The Investment Scientist

The Great Depression: Will It Happen Again?

Posted on: August 22, 2019

Why was the Great Depression so bad? Are we likely to experience something like that in our lifetimes?

This month and next, I plan to write a series of articles about financial crisis. The ideas for this series will come from my Oxford University economics class. The class was taught by Professor Oren Sussman, a prominent scholar on the subject of financial crises. My aim is to explain concurrent economic policies, as well as to answer important questions like those posted above.

Irving Fisher (1867 – 1947) was an American economist who had a very simple theory about the great depression, and who inspired many post-Keynesian economists in later years. He observed that the prices of all things tumbled during the great depression, 43% to be exact, and that had a devastating impact on firms. See a stylized example of a surviving firm below.

Irving Fisher’s debt-deflation theory of the great depression

The firm had $100 in assets on its balance sheet. On the liability side, it had $50 in debt so its capital or owners’ equity was $50. Once the gross price level P fell by 43%, the firm’s assets were reduced to 57, its debt remained at $50, thus its capital or the owners’ equity dwindled to only $7. That’s a devastating 86% loss. The simple example isn’t just an unrealistic example. During the Great Depression, the S&P 500 actually did fall by 87%!

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The firm in the example at least survived. Many firms that had a debt to equity ratio larger than 57/43 = 1.325 were not so lucky. They got wiped out completely. That’s why the Great Depression was so bad and lasted so long, it was self-reinforcing by deflation.

The debt-deflation style depression is unlikely to happen again since governments around the world have become very good at preempting deflation. Every time there was a recession, they would “print money” to engineer inflation – the reverse of deflation. The modern form of money printing doesn’t involve the printing press, instead all the government needs to do is to reduce interest rates, and once rates reach zero, employ quantitative easing (QE.) These are the modern tools to flood the market with new money.

Let’s examine some evidence of this in the US. As you can see in the chart below, every time there was a recession (grey areas,) the Fed would drive interest rates lower. In the last recession, which was the worst since the great depression, the Fed drove rates all the way down to zero, then QE was used for 6 more years to ensure inflation.

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Where did all the new money go? Much of it went to push up asset values and stock prices. The 300% return of the S&P 500 since 2009 was not by chance, nor was it a result of productivity growth, it was engineered by money supply growth.

Now with just the slightest hint of a recession possibility, President Trump is already beating up Fed Chairman Powell to reduce interest rates (increase the money supply again). Politicians seem to be addicted to easy money, but is easy money is a permanent cure for recessions? I will write about that in my next article.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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