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Mr. Ben S. Bernanke, who studied the Great Depression of 1929, is of the opinion that it was caused by reduced money supply from the Federal Reserve. Irving Fisher, a great economist, rightly pointed out that the primary reasons for the Great Depression were over-indebtedness and deflation.

Mr. Bernanke has never stressed the over-indebtedness preceding the depression. He has just focused on the role of the Federal Reserve during the crisis.

In the current scenario, the United States is in a state of over-indebtedness, along with expansionary monetary policies. Further, the crisis has lasted nearly five years, and things look no better in terms of employment and sustained recovery.

Therefore, it would be interesting to discuss whether the economy is heading towards a depression.

I am of the opinion that the U.S. economy is headed for an inflationary depression. The conclusion is based on the current state of over-indebtedness, the semi-recovery in the job market and an increasing intervention into free markets.

Before discussing the factor of leverage, I would like a point out that it is absolutely necessary for an economy to go through regular phases of recession. In general, a recession is a time when excesses in an economy are cleansed, leading to a subsequent period of robust growth.

Unfortunately, policymakers and politicians have zero tolerance for recession. With greater level of intervention in free markets, policymakers try to cut down the duration of recession through expansionary monetary policies.

Lesser time spent in recession is not leading to a healthier economy. On the contrary, lesser time spent in recession is leading to depression.

The chart gives the time spent in recession (percentage) during five different periods for the U.S. economy.

(click images to enlarge)

Time spent in recession (United States)

The time spent in recession during the best period of economic growth (1939-1982) was roughly 17%. Growth during this period was associated with rising prosperity, increased standards of living, low levels of debt and a fine blend of manufacturing and consumption in the economy.

The period from 1983 to 2007 looks great in terms of lesser time spent in recession. However, this period of growth was associated with an increasing intervention in free markets, high consumer and government sector leverage, and two big bubbles. The bubbles created wealth illusion, and consumer spending surged on the back of this illusion.

The total credit market debt increased from USD5.8 trillion in the first quarter of 1983 to USD50.9 trillion by the end of 2007. During the same period, GDP increased by 4.2 times against an 8.7 times increase in debt.

Therefore, one of the major reasons for the lesser time spent in recession was the commitment of policymakers to prop up the economy on every decline. The federal government's debt increased by nearly USD8 trillion from 1983 to 2007.

During this period, excesses have been built into the economic system, and there has been no cleansing of those excesses.

Therefore, it is not surprising that 38% of the time from 2008 to 2011 has been spent in recession. This period can be compared to the period of 1915-1938, when 37% of the time was spent in recession (largely due to the Great Depression).

Going forward, the United States is likely to witness a prolonged period of sluggish economic growth with periodic recessions. There are also some indications that the current crisis is a depression.

It is important to understand that the characteristics of the current depression cannot be compared with the depression of 1929. The 1929 depression occurred amid tight monetary policies, while the current depression is happening in an environment of expansionary monetary policies.

Further, I will not just consider GDP growth as an indicator of recession or depression. Measuring GDP growth is a complex exercise, and can be subject to manipulations. I will focus more on the job market, the standards of living and the state of consumers to conclude on the prospects of a depression.

The real unemployment rate (U6 rate) is at 15% for the U.S. This is nearly double the pre-crisis U6 rate. In other words, unemployment remains abnormally high nearly five years into the crisis. Adding to concerns, U6 has increased from 14.5% in March 2012 to 15% in July.

Unemployment Rate - U6 in United States

Clearly, sustainable growth and job creation is not in sight, and a prolonged period of high unemployment is a disaster for a consumption-based economy.

Another indicator of a possible depression is an increase in the number of Americans enrolling in SNAP benefits. Since October 2008, when the recession officially began in the U.S., nearly 16 million Americans have enrolled in the SNAP program.

Americans enrolled for SNAP

Data Source: USDA

Talking about the lost decade and its impact on households, nearly 29 million Americans have enrolled for SNAP benefits since the year 2000.

What this data tells us is that the huge government spending following the financial crisis has not percolated to the real economy, and it has not benefited the needy in terms of job creation.

The evidence of the point I am trying to make comes from the two charts below:

M1 money multiplier for United States

Excess reserves of depository institutions

The M1 money multiplier crashed after the financial crisis and remains at levels below one. This means that individuals and businesses are spending less on investment or consumption relative to the amount banks have for lending.

Clearly, the idea of easy monetary policies is not beneficial when consumers and businesses are over leveraged.

Further, as of July 2012, the Federal Reserve holds nearly USD1.5 trillion of reserves. Since the banks get interest on these reserves, there is no incentive to lend money, which might be a relatively risky bet in the current economic scenario.

Therefore, the entire exercise of zero interest rates is debatable when it comes to witnessing real benefits for the population.

As a result of these misguided policies, the probability of depression is significant. I had mentioned inflationary depression earlier, as a weak economy can also witness high inflation.

I discussed this topic in detail in one of my recent articles on the probability of Hyperinflation.

Investment Suggestions

Investing in equities would be a good idea, unlike during the depression of 1929. Continued expansionary monetary policies and a global diversification of the U.S. corporate sector make investing in equities an attractive option.

I would consider the SPDR S&P 500 (SPY), as it corresponds to the price and yield performance of the S&P 500 Index. In general, index investing is advisable, as it is not easy for investors to beat the index.

Expansionary monetary policies in the U.S. also have an impact on global equities as funds flow to emerging markets. I discussed exposure to emerging market equities in one of my recent articles.

It is also very essential to have exposure to physical gold or a gold ETF. In light of that, SPDR Gold Shares (GLD) provides a good investment option.

Investors considering bond investing need to avoid long-term U.S. Treasuries, and instead consider exposure to corporate bonds. Over the long-term, corporate bonds will be relatively safer, and also outperform the government bonds. I like the Vanguard Long-Term Corporate Bond ETF (VCLT) for exposure to investment grade bonds.

Besides these specific suggestions, a broad suggestion is to be diversified across asset classes and geographies. It is one of the most uncertain times for the global economy, and one can expect the unexpected. In such a scenario, over exposure to any specific asset class can be destructive for the portfolio.

Source: Less Time Spent In Recession Is Leading To Depression