Let it Bleed?

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. 

The 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?

At 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.

Copyright: Project Syndicate, 2013.
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