Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 5th February 2009.

In our 3rd December 2008 commentary we explained that the probability of an imminent great depression was uncomfortably high. Our reasoning, in a nutshell, was that the recent credit bubble was much bigger than any previous credit bubble of the past century and that the policymakers of today were blundering much more rapidly and on a much grander scale than their counterparts of the 1930s.

We can't over-emphasise that the Great Depression did not become "great" due to the economic problems signaled by the 1929 stock market crash, but, instead, due to government policies undertaken to counteract the economic problems. The policy errors we are referring to do NOT include the Fed's so-called failure to prevent the money supply from shrinking, but do include government actions designed to boost prices, expand credit, create employment, and re-distribute wealth. These actions delayed necessary adjustments, and as a result it took more than 15 years for the economy to do what it should have done in 2-3 years. As Franklin Roosevelt's own Treasury secretary, Henry Morgenthau, lamented in an address to Congressional Democrats in May of 1939: "We have tried spending money. We are spending more than we have ever spent before and it does not work. And I have just one interest, and if I am wrong ... somebody else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises ... I say after eight years of this Administration we have just as much unemployment as when we started ... And an enormous debt to boot!"*

It is commonly believed that the Second World War finally ended the Great Depression, but this is not true -- the Depression didn't finally end until government controls were eventually relaxed after the War. Preparing for and fighting WWII made sure that everyone had a job, but minimal unemployment does not necessarily go hand-in-hand with economic strength. In the former Soviet Union there was very little unemployment, but living standards were "third world". Herein lies the problem with treating job creation as a primary goal of economic policy.

As noted above and in our earlier commentary on this topic, government today is unfortunately enacting the same policies that made the Great Depression "great". Additionally, policymakers have stepped-up their efforts and appear to be more committed than ever to the path of increased spending, monetary pump-priming and economic intervention. As a result, we think the probability of a great depression has risen to the point where such an outcome is almost inevitable.

At this point it is appropriate for us to address a couple of related issues. The first is the perceived problem of falling confidence.

The famous economist J. M. Keynes didn't understand the link between the boom/bust cycle, fractional reserve banking and the central bank's manipulation of interest rates. He therefore relied on mysterious changes in something he called "animal spirits" to explain how booms would evolve into busts. Many of today's economists operate from within a similar faulty framework, and thus believe a key to turning the economy around is boosting the confidence of consumers and businesses. They don't seem to appreciate that the problems are REAL, as opposed to figments of our collective imagination. A loss of confidence, leading to less spending on current consumption and a consequential increase in saving, is a RATIONAL response to the current economic REALITY. By putting a hallucinogen in the water supply you could probably make people feel more confident and thus cause them to go out and spend freely for a while, but how could this possibly help given that the current predicament involves too much debt, too little savings, and a mismatch between production and consumption? Obviously it wouldn't help; it would just make a bad situation even worse.

Policies that encourage people to increase their borrowing and spending are, in effect, encouraging people to dig themselves into deeper financial holes, but such policies are now 'all the rage' in the world of economic policymaking. For example, one of this week's US Government schemes puts in place a financial incentive for people to borrow money to buy new cars. This scheme will cause damage to the extent that it actually does what it is supposed to do, but fortunately for the US economy it probably won't work (it probably won't lead to many additional car loans).

In sum, the problems are real. Confidence will naturally return after savings and production have adjusted to the new reality, while policies that convince people to ignore reality and behave less prudently in the short-term will only exacerbate the problems.

The next issue we'll cover is the implication of increasing the money supply. Many people, including the Fed Chairman, believe that the economy can be helped through its 'rough patch' via monetary inflation.

Those who share the Fed Chairman's belief should explain in detail, using good economic theory as opposed to Keynesian "animal spirits", how counterfeiting money can possibly strengthen the economy. One of the main considerations is that years of monetary inflation prompted massive investment in projects that should never have seen the light of day, leading to the situation where the economy's capital structure doesn't mesh with the needs of consumers. As far as we can tell, creating more money out of nothing couldn't possibly alleviate this problem.

Some will argue that monetary inflation 'works' (does good) by pushing up asset prices and thus reducing the debt burden, but let's think this through. If there's enough monetary inflation to push up asset prices then lenders will start demanding higher interest rates due to anticipated currency depreciation. Also, the cost of living will rise. At the same time, the aforementioned mismatch between production and consumption -- the root of the high and climbing unemployment rate -- will remain in place and probably become even more pronounced due to additional mal-investment. So, rather than having their financial burdens lessened by falling prices and low interest rates, those without jobs and those with excessive debt loads will have to deal with higher living and debt-servicing costs.

The bottom line is that the government can't improve the situation by creating money out of nothing, but it can CHANGE the situation. Specifically, it can make sure that the depression will be the inflationary kind rather than the deflationary kind. The inflationary kind is potentially worse because under this scenario the economy is less able to repair itself and you don't get the benefits that would otherwise be conferred by a falling cost of living. Unfortunately, the actions being taken by today's policymakers skew the odds in favour of an inflationary depression.

Finally, forewarned is forearmed. Our economic outlook could prove to be too pessimistic, but if you prepare for a depression -- by, for example, getting out of debt and building up substantial reserves of cash and gold -- and things turn out better than expected, you won't lose much. On the other hand, you will probably lose a lot if you prepare for a rosy scenario and a depression actually occurs.

*Quote taken from Burton Folsom's book "New Deal or Raw Deal?"

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