Do Depressions Have a Silver Lining? Posner

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—a 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—periods 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.

Comments

[Archimedes]

Like all economists (or the ones I've read), Posner posits that old metaphor for "the economy" (machine, engine) and then describes conditions within the metaphor (overheating), and suggests solutions (cooling, and other blah blahs) as if all the diagnosis and prescription added up to something beyond and more practical than poetry, or rather, interpretation of poetry, his own.

[Economics Allergy]

Archimedes,
Since you're being so critical (something I'd admire if you used your real name), why don't you also point out that Posner is also employing that silly "cycle" notion. Economists (pseudo-scientists, adherenets of "math for math's sake") seem to believe that in putting together their circle drawing from some historical data patterns they have, in the form of "business cycle", discovered something as profoundly insightful as Watson and Crick's DNA structure. They have discovered what they themselves planted.

[Economics Allergy]

Archimedes,
Since you're being so critical (something I'd admire if you used your real name), why don't you also point out that Posner is also employing that silly "cycle" notion. Economists (pseudo-scientists, adherenets of "math for math's sake") seem to believe that in putting together their circle drawing from some historical data patterns they have, in the form of "business cycle", discovered something as profoundly insightful as Watson and Crick's DNA structure. They have discovered what they themselves planted. It's about time the "republic of letters" was weeded. But I don't garden for free, so I'll stop here, having already pointed the way. Sat sapienti.

[The Drunken Priest]

So if we accept that the optimal amount of government intervention is not zero, then what? In a leap of idiocy, the honorable judge concludes the optimal level is somewhere between the Truman presidency and the Johnson years. What a joke.

[Daniel]

Did "Economics Allergy" really just criticize someone for not using their real name?

[Peter Pearson]

Just a minor quibble that I hope some will find illuminating: the widespread belief that the top marginal federal income tax rate is 35 percent is too low by at least half. I know this because I instructed my tax preparer to temporarily increase various income categories by $100, and thereby discovered that my consulting income is taxed at 54 percent, while my wife's W-2 income is taxed at 47 percent.

From what I've seen, all public discussion of tax policy is conducted by people who are grossly (though understandably, given the complexity of the computations) misinformed about this very basic number, the top marginal tax rate. That can't be a good sign.

[Scott]

Just a small change to your article if you don't mind -

"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 ............. Lincoln had not instituted the homestead act but instead had socialized all Land and charged leases to everyone based on the market value of the Land and then returned 100% of the proceeds to every individual equally in the form of a yearly Land Dividend Payment. The check everyone received would be equal to the lease payment on the average piece of Land. Life is the Foundation of every everlasting social structure and Land is a Inherent Birthright. Build upon the right foundation and our social structure will always stand. Live and Learn.

Scott

[Scott]

Just a small change to your article if you don't mind -

"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 ............. Lincoln had not instituted the homestead act but instead had socialized all Land and charged leases to everyone based on the market value of the Land and then returned 100% of the proceeds to every individual equally in the form of a yearly Land Dividend Payment. The check everyone received would be equal to the lease payment on the average piece of Land. Life is the Foundation of every everlasting social structure and Land is a Inherent Birthright. Build upon the right foundation and our social structure will always stand. Live and Learn.

Scott

[Chase Mechanick]

Unemployment lowers the opportunity cost for education? It's rather ridiculous to suggest that people will have an incentive to enroll in school because they don't have a job and therefore don't have anything better to do with their time, which is essentially what this argument amounts to. If anything, financial insecurity discourages education. A parent who is laid off will be less able to afford college for his or her kid (or him/herself, for that matter). In fact, they might not even be willing to make that long-term investment in the first place, and will instead prefer that the son or daughter spend their time looking for a job to help the family in their time of financial distress.

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[Scott Allan]

The simple comparison of 94%, 70%, and 35% tax brackets perpetuates misunderstanding. The lowering of brackets were accompanied by a corresponding elimination of deductions and so called 'loopholes'. In many cases, individual taxes in top brackets changed insignificantly. Only the calculation method changed. It did, however, remove a great deal of the 'tax effect' calculation in investment decisions.

[Brian Davis]

If current circumstances deteriorate into a global Depression, I'm confident someone will start a war to settle accounts and wipe slates clean. This planet's recorded history is benchmarked by wars.

[Jeremy Goodridge]

Dr. Posner:

You make one very misleading comment:

"Federal taxes as a percentage of Gross Domestic Product are no higher today than they were in the 1940s, 1950s, and 1960s—periods of healthy economic growth."

It's not central to your basic argument, but it is very important that these facts are right.

The problem with this statement is that it suggest that the fiscal size of government is relatively flat. But that's simply not true.

There are 3 important issues that you miss:

1. You are looking at tax receipts, not outlays. Outlays matter more becuase ALL government spending crowds out private spending -- whether borrowed or taxed.

2. You are missing state/local spending, which has increased especially in recent years.

3. You are looking at %gdp. Although this is a common way to look at government spending, it's biased toward more government spending. Why should spending automatically increase as people get richer? A much better measure would be government spending per capita, which just accounts for population-growth related increases in gdp, but not productivity/capita increases.

Check out the following article for facts:

http://en.wikipedia.org/wiki/Government_spending

It shows increasing spending since the 20's, using the flawed %gdp measure. %gdp started to stabalize during the 80's. But increased steadily up until the 80's.
And from the statistical abstract:

% GNP/GDP for federal spending
1940: 10%
1945: 43.6%
1950: 16%
1955: 16.2%
1960: 17.7%
1965: 18.2%
1970: 19.3%
1975: 21.8%
1980: 21.7%
1985: 22.9%
1990: 21.8%
1995: 20.7%
2000: 18.4%
2005: 20.2%

The only drop came in the 90's when military spending dropped. Now it has come back up. And has most certainly gone above 21% again.

But since 1940, we are about spending double the amount AS A PERCENT of gdp. So, that's many times more when looked at from a per-capita standpoint.

Jeremy

[Daniel]

Chase,

I agree that a decision to enter college as an undergraduate is not heavily influenced by the depression/recession. However, I think that Judge Posner is right with regards to graduate and Professional school. The opportunity of cost for someone considering returning to school to get an MBA or a law degree is reduced in a period of economic uncertainty. Returning to school allows access to student loans and the potential for higher income in two to three years when the economy turns around, and forgone income in the interim is less of a concern if you have already lost your job or are likely to in the near future.

[neilehat]

Recessions or Depressions? The only difference lies in the "Fear Factor" which aggravates the problem and creates the conditions for becoming self fullfilling prophecy. Perhaps, that's why no one is willing to say the "D" word, but then, if we don't, we certainly won't take the necessary actions to solve the problems with all the "market" failures. Kudos!

As for the "Orthodox Economics" that have led us to this point, clearly it is functioning as an archaism and hindrance to viable action dealing with the current problem. Even the E.U. and G8 have recognized this and are clamoring for change.

As from the "Heterodox Economics", specifically, Thermoeconomics, There is the principle of Entropy at work in all systems, i.e. "things run down". Sound familiar? So the solution is to find the magic elixer of anti-entropy. Which is and always will be the creativity of the human mind and the courage to take the necessary actions. By inserting additional "energy" into the system.

[nathan]

on "slack" in the economy:

it is not clear to me that recessions or depressions remove slack. people that have inherited lots, or have jobs due to nepotism, may not be phased as much as people who do not inherit money or jobs. furthermore, I do not see how one can possibly do what the boss says 24 hours a day at certain financials and possibly atone for gaffes of sr management.

[Robert]

Great article, as always, but Judge Posner fails to mention the role that moral hazard plays when government engages in industrywide bailouts. You say, in effect, that things could be worse even with a depression. However, don't depressions come about, in part, because bailouts protect institutions from the full consequences of their actions (and, by extension, create or exacerbate circumstances that would otherwise be manageable?) Why do we need the "silver lining" of a depression when it could have been staved off in the first place by non-interventionist policies?

[Robert]

Great article, as always, but Judge Posner fails to mention the role that moral hazard plays when government engages in industrywide bailouts. You say, in effect, that things could be worse even with a depression. However, don't depressions come about, in part, because bailouts protect institutions from the full consequences of their actions (and, by extension, create or exacerbate circumstances that would otherwise be manageable?) Why do we need the "silver lining" of a depression when it could have been staved off in the first place by non-interventionist policies?

[renminbi]

Do you really have to take global warming seriously? The scince isn't there yet.

[Betty]

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[Robert Lofts]

The silver lining of depression looks a lot more sterling for someone with a lifetime job and a government guaranteed pension than it does for a 73 year old retiree who has foregone a lot of current income to fund a retirement program that has been dramatically reduced by the depression and is now threatened with nationalization by politicians. I suggest spending a couple of days discussing the silver lining with WalMart customers to get a better perspective.

[Robert Lofts]

The silver lining of depression looks a lot more sterling for someone with a lifetime job and a government guaranteed pension than it does for a 73 year old retiree who has foregone a lot of current income to fund a retirement program that has been dramatically reduced by the depression and is now threatened with nationalization by politicians. I suggest spending a couple of days discussing the silver lining with WalMart customers to get a better perspective.

[R. Tanksley]

Posner's article is quite decent but it fails to look at the social ramifications of a depression. In the 1930s the depression had an upside in that people pulled together, many turned economic distress into greater family and community involvement. Excesses were wiped out and many returned to what really mattered in their lives. The oncoming (highly likely) depression may not have the same affects. People feel too entitled and the government too willing to assist. History however will judge the reaction of people towards each other in this new crisis.

[Jim]

Wow! What nonsense from Judge Posner! First he dismisses Hitler as a sidebar to the depression as if Hitler and the 50 or 60 million people who were killed in WWII mostly because of Hitler was a minor secondary effect to an otherwise routine business cycle. That was as far as I got in that post. Now we have the far left poised to belly flop onto Obama and our current "depression". Please visit the site below for some of their ideas. My advice is a nice Cayman or Swiss account and soon.

http://www.carolinajournal.com/articles/display_story.html?id=5081

Why is our current depression dangerous? The government is bankrupt, we import almost everything including food and 70% of our oil, our total tax burden is approaching 50% and now there are some, as related in the website above, who would confiscate the 401(k)s and IRAs to pay for the politically and financially corrupt policies of a professional political class which has been squandering our wealth since WWII.

I smell the potential for civil war, dictatorship and who knows what death toll.

Yes sir, Judge Posner, depressions are good.

[Dan]

"Confiscating" 401(k) plans to fund SSA would be the unconstitutional taking to end all takings. It will never happen. Ain't no way no how.

But undoing the trickle-down B.S. behind the Reagan era tax bracket reforms? That seems a certainty, at least to some extent.

Unfortunately for conservatives, the recent and ongoing redistribution of wealth/socialization of losses to bail out banks pulls the rug out from under anti-socialism arguments when it comes to the tax structure to provide relief to the middle class.