Macroeconomic Policy and the Current Depression--Posner

Macroeconomic Policy and the Current Depression—Posner I am not a macroeconomist, but given the strange, perhaps embarrassed silence of so many macroeconomists, mentioned by Becker, I feel less daunted by my lack of expertise than I ordinarily would be. As Becker explains, the focus of central banks, such as the Federal Reserve Board, has been on maintaining price stability by reducing interest rates when economic growth is too sluggish and raising them when it is too fast. The first response encourages economic activity when needed and the second limits inflation. But control of interest rates cannot prevent depressions, including severe depressions. Nor can fiscal policy--government spending and taxing. There appear to be three types of depression (why that word has been displaced by "recession" eludes me--who is supposed to be fooled by such a euphemism?). In one, the least interesting and usually the least serious, some unanticipated shock, external to the ordinary workings of the market, disrupts the market equilibrium; the oil-price surges of the early and then the late 1970s are illustrative. The second, illustrated by the depression of the early 1980s, in which unemployment exceeded 10 percent for a time during 1982, is the induced depression: the Federal Reserve Board broke what was becoming a chronic high rate of inflation by an unexpectedly steep increase in interest rates, which shocked the economy. In neither type of depression is anyone at fault, and the second was downright beneficial to the economy. In the third and most interesting type of depression, illustrated by both the depression of the 1930s and the current depression, the cause is the bursting of an investment bubble. There was a stock market bubble in the 1920s fueled by buying stock with money loaned by banks. That was risky lending and as a result the bursting of the stock market bubble in 1929 resulted in bank insolvencies. The severity of the depression may have been due to the Federal Reserve Board's failure to bail out the banks, but the depression itself was due to the stock bubble's bursting and precipitating bank insolvencies. There was a lesser stock market bubble, in stocks of high-tech companies, in the late 1990s, but its bursting had a small effect on the economy as a whole. The current depression is similarly the consequence, but a very grave one, of the bursting of a bubble. The bubble started in housing, but extended to commercial real estate and other sectors of the economy as well. Very low interest rates, imaginative marketing of houses (and of mortgages on houses) and other goods, and the deregulation of the banking industry spurred highly speculative investing; and the eventual bursting of the bubble, as in 1929, precipitated widespread bank insolvencies and a rapid and steep decline in the stock market, though this time the insolvencies preceded and precipitated the stock decline, rather than vice versa. An article by Massimo Guidolin and Elizabeth A. La Jeunesse published a year ago in the Review of the St. Louis Federal Reserve Bank noted that the personal savings rate of Americans had actually turned negative, meaning that people were spending more than they were earning. And now such savings as people had, being heavily invested in the stock market, have become depleted by the drop in the stock market. As a result of their inadequate savings, people who lose their jobs or cannot sell the houses they no longer can afford are limited in their ability to reallocate savings to consumption, as they had done in previous, milder depressions. So consumption has fallen steeply, precipitating layoffs that have further reduced consumption (because the unemployed have lower incomes), creating the downward spiral that the economy finds itself in at this writing. And the timing could not be worse: during a presidential transition, with the lame-duck President seeming uninterested in and uninformed about economic matters, with economic officials whose stumbling responses to the gathering financial crisis have undermined their credibility, and with the crisis accelerating during the Christmas shopping system, which normally accounts for as much as 40 percent of annual retail sales. The buying binge financed by the heavy borrowing during the bubble have left consumers awash in consumer durables, so it is easy for them to postpone buying. Moreover, consumer durables are more durable than they used to be, so that replacement can be deferred longer than used to be possible. If this diagnosis is correct, then the public-works expenditure program that President-elect Obama is proposing, though anathema to economic libertarians, resisted by the Bush Administration, and bound to be wasteful, as all such programs are, may be the most sensible response to the depression and one clearly superior to a tax cut. A tax cut or rebate, like the bank bailout, is unlikely, unless very large or credibly promised to be permanent, to stimulate consumption greatly; most of the money is likely to be used to rebuild savings or, in the case of the banks, to rebuild their equity cushion so that they can make loans, bound to be risky in a depressed economy, without courting bankruptcy. In other words, to stimulate economic activity the government will have to step in and “consume,” in lieu of reluctant or impoverished consumers by spending money on road repair and other public goods. A critical variable, however, is the length of time it will take for public-works projects actually to be begun. American government tends to be extremely sluggish.

Comments

[Tom Rekdal]

Also not being an economist, I have no useful comment to add. But I would like to express my appreciation for the quality of thought that has gone into this and the previous comments on the present economic crisis. When the stock market declines almost 50% for only the second time in 183 years, one looks, desperately, for plausible accounts of what is going on.

This blog has been most helpful in thinking about the crisis. As a true public good, I suppose it can only be "repaid" by the esteem in which it is held by its readers. I certainly want to participate in that.

[Justin Halter]

Public works is throwing good money after bad. If it was good for the economy, it would be profitable, and if it was profitable, the government would not need to subsidize it.

Filling potholes may employ some people, but it is not good for the economy, especially when financed through debt.

Our only solution at this time is general debt forgiveness. We need to unhitch the real economy from the dysfunctional banking industry. When linked, a deflation will destroy both. We can survive deflation, but not with a debt load.

A Jubilee Year debt cancellation would both reset the banking system, and stimulate the real economy.

[Daniel]

There's a perfectly logical definition why we don't want to label this downturn a depression now - some people behave irrationally, and others are rationally ignorant of macroeconomic terminology and would assume that we are really in 1929. Seems to me like the last thing you want to do DURING a downturn/crash/depression/recession is give people another reason to panic and liquidate their 401K near a market bottom.

After the economy recovers, if you want to go back and label this a depression - fine, might serve some purpose. But now doesn't seem like the best time.

[Robert]

One, I echo Mr. Rekdal's comments.
Two, a massive public works scheme, similar to what existed during the Great Depression, appears to have had--at best--a marginal benefit in lifting the country from that predicament. Here are some salient facts: 1) it was not until World War II that the effects of the Great Depression came to an end; 2) the "alphabet soup" agencies and their overregulation of the economy led to a separate recesssion in the late-1930's; and 3) the stock market did not return to pre-1929 levels until the 1950's.
Turning the government into a "consumer" is yet another way by which the idea of limted government becomes a vestige of a bygone era, and overreaching government becomes the order of the day. As in the 1930's when "emergency" legislation was passed only to eventually become permanent, who among us actually believes that the massive governmental encroachment expected to come about in an Obama administration will recede once the emergency ends?

[Wendy]

I wonder if Mr. Posner, not being a "macroeconomist," is aware that he is spouting Keynesian economic theory, which has been discredited every single time it has been tried, and has failed to predict every major economic event of the 20th century. I suspect so. I also suspect that the neo-Keynesian school of Do Something is about shoring up the self-esteem of statists and statism's sympathizers, not an honest attempt to save the economy.

Since you are not a "macroeconomist," Mr. Posner, let me recommend to you Economics in One Lesson by Henry Hazlitt.

[Patrick Murphy]

Everyone can be sure that Richard Posner is apprised of Keynesian theory and could no doubt teach Hazlitt this afternoon without notes. I infer that he fears we are in a very bad situation that will likely get worse. He is simply trying to suggest some actions that might be helpful in mitigating the carnage that is coming. Our social structure is not rugged and it will not take much to prick an implosion. A good fight plan lasts until you get hit in the teeth; so it is with economic theory. Theory that does'nt predict or point the way out of our predicament is for entertainment only.

[Luca]

"In the third and most interesting type of depression, illustrated by both the depression of the 1930s and the current depression, the cause is the bursting of an investment bubble."

Sir, it is my humble understanding that the Great Depression was caused not so much by the stock market crash, but by the Federal Response, which was to increase bank Reserve Requirements. This measure, meant to prevent bank runs by allowing people greater access to their bank account assets, led to a cataclysmic contraction of the credit market, a 'credit supply shock' if you like. I do agree that the two events you refer to had a common cause: neither the people buying stocks on margins with money backed by the value of their homes in the 20s and 30s nor the those who in the past few years traded Sub-prime Mortgages packaged like bonds, and created 'exotic securities' to defray the risks associated with them fully understood what they were doing, namely what the assets they were toying with were actually worth. Nor did they understand what would happen if their loans were called in.

I hope that makes some sense.

[Jim]

For the occasion (not often), I agree with both Becker and Judge Posner who may not have his macroeconomic ticket but who nevertheless thinks and writes quite clearly. I do have an observation and one question; the first two types of "depressions" descibed by Judge Posner are what mathematicians call nonlinear ocillations like the ocillations or cycles one sees in prey-predator population cycles. The third type of depression decribed is a nonlinear ocillation disrupted by external stimuli and cannot be normalized quickly by withdrawing the interference although that is necessary.

My question to anyone who cares to answer it is; Where is the government going to get the money to fund the public works program? Print it?, Borrow it? What will either do to the dollar? To inflation? It is also fairly well accepted that FDR's WPA didn't do much to revive the 20s depression. What is different now? While that was a "stock" bubble, isn't a bubble a bubble?

I know, that is more than one question. Sorry.

[Mark A. Sadowski]

As an all but dissertation economist, an applied macroeconomist to be precise, I found Posner's explanation of current economic thought to be straitforward and accessible. However I was somewhat taken aback by the previous two comments.

Robert is clearly rehashing the central points argued by Amity Shlaes in Forgotten Man. As pointed out by others, Ms. Shlaes misunderstands and misrepresented the basic tenets of Keynesian economics. I would further note that she has little formal background in economics. Read her book with a huge grain of salt (a boulder in fact).

Wendy is quite incorrect in saying Keynesian economics has been discredited and has failed to predict major economic events. New Keynesian economics is perhaps the dominant school of macroeconomics right now and is exemplified by the likes of Joseph Stiglitz, Paul Krugman, Gregory Mankiw, David Romer, Christina Romer, Olivier Blanchard, Jordi Galí, and Michael Woodford. Paul Krugman first warned about our current crisis over three years ago:

http://www.nytimes.com/2005/08/08/opinion/08krugman.html?ei=5088&en=7125767d2baf3fae&ex=1281153600&adxnnl=1&partner=rssnyt&emc=rss&adxnnlx=1228755614-wVSi2jBlcufxRr79BELvbg

It is in fact the Austrian economic school, of which Wendy is clearly an adherent, which is discredited. It is little more than an intellectual curiosity and has little in the way of scholarly achievements. It is nowhere an accepted school of macroeconomic thought with perhaps the exception of George Mason University. The best criticism I've read of the adherents of the Austrian school was by none other than Paul Krugman:

"Usually that appeal is strongest for conservatives, who can't stand the thought that positive action by governments (let alone—horrors!—printing money) can ever be a good idea. Some libertarians extol the Austrian theory, not because they have really thought that theory through, but because they feel the need for some prestigious alternative to the perceived statist implications of Keynesianism. And some people probably are attracted to Austrianism because they imagine that it devalues the intellectual pretensions of economics professors."

My advice is when faced with a grave crisis and someone tells you to "don't do something, just stand there" you should regard them with suspicion. They've probably been reading too much Ludwig von Mises.

[Brian Shriver]

So many people in my opinion misdiagnose the source of the credit market over-extension.

Savings does not come from frugal households per se; savings comes from flow imbalances in the real economy - too many nodes receiving more income than they plan to spend.

In the case of the US, the wall of liquidity arises from household income polarization and the large trade deficits. The latter alone implies that more than 6% of GDP must be "processed" by the financial economy annually.

Now financial markets are good at finding a credible borrower for some quantity of savings, but what happens when financial markets become saturated? Declining lending standards, temporarily self-reinforcing asset bubbles, etc. In a word: 2008.

It will be interesting to see how or whether the current train wreck can unwind without adjustment of the underlying income imbalances in the real economy.

[Mitty]

Capital kept away from the wasteful & inefficient hand of government will spark greater investment & create more jobs. Should we put our money & efforts into creating temporary, “make work” government jobs, or should we try to generate lasting, private sector jobs that augment our nation’s wealth?

Government improvidently steered capital into the housing market, until it collapsed under the weight of recklessness. Now, it wants to plan and oversee recovery? If it does, Government incompetence in directing capital will delay recovery by years.

Instead of solving the problems of their businesses, executives are standing in handout lines to see what freebees the Government might unthinkingly award them. The specter of bailout is forestalling recovery.

[Daniel]

I have somewhat of a corollary to Jim's first question. Since a large scale economic stimulus package and auto industry bailout are inevitable, are there steps that can be taken to minimize the problems associated with these measures, such as future inflation, moral hazard, etc?

I understand that these concerns do not overcome the need for drastic short run measures, but I don't think it follows that we shouldn't be concerned with them in the way we structure programs.

[BJ]

As a civil engineer working specifically in public works projects, I'd like to make 3 observations:
1. The amount of sewer, water, electrical and transportation projects built in the 1930's and is still in use today is staggering.
2. Infrastructure like these are the foundation of our economy, and without these projects in the 1930's the post WW2 growth would have been delayed at the least, so it must be looked at as an investment rahter than an expense.
3. Infrastructure has a life span, and even with proper maintenance (which has generally not been done in order to keep taxes down - google "ASCE report card") it will need replacement. Design life span is usually between 50 and 100 years (what timing!).
4. Finally, investing in projects that actually put folks to work has a multiplying effect: taxes get paid, debt defaults might slow down, slack gets taken up in the supply of things, etc.

Sooner or later, bailing out the boat is no longer feasible, and you have to build a new one.

[Pencil Nebula]

Considering that there is at least one additional type of depression one wonders at the credibility of thought here. The additional type is a forced depression by one country instigating a financial attack against another or against a group of countries.

There is credible circumstantial evidence that the 1930 depression was caused by such an event. The situation following WW1 had at least two players who had interest in destroying western financial markets – the Germans to get out of the Treaty of Versailles and the Russian with the advancement of Communism. Significantly fanatics representing of either or both of these countries could have initiated such an attack with out direct government knowledge of action so one can not dismiss such thought on the bases of lack of official government action. As far as security such attack like the attack on Mumbai can be imitated by a very small group given sufficient resources.

Again, at the current moment of time, there are sufficient piratical knowledge of how the system was brought down that an outside attack can not be dismissed unless of course one has information not available to the general public which excludes such which is doubtful.

If of course one’s interest is in how to restart the world economy and return it to previous levels of activity that is a different but strongly related is in that how it became broken has no direct bearing on how to fix it but how it became broken does have a direct relation to fixing it if the how is a recurring event the keeps the fix from happening.

The one thing that is definite is that without including such thought in your analysis grave questions are raised about the quality of analysis.

[David Heigham]

"why that word has been displaced by "recession" eludes me--who is supposed to be fooled by such a euphemism"

As I remeber it from the early 1940s, we started saying 'recession' because what happenned around 1938 was clearly different from and much less bad than the Depression which happened around 1931-33.

"American government tends to be extremely sluggish."

As an old govenment servant, I know that is true; and not only of US government. Obama's people seem to be aware of the problem. They are talking about a lot of spending on energy efficiency - which means insulation in the short run which can be installed with minimal lead times; of school building renovation where many School Boards will have ready but postponed projects; and of transport infrastructure where the engineers have long and thought through lists of overdue major maintenance, replacement and improvement. And remarkably little of this is likely to prove to be waste if we take a perspective of a decade or two.

[Bababooey]

Moreover, consumer durables are more durable than they used to be, so that replacement can be deferred longer than used to be possible.

That has not been my experience, especially since the complexity of many durables make it cost-prohibitive to fix them, which results in higher turn-over. Have you seen many electronic repair shops around? One other example: Low cost auto repair has been priced out by the expensive technology required to diagnose and fix modern cars. Is there any broad evidence on this point?

[neilehat]

To all the nay-sayers about the failure of the Government intervention during the Great Depression through the likes of the NRA and WPA. No one seems to realise that these Operations were essentially gutted by a Conservative Supreme Court and so did not have the intended positive impact on American lives or the economy and we had to wait for WWII and another Federally sponsored economic stimulus package.

As for BJ's comment, there is much truth to it. In addition to the simple Civil Projects discussed, we also need to upgrade our Mining and Refinery Complex's to further our Energy independence. How about the Tran's Canadian Pipeline? That's about a few billion dollars injection into the arm of a sick economy. It'll have more impact than bailing out Investment Bankers.

[Jim]

Now my inner curmudgeon is going to show. I will take my microeconomics and that of millions of others to anyone's macroeconomics as follows: I don't trust the feds to staighten this out because they helped get us into this. I don't trust the banks to get us out of this because they helped get us into this. The same for the investment bankers, the mortgage brokers, Fannie Mae and Freddie Mac, the oligopolies in industry, the speculators, the real estate and developer community, etc. I am not spending anything, going anywhere or doing anything and feel fortunate to have a job. I will change my miserable, selfish attitude when the politicians get real jobs and occasionally take office to serve the public interest and when the outrageous salaries of the highly paid executives approach something like 10:1 to their employees. I wonder why people move to one of the 30,000 gated communities in the US. Probably because they don't trust the state to provide basic services. I bet that many of them feel the same way I do.

[neilehat]

Jim, Those gated communities are still dependent on Public Services like Water, Sewer, Gas, Electric; that you, I and them underwrite. Although, "They's" percentage of underwriting based on gross income is considerably less than you or I pay. Besides, those gates are there simply to keep the likes of you out.

Welcome to the New America!

[Jim]

Neilehat,

That is OK since "the likes of me" doesn't want to live there anyway. I like being "gateless". Cheers!

[Jim]

Why are we even discussing this stuff when the Govenor of Illinois was just taken away in handcuffs for trying to sell Obama's senate seat to the highest bidder and offering to help the Tribune Company finacially in return for firing critical editorial board members. Yes sir, I am going to depend on the government for my welfare. NOT. Economy? What economy? The County of Cook takes a 10% sales tax on merchandise that brings the manufacturer or distributer 3-4%. And we wonder why the business cycle is aberrant. Human? I am not sure.

[Richard]

To all the nay-sayers about the failure of the Government intervention during the Great Depression through the likes of the NRA and WPA. No one seems to realise that these Operations were essentially gutted by a Conservative Supreme Court...

The NRA was declared unconstitutional by the Supreme Court, but I don't think they ever acted against the WPA. Can't blame them for the failure of make-work to end the Depression.

It was good that they brought an end to NRA, which did one of the most destructive things a government can do: interfering with the price mechanism.

depression (why that word has been displaced by "recession" eludes me--who is supposed to be fooled by such a euphemism?)

I agree with those who've commented that it's useful to have different terminology for more-severe and less-severe downturns. But overall, I prefer Ronald Reagan's definitions:

"A recession is when your neighbor loses his job. A depression is when you lose yours. And recovery is when Jimmy Carter loses his."

[neilehat]

Jim, This is Illinois! What other State in the Nation uses it's Courts so freely to discipline or pillory it's Politicians. There is a very good chance that this is ploy by the State Republican Party to "get" a Democratic Governor. Btw, the Court has already released him on his own recognizance. Remember, "Graft and corruption is the lubricant of the political machinery". Jim Ryan found out about that too. I believe the Republican President will pardon him on the way out.

Richard, BTW, I hope you lose your job, if you have one. Then come back and talk to us about the evils of a National Recovery Act.

[Jim]

Illinois gubernatorial candidates should just spend a few years in the federal pen to get it out of the way before taking office. Kerner, Walker, Ryan and now Blago. I wouldn't mind if they were competent but corrupt or incompetent but honest. But incompetent, corrupt and stupid? That's too much.

[Daniel]

Jim, you surprise me. What's wrong with letting the free market decide the seat! The Governor is obviously too stupid (assuming the indictment is remotely accurate).