And there have been more of them than you think.
Rollercoaster equity markets must scare the living daylights out of many investors. Add them to fears of double-dips, prolonged recessions, collapse of the eurozone and other horrors and it must seem like a good time to bury cash in coffee cans in the back garden, as many Americans did in the Great Depression. A Fool could be forgiven for thinking that Armageddon is imminent.
Yet depressions with a small "d" are quite common in Britain, as in other major economies. In fact, we're in one right now, as some high-powered new research by the National Institute for Economic and Social Research makes very clear.
Also, we can draw some interesting conclusions about British depressions in general. The best way to judge the depth of a depression is by the old standby of economic output. Namely, whether GDP is up or down. Generally, equity markets follow GDP. So here's some lessons from depressions past and present.
The bad news
- The longer the depression, the greater the decline in GDP and the more wealth it destroys. The Great Depression between 1930-1934, although shallower than the one in the twenties (see below), wiped out the investments of many middle and upper-class families. Most of them took it on the chin, told nobody and just turned off the heating. Similarly, many Fools (or their mums and dads) will have lost a packet between June 1979 and June 1983 -- the longest depression in UK in the last century. Margaret Thatcher was in power at the time.
- The faster the fall, the harder it hits the pocket. Output plunged by nearly 25% in the short depression of August 1920 and May 1921. Similarly, the extended depression of 1920-24 was triggered -- or more accurately, preceded – by a 7% collapse in output. (Roughly speaking, output can be taken as a proxy for wealth destruction.)
- The more indebted households are when a depression hits, the longer it takes to extricate themselves from it. When this depression started in mid-2008, Britons had run up the biggest per capita debt of any nation on earth. The vast majority of household "wealth" was built on credit cards.
- When banks trigger a depression, it's generally worse than a common-or-garden one. Yet bank-led crises are surprisingly common. As McKinsey points out in a report in August, on average there's been at least one severe financial shock of some sort in a major economy in every decade for the past 110 years. So, they're almost normal then.
- And the current depression? Unless the economy makes a rapid recovery by next April, this will be even longer than Maggie's one. Measured by output , which is down by 6.5%, it's already on a par with the 1920-24 depression.
The good news
- The more affluent a nation is -- and the bigger its welfare state -- the less it hurts the average citizen because they've got a floor under them, as now.
- Regardless of how deep, sudden or long is a depression, the greater the opportunities in the shape of distressed assets. We see that in Britain now with most hard assets such as houses, as distinct from paper securities, falling steadily in value. So, depressions are good for cash-rich investors seeking hard assets. Indeed it's often a good time to buy material assets in general.
- We're probably on the way up. By recent historical standards, there's only a year to go before we've left this depression behind us. McKinsey shows that countries take a couple of years to emerge from bank-led crises and another couple to get back to normal levels of growth. That means UK Inc should be well on the road to recovery by late 2012.
- We're much better at managing recessions these days. Much as I love financial history, you can't draw too much from it. The Great Depression happened in a very different era from today. The Bank of England's Montagu Norman didn't really know what to do and nor did his protégé, Labour's chancellor of the exchequer Philip Snowden. At that time the British economy was something of a mess -- unbalanced and damaged from the First World War.
- Finally, it very much depends on what the government does to right the economic ship. And so far the coalition has gone pretty much by the book -- low interest rates, high liquidity, cuts in unproductive costs throughout government, nurturing of the wealth-creating sector, taming the banks.
So what should investors do now? As McKinsey makes clear, what turns a crisis into a disaster is credit, shortage thereof. That means banks must turn on the credit tap, especially for working capital, for those well-run, growth-minded companies that will lead us out of it. So that's what I'd watch for now -- the flow of commercial credit.
The good news is that the tap's opening up. And the research shows that equity markets bounce back quickly when credit starts to flow.
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