BERKELEY – In the 12 years of the Great Depression – between the stock-market crash of 1929 and America’s mobilization for World War II – production in the United States averaged roughly 15% below the pre-depression trend, implying a total output shortfall equal to 1.8 years of GDP. Today, even if US production returns to its stable-inflation output potential by 2017 – a huge “if” – the US will have incurred an output shortfall equivalent to 60% of a year’s GDP.
In fact, the losses from what I have been calling the “Lesser Depression” will almost certainly not be over in 2017. There is no moral equivalent of war on the horizon to pull the US into a mighty boom and erase the shadow cast by the downturn; and when I take present values and project the US economy’s lower-trend growth into the future, I cannot reckon the present value of the additional loss at less than a further 100% of a year’s output today – for a total cost of 1.6 years of GDP. The damage is thus almost equal to that of the Great Depression – and equally painful, even though America’s real GDP today is 12 times higher than it was in 1929.
When I talk to my friends in the Obama administration, they defend themselves and the long-term macroeconomic outcome in the US by pointing out that the rest of the developed world is doing far worse. They are correct. Europe wishes desperately that it had America’s problems.
Nevertheless, my conclusion is that I should stop calling the current episode the Lesser Depression. Yes, its shape is different from that of the Great Depression; but, so far at least, there is no reason to rank it any lower in the hierarchy of macroeconomic disasters.
The US bond market agrees with me. Since 1975, the nominal annual premium on the 30-year Treasury bill has averaged 2.2%: in other words, over its lifespan, the 30-year nominal T-bill yields are 2.2 percentage points more than the expected average of future short-term nominal T-bill rates. The current 30-year T-bill yields 3.2% annually, which means that, unless the marginal bond buyer today is unusually averse to holding 30-year Treasuries, she anticipates that short-term nominal T-bill rates will average 1% per year over the next generation. CommentsThe US Federal Reserve keeps the short-term nominal T-bill rate near 1% only when the economy is depressed, capacity is slack, labor is idle, and the principal risk is deflation rather than upward pressure on prices. Since WWII, the US unemployment rate has averaged 8% when the short-term nominal T-bill rate is 2% or lower.
That is the future that the bond market sees for America: a slack and depressed economy, if not for the next generation, at least for most of it.
Barring a wholesale revolution in thinking and personnel at the Fed and in the US Congress, activist policies will not rescue America. Once upon a time, policymakers understood that the government should tweak asset supplies to ensure sufficient supplies of liquid assets, safe assets, and savings vehicles. That way, the economy as a whole would not come under pressure to deleverage and thus push production below potential output. But this basic principle of macroeconomic management has simply gone out the window.
A majority of the Fed’s governors believes that aggressive monetary expansion has reached, if not exceeded, the bounds of prudence. A majority in the US Congress is taking its cues from “Theodoric of York, Medieval Barber” (a staple of the US comedy show Saturday Night Live in the 1970’s). It believes that what America’s infirm economy needs is another good bleeding in the form of more rigorous austerity.
As Oscar Wilde’s Lady Bracknell says in The Importance of Being Earnest: “To lose one parent…may be regarded as a misfortune. To lose both looks like carelessness.” It was America’s misfortune to undergo one disaster of the Great Depression’s scale; to undergo two does indeed look like carelessness.
What, then, should economists who seek to improve the world do, if we can no longer realistically expect to nudge policy in the right direction? CommentsAt a similar point in the Great Depression, John Maynard Keynes turned away from focusing on influencing policy. Instead, he attempted to reconstruct macroeconomic thought by writing his General Theory of Employment, Interest, and Money, so that the next time a crisis erupted, economists would think about the economy in a different and more productive way than they had between 1929 and 1933.
This week, the economist and frequent US official Lawrence Summers, in a lecture at the London School of Economics, called for another reconstruction of macroeconomic thought – and of the institutions and orientation of central banking. That is a Keynesian ambition, but can it be accomplished? A latter-day Keynes is nowhere to be found, and no Bretton Woods-style global consensus to reform central banking is on the horizon.
Extended Version: Barbers on the March
In the Great Depression that struck the U.S. in 1929, the subsequent twelve years before American mobilization for World War II erased the last shadows of the Great Depression, production averaged roughly 15% below the pre-Great Depression trend, for a total depression waste output shortfall of 180% of a year's production. Today, even if U.S. production returns to its stable-inflation potential by 2017--a huge if--we will as of 2017 have incurred a depression waste output shortfall of 60% of a year's production.
The losses from what I have been calling the Lesser Depression will not be over in 2017. As best as I can foresee, there is no moral-equivalent-of-war on the horizon to pull us into a mighty boom to erase the shadow cast by the downturn, and when I take present and values and capitalize the lower trend growth of the American economy as a result of the shadow into the future, I cannot reckon the present value of the additional cost at less than a further 100% of a year's output today, for a total cost of 160% of a year's production. The damage is thus equal to that of the Great Depression, counting a 1% of production shortfall as equally painful whenever it happens.
The U.S. economy today, however, has two and a half times as many people as the U.S. economy of 1929. And the U.S. economy today is five--or perhaps more--times as rich as the economy of 1929. In terms of the sheer real value of goods and services lost due to the depression waste output shortfall, the fact that the U.S. economy today is some 12.5 times the size of the economy of 1929 means that the absolute size of this downturn looks to be some fourteen times the size of the Great Depression.
Or perhaps it is even larger. I talk to my friends in the Obama administration. They defend themselves and the macroeconomic outcome by pointing out that the rest of the industrialized world is doing far worse than the U.S. They are correct. Europe right now wishes desperately that it only had America's problems. The Great Depression hit America the hardest. This downturn is not.
I have been calling the current episode the "Lesser Depression". My conclusion is that I should stop doing so. The current downturn has a different shape than the Great Depression did. But, so far at least, there is no reason to take the current Lesser Depression to be any smaller in the hierarchy of macroeconomic disasters than the Great Depression was.
As Oscar Wilde's Lady Bracknell says in "The Importance of Being Earnest": "To lose one parent, Mr. Worthing, may be regarded as a misfortune. To lose both looks like carelessness." To undergo Great Depression-sized one disaster may indeed by regarded as a misfortune. To undergo two does indeed smack like carelessness.
Is it possible that I am assuming the pose of a "Dr. Gloom" here? I do not believe so. For one thing, the U.S. bond market agrees with me. Since 1975 the term premium on the 30-year nominal Treasury bond has averaged 2.2% points: on average the 30-year nominal Treasury yields 2.2% points more than the expected average of future short-term nominal Treasury bill rates over its lifespan. The current nominal 30-year Treasury yields 3.2%/year. That means that, unless the marginal bond buyer today is unusually attracted to holding the 30-year Treasury, the marginal financial market participant anticipates that short-term nominal Treasury bill rates will average 1.0%/year over the next generation. The Federal Reserve keeps the short-term nominal Treasury bill rate near 1.0%/year only when the economy is depressed, when capacity is slack, when labor is idle, and when the principal risks are of deflation rather than of rising inflation. Since World War II, the U.S. unemployment rate has averaged 8% when the nominal Treasury bill rate is 2.0%/year or lower.
For another thing, the U.S. stock market agrees with me. Historically, the premium expected return for stocks has averaged some 5%/year over short-term interest rates: take the short-term nominal interest rate on Treasury bills, subtract the current inflation rate, 5% points, and you have the stock market's earnings yield. At the moment the current inflation rate is 2%/year and the short-term nominal interest rate on Treasury bills is 0. That would lead one to expect that the stock market would be selling at an earnings yield of 3%/year, which corresponds to a value for the S&P Composite index of 3000. The S&P Composite is selling for half that. What is the cause? The cause is that the marginal investor in the stock market does not believe that corporate earnings will grow over the long term at their normal rate, and so fuel a normal rate of real stock price appreciation. The marginal investor in the stock market is thus also looking forward to a prolonged period of stagnation and slow growth, or worse.
Yet a third vote, this one for long-term global stagnation, is cast by the foreign exchange market. If other countries were viewed as likely to do better than and offer higher returns to investors in the aftermath of the downturn than the United States over the next generation, the value of the dollar would have fallen significantly over the past five years. It has not. The relative attractiveness of the United States to global investors remains roughly what it was, strongly suggesting that the dismal outlook for American long-term stagnation is mirrored around the globe.
That is the future that the bond market crystal ball and the stock market crystal ball and the foreign exchange market crystal ball all see for the United States and the world: a slack and depressed economy, if not for the entire next generation, at least for the bulk of it.
Barring a wholesale revolution in the thinking and personnel of the Federal Reserve, the U.S. Congress, and their counterparts elsewhere, activist policies are not going to rescue us.
I had always thought that policy makers well understood the basic principle of macroeconomic management. It was that the government's proper role was to make Say's Law true in practice even though it was not true in theory: to tweak asset supplies so that there were sufficient liquid assets, enough safe assets, and enough financial savings vehicles that the economy as a whole did not feel under pressure to deleverage, and so push production below potential output. This principle has gone out the window. The working majority of the Federal Reserve believes it has extended its aggressive expansionary policies to if not beyond the bounds of prudence. The working majority in the U.S. Congress is taking its cues from the Saturday Night Live character "Theodoric of York, Medieval Barber". It believes that what the economic patient needs is another good bleeding of rigorous austerity, and that is putting further downward pressure on employment and production. And policymakers elsewhere are more enthusiastic advocates of what used to be called "prolonged liquidation".
What, then, should economists who seek to better the world do, if we can no longer realistically expect to push policy toward an appropriate posture?
At this point in the Great Depression John Maynard Keynes turned away from focusing on influencing policy to attempt to reconstruct macroeconomic thought by writing the General Theory so that the next time the crisis came economists would think about the economy in a different and more productive way than they had over 1929-1933. Up until 2009, I would have said that he had succeeded and been correct when he wrote to George Bernard Shaw at the start of 1935 that:
I believe myself to be writing a book on economic theory which will largely revolutionize--not I suppose, at once but in the course of the next ten years--the way the world thinks about its economic problems. I can't expect you, or anyone else, to believe this at the present stage. But for myself I don't merely hope what I say--in my own mind, I'm quite sure…
But today it is clear that the task was only half-done, if that. The same ritual incantations to summon the Confidence Fairy to appear and shower the blessings of prosperity on the economy that were made by the Herbert Hoovers and Andrew Mellons and Ramsay McDonalds and Stanley Baldwins of the 1930s are now being made by the Olli Rehns, the Wolfgang Schaubles, the Tim Geithners, repeatedly and ever-more frantically.
At the London School of Economic on March 25 Lawrence Summers called for the twin reconstructions of macroeconomic thought on the one hand and of the institutions and orientation of central banking on the other--of macroeconomics so that economists could understand and advise and turn policy makers away from their incantations to the Confidence Fairy to more useful tasks, and of central banking so that never again would central bankers find themselves without the confidence to use the necessary tools to maintain prosperity.
But I am not smart enough to be a Keynes. And no second Bretton Woods consensus to rebuild global central banking is on the horizon.