1930s Style Debt Trap

The 1930’s Great Depression witnessed central banks and governments attempting to save the struggling economy through tax cuts and increasing government spending.

With the rise of monetarist ideas, (school of economic thought) the focus in fighting deflation was put on expanding demand by lowering interest rates. However, despite the government’s best efforts, Great Britain still suffered a 3 to 5% deflation problem in the 1930’s.

1930’s to 2009

If we fast forward to today’s present economic climate the worries surrounding financial fears are the same.

The country is displaying early signs of being trapped in a so-called ‘debt deflation trap,’ where families find themselves pushed further into the red every month. In addition falling prices and soaring debt add to the mounting evidence of a depression.

The Bank is using its quarterly bulletin to highlight this threat posed to the economy by deflation – where prices fall per year instead of rising. Although inflation is currently in positive stead, it is predicted to become negative in the foreseeing months.

The Bank is worried that this may combine with high levels of debt to squeeze families further. It fears that families will fall victim to the vicious predator that is the debt deflation trap.

This means that the cost of their debts, which are fixed, would increase compared to average prices throughout the economy. It is a vicious circle because whilst inflation dissolves debt, deflation makes them significantly higher.

The Bank’s report stated: “This configuration of falling asset prices and depressed economic conditions in the face of an adverse demand shock is consistent with recent and prospective macroeconomic developments in the United Kingdom and internationally”.

It helps explain why it took such dramatic action earlier this month to inject extra money into the economy. The bank slashed interest rates to just above zero and promised to create £150 billion worth of cash with which to buy up government and corporate debt.

This so-called quantitative easing is regarded as a radical measure to help prevent a repeat of the conditions associated with the Great Depression. The Chancellor recognised the situation was “grave” but pledged not to allow a repeat of the slump.

The Bank’s paper prompts that the UK is especially in the red zone because there is a high percentage of families who have prominent debt levels, and many of them are on fixed mortgage rates, which means they will not benefit from rate cuts.

Great Britain’s debt, which is owed on mortgages, credit cards and loans equals to £1.46 trillion, more than the value of what the country produces a year. Total personal debt has shot up by 165% since 1997 and each household owes around £60,000.

This debt is claimed to be the highest personal debt level in the world, according to the Conservative party.

The Bank’s findings has put yet even more strain on Prime Minister Gordon Brown, who this weekend faced calls to apologise for the credit crunch, to secure agreements on an effective international rescue strategy when he hosts the G20 leaders at a summit in London at the start of April.

The summit comes as statistics this week are predicted to show the number of people unemployed will reach the two million point.

G20 summit worries

Many feel that the Prime Minister may use the G20 as a justification for a string of further tax cuts and spending increase in the Budget next month, though a lot of economists have warned that despite the scale of the recession faced by the UK the Treasury has little capacity to borrow more.

However, Mr Darling has reassured the public by stating that the meeting must not mirror the 1933 summit held in London, which failed to stop the Great Depression.

The Shadow Chancellor said Mr. Brown must use the G20 as “the moment to send the clearest of signals that, unlike in the 1930s, this banking crisis will not send the world spinning into a protectionist spiral.”

He added that “ministerial promises” had failed to deliver any real benefits to struggling desperate businesses or home owners.