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Imagining A 21st-Century Depression

Mention the phrase “Great Depression,” and the black-and white image of men in fedoras on soup lines comes to mind. A 21st-century depression would scarcely resemble that of yesteryear, but would be similarly miserable.

Let’s be clear: The United States is not headed for an economic depression similar to the Great Depression. Since the Great Depression, countless economists have studied ways to avoid a repeat. Currently, governments worldwide, while far from perfect, are rapidly reacting to ensure that images of soup lines remain a memory. Income support mechanisms such as Social Security, unemployment insurance and food stamps are now in place that would broadly mitigate abject poverty. Governments are working together to strengthen the financial system and have agreed to avoid protectionist policies. U.S. Federal Reserve Chairman Ben Bernanke would sooner drop dollars from a helicopter than let the United States enter a deflationaryspiral.

But what happens after the victory over deflation? The U.S. government, constrained only by paper and ink, will have printed trillions of dollars. Unfortunately, U.S. output as measured by gross domestic product, or GDP, will not grow as fast as the money supply. This can cause inflation. If GDP trails money supply growth for an extended period, we may see foreigners sell their dollars and dollar-denominated assets in droves. Taken to an extreme, this process would trigger hyperinflation. Perhaps hyperinflation is the 21st-century version of a depression.

Hyperinflation, commonly associated with developing economies or postwar societies, is a low-probability, extreme scenario for the United States. But certain government tactics are pushing America in that direction. According to International Monetary Fund (IMF) researchers, “Hyperinflations are largely a modern and rare phenomenon generally associated with printing money to finance large fiscal deficits due to wars [sounds familiar], revolutions [none so far], the end of empires [uh-oh], and the establishment of new states [none planned].”

Hyperinflation is often defined as monthly inflation of 50 percent or more. The poster child for hyperinflation is Zimbabwe, where the inflation rate currently is 231 million percent. Long headed by dictator Robert Mugabe, the government is now bankrupt. Living standards have collapsed. Unemployment is 80 percent. The water supply is no longer purified. A cholera outbreak, which has infected 12,500 people since August, has claimed hundreds of lives, with thousands more likely to die.

More-developed, democratic economies also have struggled with hyperinflation. In the 1970s and 1980s, Argentina’s central bank failed to successfully regulate its money supply, leading to inflation rates of more than 1,000 percent in 1989 and 1990. In 1991, a peg to the dollar temporarily stabilized the financial system. But several years later, the central bank borrowed heavily (in U.S. dollars) from foreigners to finance its budget deficit. Eventually, its interest payments rose to unsustainable levels, leading Argentina to default on its sovereign debt. Following a run on banks, the government restricted withdrawals of deposits. Official unemployment reached 18.3 percent in October 2001. In December 2001, violent protests erupted, costing 27 lives.

In early 2002, the Argentine peso was devalued and plunged from a value of one U.S. dollar to 25 U.S. cents, a 75 percent decline. The prices of imported products became exorbitant. Businesses shut their doors. Inflation rose above 25 percent and unemployment officially rose to 21.5 percent. The poverty rate reached 50 percent during 2002 and 2003. At one point, 40,000 trash-pickers rummaged through Buenos Aires’ garbage nightly. However, the weaker currency was a boon to exports, and soon business and the government started raking in revenue. After some progress, aided by soaring commodity prices in 2007 and much of 2008, today’s Argentina is in jeopardy of again defaulting on debt payments due in 2009.

Society takes a major step backward in a depression when once-preventable diseases reemerge. Impoverished regions of Argentina eliminated certain insect eradication programs in the aftermath of the 2001 financial crisis. As a result, yellow fever and Chagas (a parasitic disease that can damage the heart and other organs), have reappeared. These diseases were under control during Argentina’s prosperous periods.

Iceland, a victim of the current global financial crisis, may be headed toward an inflationary economic depression. As the worldwide debt market unraveled over the past year, Iceland’s highly leveraged banks collapsed. The Icelandic stock market declined 80 percent. Government debt is now expected to grow from 29 percent of GDP at year-end 2007 to 100 percent of GDP by year-end 2009, including loans from the IMF, normally the lender of last resort to developing economies.

Iceland’s inflation rate currently exceeds 17 percent, while its economy is expected to contract by 10 percent in 2009. As Iceland’s currency plummets, exporters to the tiny island-state now require payments, in advance, in forms other than Icelandic krona. Fearful that imported goods will be unavailable in the future, Icelanders emptied the shelves at local grocers recently. One-third of Iceland’s residents are contemplating moving abroad, according to a recent study by market research firm Capacent Gallup.

When a home currency experiences hyperinflation, other forms of payment develop, such as foreign currency and precious metals. Imagine paying for your latte with some yuan or krugerrands.

Barter systems also develop during hyperinflation. But how would that work in a service-oriented economy such as that of the United States? Could I trade two hours of financial planning advice for one month’s worth of groceries? How many haircuts does a barber provide to Verizon Wireless for one month of mobile phone services? What if he made international calls?

A society accustomed to a certain standard of living, such as America’s, would be shocked by the changes caused by hyperinflation. Economic pain of this magnitude could lead to extremism. Might communism be next?

Good investments for inflationary periods include tangible assets such as real estate, precious metals and barrels of oil. Select foreign currencies and shares of stock that generate revenue in non-U.S. dollars also would perform relatively well. The worst investment in such an environment is a dollardenominated fixed-income instrument such as a U.S. Treasury security. Given the autumn 2008 rally in U.S. Treasuries, the market is not expecting a 21st-century depression. Let’s hope it’s right.

For more on the possible shape of a modern-day depression, please visit Preview: A Depression’s Depressing Statistics

If you enjoyed this article, be sure to check out Palisades Hudson’s books, The High Achiever’s Guide To Wealth and Looking Ahead: Life, Family, Wealth and Business After 55. Both are available in paperback and as e-books.