In The Return of Depression Economics, Paul Krugman argues that we’re facing an economy in which the dynamics of the Great Depression have been recreated – excess capacity, insufficient demand, and a banking system meltdown.

What exactly does it mean to deal with a banking system meltdown?

From 1929 to 1933, the US economy experienced an epidemic of bank failures – all told nearly 11,000 banks failed. At that time, a bank failure meant that deposits simply disappeared – if you had money in that bank, you were screwed. Your money was gone. A bank failure not only ruined the bankers, it ruined people whose money was now gone.

A banking and credit crisis is not abstract. Businesses – with almost no exceptions – depend on access to short term credit. As credit freezes, businesses aren’t able to operate. Businesses borrow against assets – including accounts receivable. As their customers find it harder to pay, banks cut business credit lines. It becomes harder for businesses to manage day to day operations – let alone expand. The collapse of the banking system spread the misery of the Great Depression.

At the same time, the Fed cut interest rates – the Prime Rate declined from 5.85% in 1929 to 1.73 % in 1933, dropped to .75% in 1935 and stayed below one percent until after WWII. It was the dreaded liquidity trap (from a 1998 paper by Paul Krugman):

A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero – so that injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes. By this definition, a liquidity trap could occur in a flexible-price, full employment economy; and although any reasonable model of the United States in the 1930s or of Japan in the 1990s must invoke some form of price stickiness, we can think of the unemployment and output slump that occurs under such circumstances as what happens when the economy is “trying” to have deflation – a deflationary tendency that monetary expansion is powerless to prevent.

The US has fallen into the liquidity trap again – the Prime rate is hovering around .25% right now. We’re facing a banking crisis of a sort we haven’t seen since the 1930s. And until we can unravel that mess, we’re going to stuck in low gear – what economics call a Growth Recession, a period when the economy is growing but growing too slowly to create real prosperity or to keep up with demographic growth. It’s looking increasingly likely that George W. Bush will be the first President since Hoover to preside over a net job loss in his time in office.

I’m about to do something I don’t think I’ve ever done: Quote Suze Orman.

So many of you are acting that just because the Standard and Poor’s 500 stock index lost 37% and the Dow shed nearly 32% last year that that somehow means we can’t or won’t see more losses in ‘09. As if there’s some sort of rule against consecutive bad years. What is so important for you to understand is that there is no magic market wand you or I can wave to make this all go away. And I am so sorry to say that I think it is foolish to think that a massive stimulus package will be an insta-cure. I can only pray it will help, but recovery is not going to be quick and there are no easy solutions. So I think it is wiser to be realistic and to keep in mind that it is going to take years, my friends, to make this all right. Yes I said years — in fact I think it will be till 2015 before everyone feels hopeful about their portfolio again. But that is okay — for the years come quickly and sooner than later we will be there.

For decades, the US has experienced short recessions – we’re already in the second longest recession since 1945. It’s looking likely it’ll bet the longest post-War recession. If Orman is right and we have 6 more years, we need to face the fact that we’re in an era of Depression economics when we need our government to be very focused, active and very smart.

It’s time to bring back Roosevelt’s motto – you try something, if it doesn’t work, you try something else.