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Depression vs recession

Economists have many fine qualities, writes Roger Nightingale, but an ability to forecast is not one of them. The problem is that they don't understand what makes an economy tick. As a result there is much debate as to the nature of the crisis we are currently embroiled in. Crucially, there are more questions than answers. Is it recession we are facing, or depression? Is the current debility the weak phase of a single business cycle, or is it going to straddle several business cycles? If the former, the problem virtually cures itself. If the latter, there is no cure.

Although the outlook may seem bleak, our past experience of both recessions and depressions shows there are still business and investment opportunities available to those who know where to look for them. But first we must identify the nature of the crisis in order to understand how to benefit from it. So what is to be made of the current economics malaise? What is the nature of the downward lurch in activity that occurred early in 2008? What is the prognosis? 

The reality is simple enough. Commercial banks gambled and lost. Their reserves are now negligible at best; negative at worst. They no longer have the wherewithal to lend to the rest of the community. On the contrary, they need to take resources from others, either by earning excess profits or by sequestration, in order to survive.

In doing so they will leave the rest of the community, the industrialists, retailers, consumers and pensioners, impoverished. The only unresolved issue is how long the process will take to rebalance itself and how much pain the rest of us will suffer. Will it be a matter of months, quarters, years or decades? The majority, a little self-servingly, thinks the cure will be quick; the minority fears that it'll be slow.

We know a good deal about recessions (which occur every five to 10 years). They are the com­mon cold of the economics world: annoying, but rarely fatal. The doctor prescribes aspirin and sympathy and a short rest. Then, for the most part, the problem goes away of its own accord.

We know much less about depressions (which occur rarely, perhaps irregularly, once every 70 or so years).  Continuing the medical analogy they are plagues that devastate communities, blighting a generation or more. And the doctor has no idea what to do; in fact, the doctor is frequently a victim of the phenomenon.

Against this background, the serious economics analyst should ask himself whether the events of the last couple of decades seem to have anything in common with those that preceded earlier depressions such as in the 1930s or the 1870s. Each lasted a long time and was horrific. Sadly, the parallels are persuasive.

On both occasions, there was an extensive period of prior excess supply, characterised by people wanting to buy less than they wanted to produce. Initially, it seems like Nirvana. Inflation falls and interest rates follow suit. People use credit to augment their incomes. Real growth is satisfactory and asset values strong.

After a decade or more, however, the central bankers get nervous. They note that much of the borrowing they've been encouraging has been incurred not by respectable elements in the real economy or financial sector, but by rogues in each. They resolve to clean up the system by tightening money and raising interest rates.

They know that this will hit activity, but they argue that the cost will be small in relation to the benefit. Worryingly, economists, politicians, investment bankers and taxi drivers all agree. Accordingly, the authorities act. But the assessment proves to be wrong. The economy is devastated, activity dives into a bottom­less pit, unemployment soars and sentiment plunges. Does any of this sound familiar?

Nothing is certain, but the balance of probabilities dictates depression rather than recession. This prognosis is terrible for the economy, horrible for the working man, but, ironically, not too bad for the investor. For inspiration look to the 1930s when real returns in bond and equity markets were very satisfactory.

Global economist Roger Nightingale is speaking at Campden's 10th Anniversary Family Investment Workshop. This exclusive, closed door event takes place at the Mandarin Oriental, Geneva, Switzerland, on 23 & 24 June 2009. Click here to register.

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