What are the chances of another world depression? Even to ask the question might seem mischievous. Everything is going marvellously well. We have discovered the secret of everlasting growth. Don’t ruin it with inconvenient scepticism.
Yet in 2001, after the Wall Street bubble burst (and only four years after the global 1998 crisis, which severely affected Russia), a senior Nobel Laureate in economics wrote to me: ‘I feel back in the early half of the twentieth century with its many business-cycle syndromes’. I thought he was wrong, for two reasons.
First, governments have learnt how to correct, or even prevent, swings in economic activity. This was the result of the Keynesian Revolution. Keynes taught that the market system was not automatically self-correcting. When markets turned down, there was no guarantee that they would recover –at least quickly. Economies could get stuck in a rut, with massive unemployment. To prevent this situation developing, governments should run budget deficits –either by cutting taxes or increasing public spending –to keep up the level of aggregate demand. Even the knowledge that they were ready to stand behind the market would act as a brake on any downward spiral.
This is exactly what happened in 2001. The conservative Bush administration, although hostile to state intervention in the ‘free’ economy, weighed in with massive tax cuts (admittedly to the rich) and increases in government spending (mainly for military purposes).This ‘stimulus’, as it was called, got the US economy growing again, after only two quarters of negative growth and the threat of a world depression passed.
My second reason for believing we were not in the 1920s is that markets themselves have acquired built-in stabilisers. In the old days when investors were worried about declining stock prices they had little alternative but to buy gold or cash. This ‘flight into money’ drained liquidity and often led to a self-reinforcing downward spiral. Today’s financial markets offer for more opportunities for making money whether markets are going up or down. Financial instruments, such as short selling, options and all sorts of derivatives, are now widely used by investors and funds. The willingness of hedge funds to bet against the herd of other investors acts as a stabilising force – there are over $2 trillion under management of thousands of hedge funds that bet against the market and each other and tend to reduce volatility by quickly reacting to any changes in the market.
George Soros, however, sees hedge funds as a potential threat. They do act as stabilisers but only until a crisis when everyone starts betting in one direction. Hedge funds can make a crisis more severe because they are highly leveraged.
How likely are we to have a major crisis in the near future? There are several risks to the global economy. First, some experts expect oil prices to go to $100 a barrel and above, which is good for Russia and Saudi Arabia, but bad for everyone else. Second, rising interest rates could produce a credit crunch and cause a collapse of house prices, which is already happening in the US. Third, global imbalances could produce even larger currency swings, which would create uncertainly and reduce investment. What gives optimism is that oil prices have been high for the last several years, interest rates have already risen and there have been substantial currency swings (e.g. appreciation of the pound vs. dollar by 30%), without much negative effect on global economic growth.
It turns out that the secret of everlasting growth is that everyone expects everlasting growth. But the most likely event is the least expected. The first world war came out of a clear blue sky. So did the Great Depression. That’s the way our expectations play tricks on us.
Robert Skidelsky 