The costs of a depression in lost output, reduced incomes, and anxiety almost certainly exceed the benefits, and can have disastrous long-run consequences--had it not been for the Great Depression, it is unlikely that Hitler would have become chancellor of Germany. But that is not to deny that there can be some benefits, as our current depression illustrates. (The use of the word "recession" to describe any contraction less severe than the Great Depression is a triumph of euphemism over clarity.)
A depression is an essential backup to efforts to moderate the business cycle. The housing bubble could not expand indefinitely; leverage could not keep growing indefinitely. The government was doing nothing to prick the bubble or to limit leverage. The longer the world economy went without a depression, the worse the collapse would be when it finally, inevitably, came. The saving grace of catastrophes is averting worse catastrophes: imagine if, instead of attacking the United States with commandeered airliners, al Qaeda had waited a few years and attacked with suitcase nuclear bombs. We would not have been on guard, as we are now because of the 9/11 attacks.
A depression increases the efficiency with which both labor and capital inputs are used by business, because it creates an occasion for reducing slack.One might think that a firm that has slack in good times will have as much incentive to reduce it as it would in bad times; slack (failing to maximize profits) is an opportunity cost, which in economics has the same motivational effect as an out-of-pocket expense. But firms are organizations, and organizations experience agency costs, which are more difficult to control in good times than in bad. If a firm's profits are growing, it is easier for the firm's executives to skim some of the profits, pocketing them in the form of excessive compensation or perquisites, than when the firm is shrinking. In the former case, stockholders will be doing well, so the pressure they exert through the board of directors to minimize the extraction of rents by executives and other employees will be less intense than when the firm is at risk of collapse. When the depression ends, the firm will have lower average costs, though they will drift upwards as the firm re-grows.
Government is rife with agency costs as well. The depression will induce states, cities, and the federal government, all of which will be experiencing sharply reduced tax revenues, to provide public services more efficiently. It will accelerate the very desirable trend toward privatization of government services such as toll roads and airports.
By increasing unemployment, a depression increases the demand for education by reducing the opportunity cost of it (forgone income is the largest cost of higher education); and education produces positive externalities. It might seem that the depression would also reduce the income gains from being educated; but those gains accrue over a lifetime and so are little affected by a depression during a person's school years.
A depression is a learning experience. The banking industry has certainly learned a great deal from the current financial crisis about the risks of leverage and the downside of complex financial instruments intended to diversify risk more effectively than by traditional means such as retaining highly safe liquid reserves to buffer any unexpected decline in the bank's loan revenues.
The current depression has depressed commodity prices. Of particular importance has been its dramatic effect on the price of oil, which has fallen by about 40 percent in the last six months. The price spike of last spring seems to have been due primarily to a shortage of supply; the industry could not expand production fast enough to keep pace with surging demand, particularly in China and India. The fall in price seems to have been due primarily to a worldwide reduction in demand for oil caused by the global depression. The combination of low prices with low demand is optimal from the standpoint of U.S. (and probably world) welfare. The low demand reduces the amount of carbon emissions, thus alleviating (though only to a slight extent) the problem of global warming. The fall in the price of oil has reduced the wealth of the oil-producing nations‚Äîa goal that should be central to U.S. foreign policy because of the hostility to us (Russia, Iran, Venezuela), or the political instability (Iraq, Nigeria, Algeria), of so many major oil-producing nations.
By undermining faith in free markets, the depression opens the door to more government intervention in the economy and eventually to higher taxes (though probably not until the economy improves). These are not necessarily bad things. Obviously neither the optimal amount of government intervention nor the optimal level of taxation is zero. There are compelling arguments for greater government intervention to deal with the threat of global warming, to improve transportation and other infrastructure, to reduce traffic congestion, and to protect biodiversity. Though in principle the money needed for such programs could be obtained from cutting wasteful government programs, that is politically infeasible. So taxes will have to rise. Federal taxes as a percentage of Gross Domestic Product are no higher today than they were in the 1940s, 1950s, and 1960s‚Äîperiods of healthy economic growth. The marginal income tax rate reached 94 percent in 1945 and did not decline to 70 percent until 1964 (it is 35 percent today). A modest increase in marginal rates from their present low level would increase tax revenues substantially, probably with little offset due to the distortions that any tax increase is bound to produce.
Taxes should not be increased during a depression, but as we come out of it they can be raised modestly to finance infrastructure investments and other investments in public goods, such as reducing carbon emissions.
The anxiety, reduced consumption, and reduced incomes during a depression are real costs and very heavy ones, but on the other hand the excessive borrowing that precipitated the depression enabled, for a period of years, higher consumption than the nation could actually afford. Thus the current drop in consumption is in part an offset to the abnormal level of consumption earlier. Indeed, since people loaded up with cars, fancy dresses, etc., while times were good (illusorily good because the nation was living beyond its means), the current reduction in the purchase of durables, while hard on sellers, may not be a great hardship to consumers. (Nevertheless, people quickly get habituated to a high level of consumption, and a decline from that level is very painful.)
A related point is that the experience of a depression will induce greater thrift, increasing the formation of investment capital after the depression abates.
Finally, the depression will stimulate fresh thinking by the economics profession. The profession's embarrassing failure to foresee the depression, and the failure of the Federal Reserve Board, of deposit insurance, and of other regulatory institutions and requirements to avert the near collapse of the banking industry, will stimulate fresh thinking about and research in macroeconomics and financial economics; and the regulatory responses initiated by the Bush Administration and those that will be undertaken by the Obama Administration will generate valuable data about the effects of economic regulation. Economists will learn from the bad policies adopted in response to the depression (and some are bound to be bad) as well as from the good ones.