How Close Are We to New Great Depression?

The risk of a new depression — a sustained, severe recession — has struck fear into the heart of markets and driven monetary policy in developed economies since the current financial crisis began.

“We’re in a very unfortunate position to be here,” Richard Duncan, author of The New Depression, warned on CNBC’s “Squawk Box Europe” Monday.

“When we broke the link between money and gold, this removed all constraints on credit creation. This explosion of credit created the world we live in, but it now seems that credit cannot expand any further because the private sector is incapable of repaying the debt it has already, and if credit begins to contract, there’s a very real danger that we will collapse into a new Great Depression,” he argued.

“If this credit bubble pops, the depression could be so severe that I don’t think our civilization could survive it.”

The explosion in cheap credit has been widely blamed for the global financial crisis, but the debate about how to fix the problem continues.

In the past few years, central banks including the U.S. Federal Reserve , the European Central Bank and the Bank of England have pumped liquidity into their financial systems through a number of ways, including quantitative easing and the ECB’s long-term refinancing operation (LTRO).

“We could keep deferring the depression, but that could just encourage the bad guys. If you do this, you possibly do more harm than good,” Roger Nightingale, economist and strategist at RND Associates, told CNBC Monday.

“You can defer, but not prevent.”

Nightingale argued that previous credit booms, for example in Japan in the 1980s, have led to sustained recessions.

“When you throw money into the system at a rate much in excess of the requirements of the real economy, you’re trying to get people to borrow and spend, but the good guys out there won’t because they’re too cautious. It’s the bad guys who come in, the malefactors,” he said.

“When the central banks realize what is going on and raise interest rates, it flings the world economy into depression.”

The ideas of Milton Friedman, the Nobel Prize-winning economist who argued that monetary policy should constantly expand, informed some of the Fed’s response to the crisis.

“Policymakers really believe that if we allow credit to contract, we will reach a new Depression,” Duncan said.

“The increase in government debt is making total debt grow, otherwise we would already have collapsed in to a debt-deflation death spiral. This creates great perils, but also tremendous opportunities.”

Duncan argues that governments in the developed world should borrow “massive” amounts of money at the current low interest rates to invest in new technologies like renewable energy and genetic engineering.

“Even if this is wasted, at least we could enjoy this civilization for another ten years before it collapses,” he said.

His views counter those of economists who believe that governments should focus on cutting their debt, particularly where repayments on that debt are threatening to reach unsustainable levels, like in Greece.

© 2012 CNBC.com