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I see the economic situation somewhat differently from Becker. The least significant of our differences concerns nomenclature. Many economists describe any economic downturn less severe than the Great Depression of the 1930s as a mere "recession." The consequence is to lump together economic downturns of greatly varying severity. The current downturn is far more serious than any of the downturns the nation has experienced since the end of the Great Depression. It is true that unemployment was higher for a time in 1982 than it is now, but unemployment is not the only measure of economic distress. Duration is important as well, but even more important are the political consequences of the downturn. These are likely to be profound, as I believe Becker agrees. Other economists use an arbitrary benchmark, like 10 percent unemployment or a 10 percent drop in output. Unemployment was 9.5 percent in June, 9.4 percent in July (a drop due solely to the fact that fewer people are looking for work--they have given up hope of finding a job in the near term). If it rises to 9.6 percent next month, will that convert a recession to a depression? I also disagree with the view that a recession or depression ends when output stops falling. That would mean that the Great Depression ended (though it later restarted, as Becker mentions) in March 1933, when unemployment was 25 percent and output had fallen by a third since 1929. A recession or depression ends, in my view, when output rejoins the GDP trend line, that is, when it reaches the level it would have reached had the economy grown at its average rate of growth, rather than being depressed. At the moment, as I point out in my Atlantic blog entry of August 1, output is 7.2 percent below the trend line, which suggests that the economy will remain depressed for at least the next two years. Distance from trend line seems, by the way (to recur to the discussion in the previous paragraph), a better measure of the gravity of an economic downturn than drop in GDP. If GDP is flat, or rises only very slowly, for years, the gap between actual and trend-line output eventually becomes enormous. The global economic crisis has exposed many weaknesses, mainly I think in government and in the economics profession, specifically that part of the profession that studies the business cycle. These weaknesses are among the most interesting aspects of the current depression. I attribute the depression mainly to unsound monetary policy by the Federal Reserve under Greenspan and (initially) Bernanke and lax regulation of financial services by the Fed, the SEC, and other government agencies, and to a general complacency concerning the self-regulating capacity of free markets. Government officials (many of them economists), business economists, economic journalists, and academic economists alike were, with rare exceptions, taken by surprise by the bursting of the housing bubble (they didn't realize it was a bubble), the ensuing banking collapse, the stock market crash, the sharp decline in output and employment, the global scope of the crisis, and the onset of deflation in the late fall of 2008 that created fears of a depression comparable to the Great Depression of the 1930s. By the beginning of this year Bernanke and other senior officials, along with many economists, businessmen, and consumers, were in a state of near panic. A number of macroeconomists and financial economists, including leading figures in these important branches of economics, had believed until last September that there could never be another depression, that asset bubbles are a myth, that a recession can be more or less effortlessly averted by the Fed's reducing the federal funds rate, that the international banking industry was robust, and that our huge national debt was nothing to worry about, nor our very low personal savings rate. All these beliefs have turned out to be mistaken, along with influential versions of the rational expectations hypothesis, the efficient-markets theory, and real business cycle theory. The rapid increases in housing prices during the early 2000s were a bubble phenomenon (contrary to Bernanke's statement in October 2005 that they were driven by "fundamentals"), and the bursting of the bubble brought down the banking industry because the industry was heavily invested in financing the bubble. The low personal savings rate reflected people's belief that ownership of houses and common stocks was a stable form of savings, so that when the prices of these assets plummeted the market value of people's savings fell steeply. People had to rebuild their savings, and so personal consumption expenditures fell, precipitating a steep decline in output and a sharp rise in layoffs. That in turn created a downward spiral accelerated by the distress of the banks, which reduced access to credit by both businesses and consumers. Our national debt, and the government's unwillingness or inability to prevent it from growing--the Bush Administration having established, contrary to traditional Republican principles, a pattern of coupling extravagant government expenditures with steep tax cuts--complicated the response to the economic crisis by limiting the amount of new debt that the government could prudently take on. Because economists have yet to achieve an adequate understanding of the macroeconomy and business cycles, I do not think it is possible to fault the government for having acted aggressively--and expensively--to fight the crisis. By flooding the economy with money (in part by purchasing huge amounts of private and long-term public debt, rather than just short-term Treasury notes), and bailing out the major banks (particularly the "nonbank banks" that have become indispensable sources of credit) with government loans, the government placed a floor under the precipitous drop in lending that began last September. Lending has continued to decline, though slowly. The continued decline is due partly to the fact that banks have hoarded most of the money they've received from the government rather than lending or otherwise investing it (because default rates are high and bank capital is still impaired despite the government largesse), and partly to the fact that the demand for loans has dropped as overindebted consumers, and businesses facing reduced demand for their output, have retrenched. Many mistakes were made in the government's response to the crisis, in part because the possible need for aggressive interventions to stave off economic disaster had not been foreseen (the problem of complacency)--notably the failure to save Lehman Brothers. But on the whole the government's response was--until reccently, as I am about to explain--appropriate, given the risk of an even worse economic collapse. The most controversial measures taken by the government have been the bailout of General Motors and Chrysler, which began last December, and the $787 billion stimulus (Keynesian deficit spending) program enacted in February. I believe both these measures were justified, though for reasons that do not receive sufficient emphasis. Contrary to what until recently most macroeconomists believed, a capitalist economy, though superior to any other economic system, is inherently unstable because of its potential for adverse feedback effects; hence the need for watchful monetary and fiscal regulation. A severe shock, such as the economy received last September, can, without prompt and effective government intervention, trigger a steep downward economic spiral, with sharply reduced consumer spending, resulting in falling output that precipitates layoffs that result in reduced personal income and so further reduces spending and hence output, which induces further layoffs, which further reduce incomes and spending. As spending falls, sellers reduce prices, which creates expectations of further price reductions (deflation), which induces hoarding, since in a deflation the purchasing power of money rises even if the money is kept under one's mattress rather than being invested; so investment drops. Deflation also increases the burden of debt, which precipitates defaults and bankruptcies and further reduces incomes and spending. The fear of a deflationary spiral such as I have just described was acute at the end of 2008 and the beginning of this year, and could not be dismissed as unfounded. In that setting, bailing out GM and Chrysler was a prudent measure, since without it both companies would have had to declare bankruptcy and might have liquidated rather than reorganized, because the credit crunch had temporarily eliminated the availability of "debtor in possession" financing, essential to a reorganization in bankruptcy. The auto companies would have run out of cash by the end of December. To continue operating, therefore, they would have had to borrow money. But no bank or other private entity was lending "DIP" money then; it was near the peak of the credit crunch. If the auto companies had been unable to obtain DIP financing, their creditors would have had to force liquidation, which would have resulted in an increase in the unemployment rolls, possibly by millions, within a very short time. That would have been a severe further shock to an already deeply wounded economy. Similarly, with regard to the stimulus, when Obama took office on January 20 the measures the government had taken to date--the easy money, the bailouts, and so on--had not arrested the economic decline. For the new Administration to have announced that it had run out of ideas for arresting the decline, and we'd just have to tough it out, could have produced a catastrophic drop in business and consumer confidence, which could in turn have increased hoarding, layoffs, deflation, and so forth. The auto bailouts staved off the collapse and possible liquidation of GM and Chrysler; and the stimulus package, by showing that the President and Congress were determined to react with maximum vigor to the economic crisis, buoyed (I am guessing) business and consumer confidence. In addition, although estimates of jobs saved by the stimulus are bogus, the initial expenditures under the program, consisting of tax credits and increased unemployment-insurance and health benefits, are probably responsible for a slight increase in personal consumption expenditures, which in turn may have had a slight indirect benefit on output and employment. The much-criticized "cash for clunkers" part of the stimulus, though it will do nothing for the environment, has, at the least, by inducing increased purchases of motor vehicles, increased confidence that the economic downturn is bottoming. Unfortunately, the auto bailouts of last December have morphed into a huge and possibly quixotic project of revitalizing, rather than just postponing the demise of, two highly inefficient enteprises; and the stimulus package, being poorly designed, is likely to have its maximum impact late next year and in 2011 and 2012, when it may not be needed but will contribute to the danger of a serious inflation. Economic recovery is also being undermined by the Administration's efforts, in the midst of crisis and without adequate study of its causes, to revamp the regulatory structure of the finance industry. The economy remains imperiled. If the Administration's trillion-dollar health care program is enacted in anything like its proposed form, the costs, on top of the rapidly rising public debt that is the consequence both of the impact of the depression on tax revenues and the costs of the anti-depression programs may create an aftershock to the current depression that will do almost as much harm to the nation as the--I insist on the term--depression itself.

Comments

[Anonymous]

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[Anonymous]

I am enjoying this series of posts. I have to make one observation relative to economists and ability to predict. I am a mere banker, and no economist. Yet as far back as March 2007 I was picking up on threads that told me we had a problem.

Not that I saw everything, but then neither am I an economist. My point is that perhaps traditional economics and thinking got in the way of rational thinking.

http://thebankwatch.com/2007/03/14/more-on-the-us-sub-prime-mortgage-market-wharton/

"This analysis from Wharton in Philadelphia describes the strategic run up to the current issues. It also implies the possibility that there might be a soft landing out of this, but its a definite maybe. In particular the tie to the overall capital markets is worrisome."

[Anonymous]

I agree with Professor Posner on this one although for a slightly different line of thinking. As you know, the "news" is always several months behind the facts of social movemnent which often drives economic movement. If you ask almost any traditional ethnic immigrant group they will tell you that their first generation members are returning to their native homelands in particular the Indians and the Polish. They cite the fall of the dollar, the diminishing real wages in the US, the growth in India and the fact that Poles can settle anywhere in the EU. If that kind of thinking is going on in those communities, you can bet it is happening in others as well. I know many first generation immigrants who are telling their children that the future is not in the US in addition to their thinking that the US is losing its freedoms to a more all encompassing government. If one adds all of that thinking to the obvious fact that our economy is based on consumer spending and bubbles (the next one being the "green" bubble), the economy will remain stagnant for quite some time. Who could imagine that the US goverment would own the financial sector (and indirectly the housing sector) the auto sector, the insurance sector and potentially the healthcare sector and that federal deficits would approach 40% of the GDP. Next they will be attaching personal financial assets. Does anyone think that productive people will work harder in these circumstances? Does anyone think that federal spending is "productive"?

[Anonymous]

I'm with the Judge on this one. We've got a "W" rally in Wall St investment securities, that's all. The U.S. had one in 1938 but only the WW II mobilization pulled the vast majority of American households out of the ditch. A year or two from now we'll still be wrestling with unemployment/underemployment, soaring govt deficits, residential foreclosures, and a severe bust in commercial real estate values and loan defaults. Quit listening to the pump-n-dump rapid-trader crowd and read the handwriting on the walls of Main St.

Brian Davis
Austin, TX

[Anonymous]

Posner errs in speculating that bankruptcy filings by GM and Chrysler, without government intervention, likely would have led to liquidations of those firms. This is rather shabby dismissal of the bankruptcy system established by Congress -- with authority granted by the Constitution -- as compared to the neo-bankruptcy system crafted by the Obama Administration, which in ends and means amounts to sheer political thuggery.

That aside, Posner is correct in noting (even though he doesn't come right out and state the fact) that the Obama Administration is like a bunch of children unleashed in the dynamite shack with lots of matches.

[Anonymous]

Mr Posner's comments on the adverse feedback possibilities of a capitalist economy remind me of "Lazarus Long's" comments in Heinlein's novel.

[Anonymous]

The present crisis is not one of economic theory or economic policy. It is a crisis of character. Either we will insist upon fiscal discipline, or we will not. In the late 1970s, we had the extreme good fortune to appoint a man to the Chairmanship of the Federal Reserve who was prepared to do whatever it took to halt the spiral of inflation. Today, alas,there is no one individual, or group of individuals, who has the power to put a stop to the spiral of federal spending. Only a committed electorate can accomplish that, and I am far from confident that there is enough character left in the nation to sustain that effort. Next to that question, all other issues of economic policy seem to me to be utterly trivial.

[Anonymous]

I agree with the comment above. It is not a matter of economic theory but rather of national character or the lack thereof. The public elects the followers who make destructive decisions to keep the public voting for them in the short term while the long term keeps going down hill. It is a sad case of national suicide.

[Anonymous]

All said and done, banks are still big, regulation is still lax, savings is still low, nothing in the horizon which promises productivity, higher deficits and profligate spending. While we can debate on whether this recession is going to be over or not, it is probably the effect of Tylenol. Where is the antibiotic?

[Anonymous]

"Because economists have yet to achieve an adequate understanding of the macroeconomy and business cycles, I do not think it is possible to fault the government for having acted aggressively--and expensively--to fight the crisis."

This is an interesting argument in the sense that it is very similar to the "Neoconservative" case for torture. The perceived worse case scenario is another great depression in one case and a another 9/11 in the other. I'm not passing judgment, just thought I would point that out.

Also, I think a lot of people will be proven wrong when we come out of this with a without a high level of inflation. The more the fed inflates -- the more tools they have to deflate. The fed still seems to have a lot of tools at their disposal to get credit flowing again, especially, if they heed Scott Sumner's advice on negative interest rates on excess bank reserves.

[Anonymous]

I'm not exactly sure how stocks and houses are necessarily much different than savings. It is possible for some level of over investment in these areas, but generally savings also get used for loans or investments by banks to justify a rate of return.

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[Anonymous]

I agree with you on the actual crisis being not only financial and economic, but also theoretical – in economical theory, but also in political and business ethics. However I think both your analysis, especially Berger’s but also your own, lack the long term perspective. Namely, the analysis of this crisis according to something like Carroll Quigley’s “instrument of expansion”. For your readers that understand Portuguese, I’ve developed this idea in http://onodoproblemaocidental24x7.blogspot.com/2009/08/perspectivas-economicas-para-proxima.html.

[Anonymous]

Thanks for the post. Reading it late, but that's why I love your site--it's timely, but not ephemeral.

A minor note on your point that "[a] recession or depression ends, in my view, when output rejoins the GDP trend line"--there is some evidence that after a financial crises GDP may never rejoin the original trend line. See here, for example: http://gregmankiw.blogspot.com/2009/08/blanchard-on-outlook.html

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