A tale of two depressions

Come the next catastrophe, we will rue governments’ cowardice
in failing to reform the banks

Talk of economic recovery is in the air. The FTSE has been steadily climbing over recent days. The banks are once more recruiting and paying fat bonuses. The sense of impending financial catastrophe which stalked the western world last autumn now seems a long time ago. But the mood of cautious optimism that is tangible in some circles is profoundly misplaced.

Certainly, as a result of the decisive action of governments last autumn, a meltdown has been averted and the financial sector has made a modest recovery. The US banks are once more recording significant profits, with a similar improvement in the UK. That said, the UK banking sector remains heavily socialised; a reminder of the near-death situation that threatened last autumn. And its capacity and willingness to lend remains severely impaired by the legacy of its previous excesses.

The state of the real economy is a different matter altogether. Over the past year, the British economy contracted by 5.6 per cent and it is expected that GDP will fall by 4-5 per cent over the course of 2009. Projections for the American, European and Japanese economies remain firmly in negative territory for this year, with close to zero growth predicted for 2010.

A recent report suggested that British living standards would not recover to early 2008 levels until 2013, a scenario which bears strong echoes of the 1930s. The general picture now emerging suggests that for the indefinite future western economies will be characterised by extremely low growth rates. We might avoid a 1930s depression, but far from having a V-shaped recession, or even a U-shaped one, we might be contemplating something more like an L-shape. High unemployment levels, excess capacity, severe contraction in private spending levels and huge fiscal deficits are likely for the next five years, if not longer.

Even this rather bleak prognosis should not blind us to the possibility of something worse. Two leading American economic historians, Barry Eichengreen and Kevin H O'Rourke, have argued in their recent paper, "A Tale of Two Depressions", that "world industrial production continues to track closely the 1930s fall". Both world stock markets and world trade "are still following paths far below the ones they followed in the Great Depression", and the United States and Canada "continue to see their industrial output fall approximately in line with what happened in the 1929 crisis". They conclude: "Globally, we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations . . ."

If uncertainty still surrounds the economic outlook, it is possible to speak with much greater assurance about two other aspects of the financial crisis: the political response to the failure of the banks and the economic fortunes of China in the wake of the western financial meltdown. Last autumn it seemed possible - if a little unlikely - that the US and UK governments might act to reform the financial sector. This has proved to be a chimera. Huge banks continue to combine both their traditional high street functions and the casino activities that brought them to their knees. Precious little new regulation has been introduced or is in the pipeline: in other words, an even bigger crisis lies in wait a few years down the road when the next hubristic boom collapses as a consequence of another round of excessive risk-taking. Worse, the banks now know that they are regarded as too big to fail: that governments will bail them out using taxpayers' money. This can only encourage even more irresponsible risk-taking.

The failure to reform speaks to the power of the financial sector and the timidity of government. The meltdown almost bankrupted the British economy and did considerable damage to the American economy. In terms of the resulting indebtedness - something that will be with us for many years to come and for which the bankers were directly responsible - the financial implosion cost the equivalent of a war. The parliamentary expenses scandal was not even peanuts in comparison. And yet, extraordinarily, bankers are already returning to their bad old risk-taking ways. Goldman Sachs has just notched up a huge increase in profits by resorting to familiar speculative ways. The failure to reform the banks will be regarded - come the next financial catastrophe, be it in five, ten or 20 years' time - as an act of abject political negligence and cowardice.

Finally, there was much speculation earlier in the year as to the likely impact of the financial crisis on China. Would the collapse of western export markets result in a severe decline in its growth rate and perhaps even serious social unrest? The forecast for China's economic growth in 2009 was downgraded by western financial institutions to around six per cent. These predictions have been confounded. The growth rate for 2009 is now expected to be in the region of 9 per cent, rising to 10 per cent in 2010. This is more or less in line with China's trend figures over the past 30 years and owes much to the decisive action taken by the Chinese government in response to the downturn - deficit financing, infrastructural spending and strict lending instructions to the banks. Unlike the west, of course, the government's capacity to act was not constrained by a banking crisis or chronic government debt.

The implications are profound. China's performance, like that of India, suggests that the phenomenon of decoupling - the fortunes of these economies ceasing to be inextricably bound up with those of the west - is no longer simply a hypothesis but is actually happening. Furthermore, the disparity between the performance of the American economy and the Chinese economy during the western recession is now even starker: this year the US economy is projected to contract by around 3 per cent. So during this recession China will be closing the gap with the United States even more quickly. It is hardly surprising that President Obama placed a quite new stress on the importance of co-operation during discussions between the two countries in Washington this week.