Of Deflation and Depressions

Of Deflation and Depressions

Large declines in the CPI and PPI during October have prompted a flurry of concerns that deflation may be taking hold. Add to that, a host of lousy economic data such as the recent spikes in unemployment insurance claims, declines in consumer spending and tumbles in manufacturing activity and talk of Great Depression 2.0 has started to crop up.

This abundance of negative data makes it tough for even the most bullish person to sugar-coat the health of the economy right now. Some parallels to the Depression can be drawn (see here for an eerily similar description of the catalysts), but some of the beggar-thy-neighbor policies (i.e. punishing taxation and heavy trade protectionism) that turned a financial panic into what was arguably the worst economic chapter in American history do not exist now.

Furthermore, policymakers appear to have learned a thing or two about the mistakes made back then. For example, the money supply plummeted during the early 1930s as central banks around the world sat on their hands and watched numerous banks fail. In today's environment that is clearly not the case as the Federal Reserve, ECB and others have cut interest rates and boosted the monetary base by more than a third. The Fed's balance sheet alone has ballooned to nearly $2.2 trillion and numerous U.S. banks are being re-capitalized with direct injections by the Treasury, hardly the contractionary policies in place 70+ years ago. So clearly, Ben Bernanke et al are following the reflation handbook for dealing with the credit crisis. For a nice explanation of how all of these mechanisms work and should allay fears of any repeat of the Great Depression, see this article.

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