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That’s what Paul Krugman says is on the horizon. In a sobering article in Sunday’s NY Times Mr. Krugman says policy errors are leading us right off the cliff:

We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense.

And this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.

Regular readers know my position. I never thought the secular bear ended or that the credit crisis was over. This has become abundantly clear as unemployment has remained stubbornly high and the credit crisis evolves into a full blown sovereign debt crisis. The recent evolution of the Greek crisis and scare mongering of certain market participants is almost certainly walking us off the edge of the cliff. Policymakers have misdiagnosed this crisis from the very beginning so it’s not surprising to see them continue down this same path.

It’s unfortunate that this is all unraveling with Greece at the epicenter. Policymakers have utterly failed in understanding that the Euro currency system is fundamentally different from the others around the globe – specifically in Japan, UK and USA. We’ve all become convinced that we are the next Greece (which is utterly insane). The Euro crisis is staggering and beyond frightening in my opinion. As I have maintained for years there is no true fix in Europe that doesn’t include full unity (a United States of Europe – which is impossible) or partial or full restructuring (full restructuring is inevitable in the long-run in my opinion). There is no bailout that can fix the inherent flaws in the single currency system. It is destined to fail in my opinion. That’s a terribly frightening thought and the Euro’s death might very well be on our doorstep. A swift death would be preferable in my opinion. Unfortunately, I see this crisis playing out for a very long time as politicians hang on to their Euro baby for as long as possible. The first step in rehab is always admission. We’re not even there yet.

Sometimes this feels like a terrible dream to me. It’s as if we are reliving the gold standard days all over again when countries realized the inherent restraints imposed on their nations via this foolish currency system. Many are arguing that austerity is the only way out of the Euro crisis, but austerity is already proving futile in countries that have undergone austerity measures. Exhibit A is Ireland where their budget deficit continues to expand. The same will occur in Portugal, Italy, Spain and Greece where austerity measures are in the works. Unfortunately for the Europeans, this is a currency problem and not just a budget problem. Europe appears doomed in my opinion unless a true currency fix is implemented. That alone could bring us all to our knees. Unfortunately, the problems don’t stop at the borders of Europe.

Here in the USA the economic woes continue long after the supposed end of the recession. I have long argued that we are Japan, yet we have implemented almost all of their failed policies. In 2008 I wrote a letter to the Fed asking that they very seriously consider what I referred to as the “Swedish Model” (I figured that even a married man like Ben couldn’t resist a Swedish model – I was wrong). In the late 80’s and 90’s the Swedes were suffering from a banking crisis that arose from a private sector debt bubble. It was strikingly similar to the problems in Japan, however, their responses were drastically different. The Riksbank detailed their options at the time:

The Swedish Bank Support Authority had to choose between two alternative strategies. The first method involves deferring the reporting of losses for as long as is legally possible and using the bank's current income for a gradual writedown of the loss making assets. One advantage of this method is that it helps to avoid the bank being forced to massive sales of assets at prices below long run market values. A serious disadvantage is that the method presupposes that the bank problems can be resolved relatively quickly; otherwise the difficulties compound, leading to much greater problems when they ultimately materialise. The handling of problems among savings and loan institution in the United States in the 1980s is a case in point.

With the other method, an open account of all expected losses and write-downs is presented at an early stage. This clarifies the extent of the problems and the support that is required. Provided the authorities and the banks make it credible that no additional problems have been concealed, this procedure also promotes confidence. It entails a risk of creating an exaggerated perception of the magnitude of the problems, for instance if real estate that has been taken over at unduly cautiously estimated values in a market that is temporarily depressed. This can lead, for instance, to borrowers in temporary difficulties being forced to accept harsher terms, which in turn can result in payments being suspended. The Swedish authorities opted for the second option.

Option A: Take your pain. Avoid the inevitable. Make the losers lose. Avoid moral hazard. Be transparent with the public’s money. Option B: bailout the losers. Let them live to fight another day. Hope they survive. Let moral hazard run wild. Use the public’s money foolishly and secretively. We obviously chose the same plan B that Japan chose – don’t make the losers lose. Now we are wrangling with a giant sized case of moral hazard and a banking sector that is still sitting on a potential time bomb.

The worst part is that public faith is slowly being shattered. This is, in my opinion, the death grip in deflation – which is very much a psychological battle. Allowing the losers to win was essentially admitting that the system is rigged. That’s no way to instill trust & confidence (which, at the end of the day, are the foundations of any economy).

I have long advocated an approach that was focused on Main Street and not Wall Street. After all, the crux of the issue has always been Main Street. And after years of bailing out Wall Street (only to discover that it achieved nothing – thank you Ben and the other Monetarists!) we are going to implement policy that further kicks Main Street when its down (thank you Austrians!). Last week’s watered down financial regulatory bill was just one more sign of how corrupt and inept our politicians are. It’s as if we keep bailing these losers out no matter what. This sort of backwards policy that ignores history is destined to fail. We continue to ignore Main Street at the benefit of Wall Street. History has shown this to be a very poor approach to a credit crisis.

We have truly wasted a crisis. Effective reform has been debauched. The banks remain as powerful as ever. Main Street remains weak. Monetary and fiscal policy has been primarily focused on helping the losers win (homebuyers tax credits to boost home prices, TARP & QE to bailout the banks, cash for clunkers to give more debt to the financially incompetent, etc). We could have crushed the banks and given the power back to consumers. We could have bailed out Main Street and not Wall Street. We could have forced the losers to lose and ensure trust and confidence in a capitalist system that has served this country pretty damn well since its inception. We have failed on all fronts.

I hate to sound so negative, but if policy continues to devolve with the flat earth economists at the helm we might very well end up being something worse than Japan – the United States (circa 1937). It’s looking more and more likely to me.

Source: The Third Depression?