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Learnings from past recessions

The central banks have been caught napping on the inflation front as US and Western economies contract

Most economists and analysts are now coming around to the view that the USA and much of the Western world will enter an economic recession this year.

A country is supposed to be in a recession when its economy has contracted for two consecutive quarters.

The American economy as measured by its gross domestic product (GDP) contracted by 1.5 per cent between January and March in comparison to October to December 2021.

It forms a little under one-fourth of the global economy and hence, when America sneezes the world catches cold. Given this, it is important to understand the past recessions that America has been through and what we can learn from them.

The Great Depression of 1929

The mid-to-late 1920s were a great time for America with the stock market going from strength to strength.

In October 1929, the stock market started to collapse. As the stock market kept falling, the depression was born and began to spread. An economic depression is a long-term contraction of the economy and is much more severe than a recession.

The New York bankers tried to halt the declining stock market. In doing so, they reduced loans to commodity dealers. The commodity dealers were unable to borrow, and they could not buy commodities. With no credit available, the prices of commodities such as coffee, rubber, hides, silk and tin, collapsed.

As the economic historian Charles Kindleberger wrote: “If the price of a commodity falls, it falls everywhere.” This is how the stock market crash turned into a depression. Between 1929 and 1933, the American GDP fell by over a fourth and unemployment grew to 25 per cent.

John Maynard Keynes

While economics as a subject had existed for a few centuries, its serious study started only after the Great Depression. John Maynard Keynes was one of the first off the block and his magnum opus The General Theory of Employment, Interest and Money was published in 1936. Keynes’ explanation of the Great Depression was the paradox of thrift or savings. For an individual to save by cutting down on expenditure made tremendous sense. But when the society began to save more, there was a problem. One man’s spending is another man’s income.

After the stock market crash in late October 1929, people’s perceptions of the future changed, leading them to cut down on their expenditure. As Nobel Prize winning economist Robert J. Shiller writes in Narrative Economics: “Sales of new cars by Ford Motor Company… fell 86% from 1929 to 1932.” Why did this happen? According to Shiller: “Those who already owned a car decided to keep the car going rather longer. Those who did not own a car, decided to continue taking public transportation.”

For those who lost their jobs, it obviously made sense to postpone purchasing a car. Even those who were not impacted by the Great Depression postponed their car purchases (and purchases of other things as well) given that they had a huge fear of losing their jobs.

In this scenario where people had cut down on their expenditure Keynes felt the government should become the ‘spender of the last resort’.

Around and after the time Keynes’ book was published countries across the world started to arm themselves in preparation for what would become the Second World War. This spending revived economic growth and told the world at large that what Keynes was saying was right.

Keynes believed that on an average, the government budget should be balanced. This meant that during years of prosperity, governments should run budget surpluses by spending less than what they earn. But when the environment is recessionary, governments should spend more than what they earn, running budget deficits. But over the decades, politicians ended up taking only one part of Keynes’ argument and ran with it. The idea of running deficits or spending more than what a government earns became permanently etched in their minds.

The mid-1970s and early 1980s

Over the next few decades, inspired by their understanding of Keynes, high-spending governments became the order of the day. America ran the guns and butter policy. The word ‘gun’ was in reference to the war that the US was fighting in Vietnam, and the word ‘butter’ was in reference to social programmes designed to achieve very low unemployment and redistribution of income.

This high spending by the government led to more money chasing the same set of goods and services, leading to prices rising at a faster pace or higher inflation. Inflation in the US touched 10 per cent in early 1974. This led to the economy contracting for three consecutive quarters from July 1974 to March 1975. The economists and the politicians had no idea of what had hit them. They hadn’t seen a period of high inflation and economic contraction, at the same time. Up until then, economic contraction was accompanied by falling prices or low inflation.

The inflation peaked at 14.7 per cent in early 1980 with the economy contracting by 8 per cent during the period April to June 1980. Finally, the inflation was brought under control with the Federal Reserve, the American central bank, raising interest rates and dampening consumer demand. What followed was almost two decades of economic progress.

The dotcom bust of 2000 and the real estate crash of 2008

The stock prices of dotcom companies which hoped to make money someday, went from strength to strength during the mid to late 1990s. The party ended in 2000 and 2001. But this did not hold back economic growth as investors moved to the next bubble, which was real estate. The real estate bubble ran out of steam through 2007 and 2008. In mid-September, Lehman Brothers, the fourth largest investment bank on Wall Street at that point, collapsed. Other large financial institutions were also in trouble. The Federal Reserve came to their rescue by printing and handing over money to them.

The American economy contracted through 2008 with a contraction of a massive 8.5 per cent from October to December 2008. This led the Federal Reserve to print more money and pump it into the financial system. The idea was to push down interest rates, encourage people to borrow and spend more, and companies to borrow and expand. With some hiccups, another Great Depression was prevented.

The Covid-19 pandemic

When the Covid-19 pandemic started in early 2020 the economic activity collapsed. The American economy contracted by around a third in the first half of 2020. The Federal Reserve went back to its 2008 formula where it printed money and flooded it into the financial system in a bid to drive down interest rates and encourage people to borrow and spend money, so that it would benefit the businesses and, in the process, drive economic growth.

Further, the governments across the rich world deposited money directly into bank accounts of people. This basically ensured that people had adequate purchasing power in their hands, something that Keynes had envisioned. The paradox of thrift was avoided.

Nonetheless, due to the covid pandemic global supply chains broke down, creating a shortage of goods. At the same time as people had money in their hands, prices went up.

Russia’s attack on Ukraine led to a global shortage of several commodities like oil, coal, sunflower oil, fertilisers, natural gas and nickel. As Kindleberger had said in the context of the Great Depression: “If the price of a commodity falls, it falls everywhere.” The vice versa is also true. This has led to a multi-decade high inflation in the rich world.

The conclusion

The world right now is much like it was in the mid 1970s to early 1980s. There is high inflation accompanied by the prospects of low economic growth or even an economic contraction. The central banks have clearly been caught napping on the inflation front. They thought that since money printing did not lead to inflation at the retail level in 2008, it won’t lead to inflation even in 2021 and 2022.

What they did not consider was the fact that in 2008, the printed money only reached financial institutions across the Western world. It did not reach the hands of people like it did this time around.

Now the central banks are trying to catch up by raising interest rates and trying to take out the money they have printed and pumped into the financial system over the years. As interest rates go up the hope is consumer demand will go down and at the same time inflationary expectations will be controlled.

Vivek Kaul is the author of the Easy Money trilogy