A World Depression?

In the summer of 1929 a few prophets foresaw the coming stock market crash. Only one gifted with second sight could have foreseen the sequel-a world depression historians would single out by calling Great. In the United States at any rate, most of the business community continued to believe in permanent prosperity, until the bottom fell out. In contrast to this optimism on the brink of the abyss, the mood of business in the United States, Western Europe and Japan today is deeply pessimistic. The doomsayers among us see the current world economic slowdown not as an ordinary recession of the familiar postwar variety but as the onset of something closer to what happened in the early 1930s.

Can support for such fears be found in an analysis of the causes of depression and the present state of the world economy? Or are they mainly a psychological phenomenon-a manifestation, perhaps, of anxiety about the state of the world and of a certain loss of nerve?

To answer these questions it is well to combine historical and analytical approaches-focusing, in the former, on the causes of the Great Depression in order to shed light on whether any comparable contraction of economic activity is probable today; and, in the latter, examining the background and causes of the present recession in order to see how serious it is likely to be.

The Great Depression was caused by a prolonged contraction of the money supply in the principal industrial countries, which brought about a massive deflation of incomes and prices, not only in these countries but in the world at large. In the three-year period 1930-32, the combined money supply of the four largest countries-Britain, Germany, France and the United States-contracted by some 18 percent, and in the United States alone it fell by more than 26 percent. Since it would probably have required about a 10 percent increase in the money supply of these four countries in this period to maintain full employment, it is hardly surprising that the world fell into a deep depression.

This extraordinary monetary contraction was due partly to gross mismanagement on the part of the U.S. and French monetary authorities. In the main, however, it is attributable to the fallibility of the monetary institutions of the day-in particular, the shortcomings of the U.S. Federal Reserve System and an international monetary system, the gold-exchange standard, that was highly efficient in transmitting monetary disturbances.

The current world recession is the aftermath of another traumatic monetary accident. In the three years 1970-72, the money supply in the ten largest industrial countries increased by 55 percent. The resulting price explosion, in conjunction with the return of more normal rates of money growth, has now plunged the world into recession.

Like the 1930s contraction, the 1970-72 monetary explosion originated in the United States and was transmitted to other countries via the balance of payments. It, too, should be attributed less to particular bad judgments than to the malfunction of institutions. The international monetary system of the period, the dollar standard, not only placed no effective check on monetary expansion in the United States, it also transmitted-and amplified-U.S. monetary expansion to the rest of the world, because foreign central banks were required under the rules of the system to support the dollar on the exchanges at its official exchange rate. This system's collapse early in 1973 has now allowed the authorities to slow money growth. Hence the recession.

But unlike the prolonged monetary contraction and depression of the early 1930s, which ran out of the authorities' control, the current recession will be short-lived. Inflation at anything like present rates cannot persist for long in a recession, nor can central banks keep their monetary policies tight for long now that unemployment is rising.

II

Like inflation, recession and depression, though they may be aggravated or mitigated by "real" (non-monetary) or psychological factors, are fundamentally monetary phenomena. In modern times, at least, there has been no major inflation or recession in any Western industrial country that was not initiated by a large imbalance between money supply and demand for money.

The supply of money is usually defined as total currency in circulation plus demand deposits (checking accounts) in commercial banks, known as "M1," although it is sometimes defined to include also time deposits, in which case it is known as "M2." The demand for money is the total amount of currency and deposits that the community feels it necessary to hold. This aggregate tends to grow regularly, because it depends chiefly on the normal or average rate of growth of people's incomes. Because the demand for money is fairly stable in the sense that it normally grows at a rather regular rate, an imbalance between the supply of and the demand for money usually arises from the side of supply. It is due to actions by the monetary authorities-or to monetary accidents-that speed up or slow down the rate at which the banking system is adding to the total money stock.

What happens when a monetary imbalance arises? Let us start from a position of monetary equilibrium, with the supply of money growing at the same rate as the demand for money, and the price level rising at a certain rate. In these circumstances, there is no monetary reason why the economy should not be operating at full employment. If the authorities now cause the money supply to grow more slowly, there will, for a time, be a deficiency of money relative to the demand for it. Households and firms will accordingly reduce their spending, as they attempt to build their real cash balances back up to the desired levels. As a result, incomes will grow more slowly or contract, business activity will decline and unemployment will rise. The economy will slide into recession.

Unless something happens to cause the money supply to keep on slowing down-which is what happened in the early 1930s-a recession is normally self-limiting and short-lived. The monetary disequilibrium which caused it sets in train a process of adjustment which tends to bring the demand for money back into balance with the reduced supply, and thus to bring the real economy back to full employment.

Rising unemployment of men and machines puts downward pressure on costs and prices and inflation gradually slows down. As inflation slows, given a constant growth in the money supply, the real value of cash balances begins to rise. This begins to correct the imbalance between the demand for real balances and the supply. As the imbalance is corrected, spending and business activity pick up again, and the economy returns to full employment.

In today's world, however, this process of adjustment is a long one because the response of prices to monetary restraint is slow. It seems to take from one to two years for a slowdown in money growth to have a major impact on the pace of inflation. Meanwhile, unemployment goes on rising. At some point in the evolution, the monetary authorities usually decide, for political reasons, to short-circuit the process by speeding up money growth, in order to accelerate recovery. In doing so, they interrupt the orderly slowing of inflation before it is fully accomplished, but they also ensure that the recession will be relatively brief. The low political tolerance for unemployment, coupled with the slow response of prices and costs to monetary restraint, are the chief reasons why recessions in the postwar period have been relatively mild-and why, too, this is an age of inflation, not deflation.

In principle, a central bank's control of the money supply derives from its ability to determine the volume of its own liabilities, which include the currency it issues and the deposits which commercial banks keep with the central bank as reserves. Together, these two monetary aggregates constitute the "monetary base" or "base money." The central bank creates or destroys base money whenever it expands or contracts its credit to banks or to the government-that is, whenever it adds to or reduces its portfolio of government securities and loans or discounts to commercial banks. The monetary base also expands or contracts when the central bank buys or sells gold or foreign currencies-to maintain the gold parity or the exchange rate of its currency.

The central bank has control of the rate at which it expands its domestic assets, so far at least as political pressures allow. But what happens to its foreign assets (gold and foreign currencies) depends on the country's overall balance of payments. This depends in turn not only on how fast the central bank expands its domestic assets but also on how rapidly other central banks are expanding or contracting their holdings of domestic assets. This is true, at any rate, as long as exchange rates are fixed, because in these circumstances, changes in any country's money supply will affect to some extent all countries' payments balances and monetary bases. Faster monetary expansion in the United States, for example, will cause funds to flow out (net) to other countries-i.e., there will be a deficit in the U.S. balance of payments-which means that foreign central banks' holdings of dollar assets rise, thereby increasing their monetary bases. Thus a central bank's monetary control is limited by the interconnections among national monetary systems, when exchange rates are fixed.

It is further limited because the relationship between the monetary base and the money supply-known as the money multiplier-may change. Normally, however, it does not. As long as the proportions in which the public desires to hold currency and bank deposits do not change much, and as long as banks do not alter substantially the amount of reserves they hold relative to the volume of their deposits, the money multiplier will be stable. The money supply will then be determined simply by the monetary base.

III

We have gone into these rather technical aspects of the process of monetary control because they are essential to an understanding of how the monetary contraction in the early 1930s happened. Early in 1928 the Federal Reserve began to cut back domestic credit in an effort to damp stock market speculation, and this policy was intensified the following year. The U.S. monetary base stopped growing and, toward the end of 1929, began falling gradually and continued to do so for the following 12 months until it turned up again.

The decline of the U.S. monetary base in 1929-30 would doubtless have led to a severe business recession in the United States, but what made the recession deepen into depression was the protracted U.S. banking crisis. The Fed's pressure on bank reserves, along with the declining value of bank assets (due to falling prices and business failures) caused some banks to fail. As bank failures spread there was a stampede of deposit withdrawals, but the Federal Reserve Board and the Administration took no action, allowing hundreds of banks to go to the wall. The public's confidence in banks was undermined and there was a sharp increase in people's preference for holding currency as against bank deposits. This tended to reduce bank reserves. The banks themselves contributed to the problem by protecting their solvency and raising the ratio of their reserves to deposits. The ability of the banking system to create money in the form of deposits was sharply curtailed, and the money supply fell much more rapidly than the monetary base. It continued to fall in 1931 and 1932, long after the base had started to rise again.

The U.S. banking crisis could have been arrested in its early stages by a massive injection of reserves into the banking system through open market purchases of government securities by the Federal Reserve, along with some form of deposit insurance-such as now exists-to reassure the public about the safety of its deposits. But the majority of the Federal Reserve banks and the Federal Reserve Board, the Hoover Administration and most financial leaders had no stomach for such intervention in a process which was accepted in the spirit of laissez-faire as natural-even as a beneficial cleansing of a banking system whose troubles were widely attributed not to general economic conditions but to excessive credit expansion and imprudent or incompetent management. Today, however, no central bank-least of all the Federal Reserve Board-is likely to be inhibited by such considerations from doing what is necessary to prevent a breakdown of its monetary control. The lessons of the U.S. banking crisis of 1930-33 are not likely to be forgotten.

IV

Monetary contraction in the United States in 1930-31 set off a chain of events on the other side of the Atlantic that culminated in a depression in Germany as deep as that in the United States, with political consequences far more destructive. From a monetary standpoint, Germany in 1930 was vulnerable. Reparations were a heavy burden on its balance of payments and the Reichs-bank's foreign reserves were small. As the Federal Reserve tightened up and the U.S. money supply fell, Germany's balance of payments went into deficit and the Reichsbank's reserves of gold and foreign exchange declined. At the same time, the flow of U.S. capital to Germany fell off and ceased altogether in 1930-31. The German monetary base fell. And, because Germany was on the gold-exchange standard, with a minimum ratio fixed by law between the Reichsbank's foreign assets and the currency issue, the Reichsbank could not cushion the contraction of the monetary base, due to the loss of foreign assets, by expanding its domestic assets.

Then came the collapse of the Kreditanstalt, Austria's largest commercial bank, in May 1931, followed by the banking crisis in Germany. Money fled Germany as foreigners, fearing that their assets would be frozen or lost when German banks failed, or that the Reichsmark would be devalued, withdrew their funds. Both fears were amply justified. Having failed to obtain the large foreign credits needed to halt the crisis-mainly owing to obstruction from Paris and indifference in Washington-the German authorities were forced, in order to arrest the outflow of funds, to close the banks temporarily and negotiate standstill agreements with foreign creditors. The mark was also devalued de facto by imposing exchange controls, and its convertibility into gold was effectively suspended.

How Money Supplies Behaved In The 1930s

Unlike their American counterparts, the German authorities did not allow the banking system nearly to collapse before intervening. Insolvent banks were propped up and the money multiplier in Germany does not appear to have fallen much. But the loss of the Reichsbank's foreign assets was so rapid and the resulting decline of Germany's monetary base so steep-during 1931 the base fell by 27 percent-that a severe depression was unavoidable. By April 1932, unemployment had reached six million, more than a quarter of the labor force, and the days of the Weimar Republic were numbered.

The German currency and banking crisis led to a speculative run on the British pound. For with the mark effectively devalued, the pound looked vulnerable-particularly so in view of Britain's large short-term indebtedness to foreigners and slim gold reserves. Sterling was further weakened by withdrawals of funds from London by continental banks and firms which needed liquidity, because their assets in Germany had been frozen under standstill agreements. Caught between the necessity to adopt restrictive monetary and fiscal measures if the pound's gold parity was to be saved and pressure from the Labour Party for a more expansive domestic policy to combat rising unemployment, on September 16, 1931, the British government suspended the gold convertibility of the pound and allowed it to float.

The German crisis and the pound's fall were blamed at the time on speculators. But the necessary condition for these events was the antecedent monetary contraction in the United States. Monetary contraction in the United States meant inevitably payments deficits for the rest of the world, and because the contraction was so rapid and prolonged, a gradual process of balance-of-payments adjustment, working mainly through changes in trade flows but leaving exchange parities intact, proved to be impossible. In the circumstances, currency speculation only speeded up a process that the extreme U.S. monetary contraction had already made inevitable.

Britain's prompt decision to float the pound saved that country from the depths of depression that the United States and Germany endured. No longer inhibited by fear of the impact on its gold reserve and on confidence in sterling's gold parity, the Bank of England was able to revalue Britain's gold stock and expand its domestic credit, thereby enlarging the monetary base and the money supply. The British economy began to recover, more than a year ahead of Germany and the United States.

But the pound's quick fall transferred the speculative pressure to the dollar, whose gold parity now looked precarious. European funds poured out of New York, and in three months the United States lost more than 10 percent of its gold stock. The Federal Reserve's response was a further tightening of monetary policy, despite the deepening depression, and this along with the loss of gold put more downward pressure on the U.S. monetary base. In April 1933, the Roosevelt Administration let the dollar float, and then in March 1934 devalued it. These moves, along with measures to strengthen confidence in banks (including federal deposit insurance provided for by the Banking Act of 1933), marked a turning point in U.S. monetary policy. Gold flowed in; the gold stock was revalued, and the money supply began to grow again, setting the stage for economic recovery.

With the pound floating and the dollar devalued, it was the turn of France to suffer monetary contraction. France lost gold, the monetary base fell and the economy slid into depression. Monetary contraction continued and the French economy languished until the franc was finally forced off gold, in 1936, by the expansive domestic policies of Léon Blum's Popular Front government.

The story of monetary contraction in the early 1930s would not be complete without mention of French and U.S. gold-sterilization policies. Beginning in 1926 after Poincaré's stabilization of the franc, France adopted a monetary policy whose purpose and effect were to attract gold in large quantities from the rest of the world. The Bank of France held down domestic credit expansion, creating a relative deficiency of money in France, which led to a large overall balance-of-payments surplus and a big gold inflow. If this golden avalanche, as it has been called, had been allowed to exert its normal expansive effect on the French monetary base, the payments surplus and the gold inflow would probably have been short-lived. Instead, the French authorities used a part of the increase in France's gold holdings to increase the gold backing of the French currency, thus preventing the inflow from having its normal one-for-one expansive effect on the monetary base. The aim was to restore the franc's gold backing as nearly as possible to 100 percent, its pre-World War I level. (Traditional French monetary doctrine holds that currency derives its fundamental value from its gold backing.)

This policy was not immediately harmful to France, whose monetary base and money supply continued to grow enough to sustain domestic employment, as long as the gold inflow continued. But the result was downward pressure on the gold reserves and the monetary base in Germany and other countries. The United States, too, played the gold-sterilization game in the period 1929-31, though for different reasons. By holding down its domestic assets, the Federal Reserve offset the effect of gold inflows on the U.S. monetary base.

Finally, the inadequacy of the world's monetary gold stock in this period contributed importantly to world deflation. At the official price of $20.67 an ounce, the price of gold in the 1920s and early 1930s was too low in terms of national currencies-too low, that is, to attract newly mined gold into monetary reserves. Given that the principal currencies were all tied to gold at a fixed parity, the world's monetary base was thus linked to a static gold supply. The deflationary potential inherent in the failure of central banks' gold reserves to expand was held in check for a time by the practice followed by central banks in continental Europe and elsewhere of supplementing their gold reserves by holding sterling and dollar assets as foreign reserves which were convertible into gold at a fixed parity-the practice which gave the gold-exchange standard its name. But when sterling and then the dollar came under pressure in 1931, large quantities of these currencies were converted, by private holders and central banks, into gold. In fact, some time earlier, the Bank of France had begun to convert its own holdings of sterling into gold, following the 1926 stabilization, pursuant to its basic policy of restoring the prewar gold basis of the franc.

In 1928, holdings of sterling and dollar assets by central banks had constituted more than 40 percent of total central bank reserves. By the end of 1931, the sterling-dollar component of central bank reserves was reduced to an almost nominal level, mainly as a result of private and official conversions of these currencies into gold. Such conversions left the world's supply of monetary gold unchanged but they wiped out a large part of world reserves, destroying in the process a considerable part of the world's monetary base. Thus the deflationary potential inherent in gold's undervaluation became actual.

In these varied ways, the workings of an international monetary system based on fixed gold parities helped to spread the U.S. monetary contraction to other countries, and in the process to amplify its deflationary effects both at home and abroad.

Fortunately, domestic and international monetary institutions have changed greatly since the monetary contraction of 1929-33. Central banks are far more sensitive to political pressure and more aware of the monetary consequences of a loss of confidence in banks. They are more willing to act, separately or together, to prop up ailing banks. Internationally, the crucial difference lies in the absence of fixed exchange parities and the fact that no currency, not even the dollar, is any longer convertible into gold. Thus the world's monetary base is no longer tied to a gold base that may become inadequate. National monetary authorities are no longer under the compulsion of protecting the gold convertibility of their currencies by eschewing domestic credit expansion. The link between the balance of payments and the monetary base has become less direct and automatic. Countries that are willing to allow their exchange rates to depreciate can keep their money supplies growing by virtue of domestic credit expansion even though other countries are pursuing more restrictive monetary policies. And with exchange rates more flexible, bank liquidity in a country is less likely to be suddenly reduced by a massive withdrawal of foreign funds.

These differences between then and now are reassuring. But before we conclude that forecasts of another depression can safely be ignored, we must look directly at the present recession and its causes, in order to assess the likelihood that this could lead on to something worse.

V

The current recession can be understood only against the background of the monetary binge that preceded it. In the 1960s, the money stock (M1) of the ten principal industrial countries grew at an average annual rate of about seven percent. In 1971-72, money growth in these same countries suddenly accelerated to about 12 percent per annum, and then slowed precipitously again to average about 7 percent from mid-1973 through 1974.

In these bare statistics lie most of the explanation of the extraordinary inflation of 1973-74 and of the present world recession. Fueled by this massive injection of money, prices took off, and with a powerful assist from the increase in oil prices in the winter of 1973-74, inflation in the ten countries reached a peak 16 percent annual rate (on the basis of consumer prices) in the first quarter of 1974, from which it has now receded to around 12 percent in the fourth quarter. With world prices thus rising so much more rapidly than the money supply, a recession of some severity was inevitable.

Money Supply & Prices in 10 Industrial Countries*

Seasonally Adjusted Annual Rates of Change

* Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Switzerland, U.K., U.S. Quarterly figures. Fourth quarter 1974 figures are projections.

The 1971-72 money explosion-like the monetary contraction of the early 1930s-was in large part due to an international monetary system based on fixed exchange rates. During the latter half of the 1960s that system had been under increasing strain. Ever since the Johnson Administration's decision in 1965 to escalate the war in Vietnam, U.S. monetary policy had become gradually more expansive. And, under the dollar standard as it existed until last year, there was little external constraint on U.S. monetary policy, since foreign central banks were obliged under the rules of the International Monetary Fund to buy any excess of dollars that emerged in their exchange markets at official rates of exchange. Leading European governments, France and Germany in particular, became increasingly restive about the inflationary consequences for their economies of growing U.S. balance-of-payments deficits-that were a direct consequence of accelerating money growth in the United States. Thus, the markets' belief in the immutability of the exchange rate between the dollar and other currencies-the belief that had been the linchpin of the postwar monetary system-was undermined.

In retrospect, it is clear that the 1968 gold crisis was the beginning of the end. Just as in 1931, the devaluation of the pound (in November 1967) was followed by a speculative run out of dollars and into other currencies and gold. To end the crisis, central banks had to terminate de facto the convertibility of dollars into gold, thus weakening still further confidence in the dollar's immutability. The system enjoyed a brief respite in 1969-70, as U.S. monetary policy was tightened. But when the Federal Reserve again opened up the money tap wide early in 1971, the system began to crumble. The U.S. payments deficit widened dramatically and was aggravated by a massive speculative run out of the dollar and into European currencies and the yen. The flows continued until February 1973, when the European and Japanese central banks finally gave up the unequal struggle with the exchange markets and abandoned any attempt to maintain fixed parities for their currencies vis-à-vis the dollar. The enormous flows across the exchanges pumped up the European and Japanese monetary bases rapidly. In the period January 1, 1971 to March 1, 1973, Europe's and Japan's foreign reserves increased by some $47 billion and their money supplies rose by more than two-thirds.

As in the 1930s, the breakdown of fixed exchange rates is popularly blamed on speculation. But, again, the necessary condition was what happened to the monetary aggregates in the largest economy, that of the United States. Without the increasingly expansive trend of U.S. monetary policy from 1965 on, the fixed-rate system could have survived-for a while longer at least-and in any event the world would have been spared the price explosion of 1973-74.

On top of all this came the Arab oil embargo and the decision of the Organization of Petroleum Exporting Countries (OPEC) to quadruple the price of oil. Coming at a moment when inflation in the ten leading industrial countries was already running around 12 percent per annum, the oil-price hike and its side effects on other prices, while not inflationary in a monetary sense, added another three to four percent on an annual basis to the general indices of world prices in the first quarter of 1974, and a diminishing increment on through 1974. The oil embargo and the rise in oil prices not only caused a sharp rise in the prices of fuels and of goods and services that incorporate petroleum, such as petrochemicals and transportation. It also helped to set off a sympathetic wave of speculation in other commodity markets. Firms in the United States, Europe, Japan and in many other parts of the world, fearing acute shortages and seeing commodity prices begin to accelerate, built up their materials inventories rapidly, putting further strong upward pressure on commodity prices generally. If there had been no oil crisis, inflation would probably have begun to cool off early in 1974, because world money growth had already been slowing down for about a year.

The decision of Europe and Japan to float their currencies against the dollar in February 1973 marked the end of the expansionary phase of world money growth and the beginning of the monetary slowdown that led to the current recession. Having again regained control of domestic monetary conditions by allowing their currencies to float, Germany, Britain and Japan took advantage of their new-found monetary autonomy to come to grips with inflation and adopted severely restrictive monetary policies. In all three countries the turn to restraint was abrupt. Money growth rates fell off from 10-15 percent in Germany, 15-20 percent in Britain and 25-35 percent in Japan in 1971-72, and to much lower rates in 1973. Meanwhile in the United States, the Federal Reserve was also moving toward restraint.

The price of this policy is a recession severe by postwar standards. Yet the world's monetary authorities could hardly have done anything else but call a halt to extreme monetary expansion. To have continued to expand money at anything like the 1971-72 pace would have been to accept an average rate of inflation in the industrial countries in the 10-11 percent range for the indefinite future.

VI

Looking ahead, the key questions are what is likely to happen to world inflation and to world money. If inflation slows sharply in the months ahead and money growth accelerates, business activity will begin to increase again sometime in 1975. But if inflation slows only a little and the monetary authorities press hard on the brakes, the recession will be longer and deeper.

As to money, there are already clues as to what is likely. The pace of money growth has turned up, particularly in Germany, Britain and Japan. In the German government, stimulating recovery now has a clear priority over fighting inflation, and the central bank seems to be going along. In Britain, too, a similar policy shift is in the making; and the Federal Reserve seems now to be taking effective measures to accelerate U.S. money growth from its dangerously low rate this summer. Money expansion in the ten principal industrial countries is likely to accelerate from about eight percent in 1974 to ten percent in 1975.

On this assumption, the combined gross national products, expressed in nominal terms (money values), of the ten countries would rise by approximately 12-13 percent in 1975. This forecast is based on statistical relationships between money and nominal GNP for this group of countries derived from past experience. The difference of two to three percent between the assumed expansion of the money stock and the projected growth of nominal GNP is accounted for by a projected increase in the rate of turnover ("velocity") of circulation of money in these ten countries, in accordance with an established trend.

The projected 12-13 percent growth of nominal GNP in 1975 in the ten countries is no greater than the 13 percent likely to be realized in 1974, which may seem odd in view of the acceleration in money growth we have assumed. The explanation lies in the extraordinary rise in the velocity of circulation of money in 1974 associated with the sudden rise in the price of oil and speculation in commodities. Since a repetition of this phenomenon is not likely, it will require more monetary expansion in 1975 to yield a somewhat smaller increase in nominal GNP than in 1974, even after allowing for the underlying upward trend in velocity.

What will happen to inflation next year is more difficult to foretell, but two factors are working together to diminish it. The more important is the slowdown in world money growth, which began nearly two years ago. This should mean a marked reduction in inflation in 1975. The less important is the non-recurring nature of the oil-price hike and its effects on other prices. These effects have now probably been exhausted; indeed, we are now witnessing a substantial decline in many commodity prices. For both these reasons, the feverish pace of inflation, which saw the world price level, measured by consumer prices in the ten industrial countries, rise by some 14 percent in 1974, seems likely to cool off to not more than 10-11 percent for 1975 as a whole-and substantially lower than that toward the end of the year.

Putting the nominal GNP and price projections together yields, by simple arithmetic, the conclusion that real gross national product (total output expressed in real or physical terms) in the ten countries in 1975 will be up one to three percent as compared with 1974, with output accelerating toward the end of the year as the pace of inflation slows. This forecast means that unemployment in most of the industrial countries-including the United States-will continue to rise right through 1975. 1975, in other words, will be much like 1974 so far as the average level of business activity and output in the principal countries as a group is concerned, but it will be quite different-and considerably better-so far as the trend of inflation and the condition of financial markets are concerned. By the end of the year, recovery should be underway in nearly all the industrial countries, and inflation clearly on the downgrade. The 1974-75 slump will go down in economic history as the worst of the post-World War II recessions-but not as a depression.

Another cut in oil supply from the Middle East could if sufficiently large cause a temporary fall in world output and employment, but a decline in economic activity due to a shortfall in energy supplies would not be a depression in the usual sense of a serious decline in activity caused by a shortfall in demand.

VII

Those who see depression coming may not be persuaded by the foregoing analysis, based as it is on history and on past relationships among money, nominal GNP and prices. In their view, novel elements in the world economic situation, especially the problem of recycling "petrodollars," create a new situation that contains the threat of a world depression.

The oil-producing countries are able to spend only a fraction of their vastly increased oil revenues. Those that cannot be spent are invested in the United States and other industrial countries, and it is feared that this could depress world demand because the surplus revenues are being saved rather than immediately spent for goods and services, but the monies so invested are not thereby withdrawn from the world's money supply and somehow sterilized. They are not bank notes buried under the sands of Araby. They remain in the industrial countries' banking systems, available for on-lending by banks and other private financial institutions.

A recycling problem arises only when countries that wish to take out such loans are unable to meet the credit standards that private lenders insist on. And this situation is likely to arise only when the borrowing country has a serious overall deficit in its balance of payments, independent of oil.

Stripped of complexities and of the mystique that has grown up around it, the petrodollar recycling problem boils down to the difficulty which several countries have in financing large overall balance-of-payments deficits, due in part to the high price of imported oil, through private money and capital markets. The issue here is not whether a country has a trade deficit; nearly all countries now have trade deficits as a result of high oil prices, including the United States, which has no recycling problem. The issue, rather, is whether or not the trade deficit causes the country's overall balance of payments to register a deficit, because capital inflows through regular channels, including investment of surplus oil revenues, are insufficient to offset the trade deficit.

Among the industrial countries only Italy and Japan (though in quite different degree) now have a serious payments problem, but the problem cannot simply be attributed to the high cost of imported oil. As we have observed in other connections, an advanced industrial country has a serious overall payments deficit only when its central bank is creating base money a lot faster (relative to the demand for money) than other leading central banks. Indeed, both the Bank of Italy and the Bank of Japan have been creating base money much more rapidly this year than central banks in the United States and other large industrial countries. In consequence, these two countries have large overall payments deficits-which they would have even if the price of oil were lower-because their monetary policies have been out of step with the rest of the world.

It follows that Italy's and Japan's recycling problem will ease as these two countries take steps to slow the expansion of central bank credit, and as monetary policies in other countries are relaxed. Meanwhile, they need financing outside normal private channels, such as the recent $i billion loan by Saudi Arabia to Japan and, in Italy's case, the credits from the German government, the European Community, and the International Monetary Fund's oil facility. Developing countries' balance-of-payments problems are more difficult to manage but fortunately, they are on a smaller financial scale. For a number of these countries, special assistance through official channels, bilateral and multilateral, is essential-and now seems likely to be forthcoming.

There is fear, too, that balance-of-payments deficits associated with high oil prices may lead a number of countries to adopt severely restrictive fiscal and monetary policies, trade restrictions and competitive exchange-rate policies, and in this way lead the world into depression. Perhaps it was a scenario of this kind that Secretary of State Henry A. Kissinger had in mind when he warned the U.N. General Assembly on September 23, 1974, that "Strains on the fabric and institutions of the world economy threaten to engulf us all in a general depression."

Yet if major international payments problems are due primarily to sharp differences among countries in monetary policy, the probability of this grim scenario is not high. Once monetary conditions in the United States and Western Europe ease again-as is now beginning to happen-balance-of-payments problems will become less acute. Present fears of a breakdown of international economic order, leading to depression, should then recede again. Such, at any rate, is the hopeful thesis of this essay.

There are many legitimate sources of anxiety in the world economic scene, but the question at issue is whether they include a depression. Psychiatry uses the term "free-floating anxiety" to mean an anxious state of mind induced by causes below the level of consciousness, which the patient is wont to attach, arbitrarily, to some familiar object of fear. So, the prophets of world depression may have conjured up a familiar danger in order to explain a deep-seated anxiety about the world's economic future which, in fact, derives from other sources.