that this first synchronised recession in the advanced economies in more than 50 years will last at least until mid-2009, and emerging economies are slowing very sharply.

Headline inflation is likely to turn negative in the US and in the UK (on the RPI measure) next year and looks set to fall below target in the euro area.  

However Morgan Stanley continues to look for an anaemic recovery to set in during 2H09 and 2010, and believe that we will see a multi-year period of deflation.

Neither the Great Depression Nor Japan

Comparisons with Japan’s ‘lost decade’ of the 1990s or even the Great Depression of the 1930s have become quite popular.  

Given the size of the shock to the financial sector and the recent sharp deterioration of economic indicators, this is understandable.

However, there are a few important reasons why Morgan Stanley think that things will turn out to be neither as bad as in the Great Depression nor in the milder version of a depression that played out in Japan in the 1990s.      

Three policy mistakes in the Great Depression

The Great Depression started out with a bursting asset bubble after a period of easy credit and irrational exuberance in the late 1920s that led to a recession.

What turned the recession into a depression, however, with the US unemployment rate rising to 25%, was largely three major policy mistakes:
  • First, the Fed (and other central banks) stood by watching as one bank after another collapsed, and allowed a major contraction of the money supply.
  • Second, fiscal policy was passive as governments tried to adhere to the balanced budget doctrine. Falling tax receipts thus led to cuts in government spending, aggravating the downturn in private sector demand.  This only ended when Franklin Roosevelt took office as US President in 1933 and created the New Deal.
  • Third, starting with the US Smoot-Hawley Tariff Act in 1930, a trade war began between the US and Europe, with governments raising import tariffs and thus choking off world trade.
Today, however, policymakers are acting very differently, thanks to the lessons drawn from the Great Depression.  

Following the collapse of Lehman Brothers, the regulators have made it clear that no systematically important banks will be allowed to fail.  

Central banks have resorted to major monetary easing, consisting of a combination of much lower official rates and massive quantitative easing (see David Greenlaw’s piece that follows).

Governments around the world are busy devising and enacting large fiscal stimulus packages. And, it appears unlikely that the world will see another trade war.  So, the reason why another Great Depression is unlikely is that today’s policymakers understand what went wrong back then and are eager not to repeat the mistakes of their predecessors.

Also, a Japanese-type scenario is unlikely.

If this is not the Great Depression, could it turn out to be Japan’s milder version of the 1990s?  

After all, Japanese policymakers had the advantage of having studied the Great Depression and still ended up with a ‘lost decade’ of recurring recessions and (mild) deflation.  

Again, Morgan Stanley thinks it is different this time, mainly because policymakers in the US and Europe are doing already now, and in size, all the things that Japan did in a staggered fashion and partly with long delays:

After the equity and real estate bubble burst in 1989-90 and the economy entered recession, for many years banks were allowed to carry bad loans on their books without having to write them down.

The government only started to inject capital into banks in 1997, seven years into the lost decade.

Fiscal policy was stimulative, but the direct impact on effective demand was relatively small (less than 1% of GDP in most years), according to our Japan team.

The Bank of Japan only resorted to quantitative easing (QE) in 2001, more than 10 years after the crisis started.

By contrast, US and European banks over the past year have been busy writing down bad assets, governments have started to recapitalise banks, major fiscal stimulus is on its way and central banks are not only cutting interest rates but have started QE.  

The monetary base (consisting of cash in circulation and banks’ reserves at the central bank) is currently growing at rates of 30-40% in the US, the euro area and the UK, and thus faster than in Japan in summer 2001 when the Bank of Japan started QE.  And importantly, as David Greenlaw explains in the note that follows, M1 growth (cash and sight deposits held by the public) has been surging in the US recently.

We take this as an early sign that the monetary policy transmission process is starting to work again.   

Bottom Line

Again, it is important to emphasise that the G3 are in a severe recession that will last at least until mid-2009, possibly longer, and headline inflation will likely become negative at some stage next year in the US and Japan and drop below target in the euro area. However, the early and massive policy reaction will, in our view, prevent a replay of Japan in the 1990s or, worse, another Great Depression.
 
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