By Brendan Brown

Global equity markets are understandably not taking seriously the ominous pessimism from commentators dissatisfied with the notion of an economic recovery emerging from below.

Yes the S&P 500 may be down a few per cent in recent days but that is mainly a reflection of the US dollar’s mini-rebound (which means foreign earnings become worth less in US dollar terms) and some long overdue downward correction (very small so far) in commodity markets.

Perhaps most significantly there is some anxiety in the consumer discretionary area.  In New York, consumer discretionary exchange traded funds rose by 50 per cent from their low-point of early March to early May, since when they have fallen by around 5 per cent, among considerable volatility. And some recent economic data releases on store sales and on industrial production have been a touch disappointing.  But given the Detroit bankruptcy-related slump in auto production in May, what meaning can really be given to the overall manufacturing decline for that month? And given that Chrysler autos have been flying out of dealers’ doors at distress prices, and overall auto sales have been rising most recently, it is not surprising that chain store sales have been correspondingly weak.

So how can we explain the excitement among the most bearish economic commentators? Some of this has been linked to an update of a widely circulated article by Professors Eichengreen and O-Rourke under the title of “A Tale of Two Depressions“. This shows that for an array of global indicators the decline from last autumn to now has been worse than that which  took place in the six to nine months after the Wall Street Crash of October 1929.  The authors infer that if it were not for the bold policy response by our “dear central bankers and finance ministers”, the next three years would bring an economic calamity (depression).

Caution is always advisable in making historical cross-comparisons. But it seems that September/October 2008 was not a parallel juncture to October 1929 but rather to June/July 1931. It was in October 1929 that the US equity market bubble burst. By contrast, there was no broad equity market bubble in this last cycle.  There was a bubble in financial equities only.  Although there was a credit and real estate bubble as in the late 1920s, it did not move into the phase of drastic fall in temperature, accompanied by global financial panic, until 1931.

Indeed in many ways, the panic and temperature fall of 1931-1932 was far  worse than what we have experienced over the past year.  In that earlier period, Germany, the world’s second largest economy, had been in the greatest credit and real estate bubble of all (1925-1928), and was locked into a fixed exchange rate system with the US dollar, its banking system hugely under-capitalised and with large net external short-term liabilities to the rest of the world.

In fact, the Nazi Party had already made sweeping gains in the elections of 1930, raising the spectre of an eventual collapse of the Weimar Republic.  The collective global monetary response to the unfolding panic entailed a rise in German interest rates not dissimilar to what is happening in the Baltics today, a beggar-your-neighbour devaluation shock from the UK, and a panic global attack on the gold standard. This triggered a sharp rise in US interest rates even before the recession of 1929 had ended.

It was hardly surprising that a steep global economic downturn continued for a year to 1932 (when distinct improvement already occurred in Germany, so much so that the Nazi Party began to lose support); the ultimate recovery in the US was delayed from 1932 to 1933 because of a run on the dollar and rise of US interest rates amid fears that the incoming Roosevelt administration would take the US off the gold andard.

For John Maynard Keynes, this was the opportunity of a lifetime. The series of disasters provided a case for attacking the self-rebalancing concepts of classic economists which had been so meticulously assembled over more than a century to combat old notions of under-consumption and other related mercantilist drivel.

Here was the opportunity to construct a new order based on government interventionism in the economy and in the process kill the despised “rentier” investor class. The pity is that the Keynesian attacks on neo-classical economics gained the ascendancy in economics as taught around the world without due notice to the extreme circumstances of monetary disequilibrium and political catastrophe which created the depression.

It is a pity not to make those distinctions when analysing the present.  Yes, there is one similarity between then and now; the perverse, severe tightening of monetary policy which the European Central Bank and the Bank of England fostered throughout the first three quarters of 2008, already six to 12 months beyond the first great credit quake, because of fear of oil-induced inflation.

Every criticism is appropriate of that monetary policy which undoubtedly has made the European recession more severe and long-lasting than otherwise.  But we can take comfort from the fact that Germany today bears no political or economic resemblance to 1931. It stands out as the economy where there was no credit bubble and no real estate bubble.

What would one of the leading opponents of Keynesian populism in the 1930s, Professor Hayek, have to say about the neo-Keynesian followers of today warning about a new Great Depression and slapping the central bankers and finance ministers on the back for doing such a good job in preventing this?

A key insight of Hayek, distilled from the Austrian School of Economics to which he belonged, was that there is no such thing as “under-consumption”.  A rise in the propensity to save translates into higher investment spending and a well-functioning market economy has the mechanism to achieve this over the medium-term.

Yes, any shift, especially sudden, has the capacity to trigger a monetary disequilibrium, given that there is no guarantee in even the best functioning market system that money interest rates will remain closely in line with neutral or natural level.  And if that level changes suddenly and is very hard to estimate, then the risk of disequilibrium intensifies.

The main mechanism for producing higher investment spending is a fall in the cost of capital; both risk-free rates and equity cost of capital.  Higher saving means lower cost of equity capital and higher equity market valuations. Those in turn spur investment spending.

All the economic commentators and policy-makers now warning about continuing weak private final demand, shorthand for concerns about under-consumption, could take cheer from the Hayekian theory that low capital cost (and potential further equity market gains to achieve this) means that a long period of capital deepening (business investment strength) likely lies ahead.

Will businesses step up capital spending when consumer spending is lacklustre? Yes! It will be the financially strong and the winners of the Schumpeterian creative destruction process who will be pressing the button!

Related reading:

See Martin Wolf: the recession tracks the Great Depression

Brendan Brown is chief economist at Mitsubishi (UFJ) Securities International and author of Bubbles in Currency and Credit” (Palgrave, 2008). A version of this piece was published by Mitsubishi UFJ Securities International on June 17, 2009.

June 18, 2009 6:02pm in Central banks, Crisis, Keynesianism, Monetary policy, Recession | Comment