The American economy went into recession just over one year ago. The OECD has just announced that for the last part of 2008, the OECD area suffered the largest average quarterly downturn in GDP (1.5 per cent) since it began to keep records in 1960. As the U.S. downturn goes global, the rest of the world looks to the U.S. for clues as to what to expect next.

To arrest economic decline, the American central bank, the Federal Reserve Board, with assistance from the U.S. Treasury, has increased its lending to the financial sector by a stupendous amount. We are talking about $7.6 trillion with $2 trillion more still to come.

The Obama administration has just signed into law a stimulus package that is expected to drive the American deficit spending up well past the records set by that of his predecessor, George W. Bush. The U.S. federal budget deficit is estimated to increase from just short of $500 billion, to some $1.2 trillion, in order to fight the recession.

Still, many fear the U.S. economy will collapse into depression. Wall Street Journal columnist, Peggy Noonan, talks about the prevalence of "collapse anxiety" among Americans. Indeed parts of the U.S. economy have already collapsed, most obviously auto sales, the Detroit Three, real estate sales and housing starts.

A depression is when the economy declines and does not recover. Instead, output growth stagnates, and employment gets stuck at high levels. In the 1930s, for example, U.S. unemployment went up to well over 20 per cent, and stayed there until World War II brought a recovery of employment.

Professional economic observers are fearful and anxious as well. The American economy is undergoing much more than a downturn in a cycle, soon to be followed by a recovery. The financial sector is suffering a systemic crisis. Analysts, like NYU business professor Nouriel Roubini, talk about the American banking system being insolvent.

Insolvent means broke. Can a bank go broke? Yes. When it makes bad loans, its expected revenues disappear, and the bank still must make its interest payments to depositors, but it does not have the revenue to do it. Bankruptcy is not inevitable, but bailouts are needed.

The current U.S. recession has been characterized as a balance sheet recession. In other words the drop in across-the-board spending in the downturn is not the only problem. U.S. companies, families, and individuals went into debt to buy assets that turned out to be over-priced. When corporate assets did not produce expected revenue, the assets could not be sold at a high enough prices to pay off debts. When housing prices fell, owners were caught with mortgage debts that exceeded the value of their house, their main asset. Corporate and family borrowers stuck with bad assets, defaulted on loans. American banks have had to eat losses from these bad debts. This in turn feeds into more spending declines.

The balance sheet recession has spread out across the world economy, provoking more fears and anxieties elsewhere. European banks have bad loans on their books as well, and balance sheet pressures are also curtailing already slowed spending, pushing Eurozone economies down.

In the aftermath of the Reagan Revolution, lessons that were learned long ago by economists familiar with the depression were overturned, and replaced with fairytales about efficient, self-regulating markets.

What America needs to learn again is that markets have to be regulated, and that market failures are a constant feature of economic life.

The current crisis shows calculating future returns on assets cannot be turned by sophisticated mathematics into a scientific endeavour, because unseen and unsuspected risks always abound in a capitalist economy. The main capitalist criteria for measuring rewards — return on investment — cannot be established with certainty.

Americans are anxious, and there are good reasons to be anxious. It matters that economic advisors to Obama, such as Larry Summers, are among the economists that have got the nature of markets wrong up to this point. It is a lot to ask of them to set things right.

Duncan Cameron writes from Vancouver.

Duncan Cameron

Duncan Cameron

Born in Victoria B.C. in 1944, Duncan now lives in Vancouver. Following graduation from the University of Alberta he joined the Department of Finance (Ottawa) in 1966 and was financial advisor to the...