Current Recession Is a Severe Credit Bust of Depression-Era Magnitude

Economics / Great Depression II
Jul 04, 2009 - 12:16 AM

By: Mike_Whitney

There's a big difference between inventory-driven recessions and credit-driven recessions. An inventory recession is caused by a mismatch between supply and demand. It's the result of overcapacity and under-utilization which can only work itself out over time as inventories are pared back and demand builds. Credit-driven recessions are a different story altogether. They typically last twice as long as and can precipitate financial crises. The current recession is a severe credit bust of Depression-era magnitude.



The financial system has effectively melted down. The wholesale credit system (securitization) is frozen, the banking system is dysfunctional and insolvent, and consumer spending has tanked. The Fed's multi-trillion dollar lending facilities and monetary stimulus have kept the financial system from grinding to a halt, but the underlying problems still persist. Fed chairman Ben Bernanke has chosen to avoid the hard decisions and keep the price of toxic assets artificially high with the help of a $12.8 trillion liquidity backstop. That's why stocks have rallied for the last 4 months while conditions in the real economy have steadily deteriorated. Bernanke is using all the tools at his disposal to keep the market from clearing and prevent the mountain of debt that has built up over decades from being purged from the system. Unfortunately, as Ludwig von Mises said, "There is no means of avoiding the final collapse of a boom brought on by credit expansion."

The surging stock market has made it harder to see that the economy is resetting at a lower rate of economic activity. Deflation is setting in across all sectors. Housing prices are leading the retreat, falling 18.1 percent year-over-year according to the new Case-Schiller report. Vanishing home equity is forcing households to slash spending which is weakening demand and triggering more layoffs. It's a vicious circle which ends in slower growth.

Also, the banking system is still broken. The $700 billion TARP program was not used to purchase toxic assets, but to buy equity stakes in the banks and to bailout insurance giant AIG. Bernanke knows that a hobbled banking system will be a constant drain on public resources, but he refuses to nationalize the banks or restructure their debt. Instead, he's expanded the Fed's balance sheet by $1.2 trillion and ignited a rally in the stock market. Bernanke's bear market rally has lifted the financials from the doldrums and generated the capital the banks need to survive the downgrading of their bad assets. Former Fed-chief Alan Greenspan (unintentionally) clarified this point in an editorial in the Financial Times :

"The rise in global stock prices from early March to mid-June is arguably the primary cause of the surprising positive turn in the economic environment. The $12,000bn of newly created corporate equity value has added significantly to the capital buffer that supports the debt issued by financial and non-financial companies.... Previously capital-strapped companies have been able to raise considerable debt and equity in recent months. Market fears of bank insolvency, particularly, have been assuaged.

Global stock markets have rallied so far and so fast this year that it is difficult to imagine they can proceed further at anywhere near their recent pace. But what if, after a correction, they proceeded inexorably higher? That would bolster global balance sheets with large amounts of new equity value and supply banks with the new capital that would allow them to step up lending. (Alan Greenspan, "Inflation, The real threat to a sustained recovery", Financial Times)

Clearly, Bernanke was thinking along the same lines as Greenspan when he decided to push traders back into the market with his generous liquidity programs and quantitative easing (QE). He probably realized that political support for more bailouts had waned and that "large amounts of new equity" ( Greenspan's words) would be needed to keep the banks from defaulting. Whatever his motives may have been, Bernanke's stimulus has turbo-charged equities while the real economy continues to sputter.

Jordan Irving, who helps manage more than $110 billion at Delaware Investments in Philadelphia told Bloomberg News, “This has been a government-induced rally. We need to see some real positives coming from internal demand, as opposed to government-related demand, and it’s just not there.â€