2009 March 05 Thursday
1 In 5 Chance Of Economic Depression
Harvard econ prof Robert J. Barro says a historical comparison of countries that have had stock market crashes and depressions suggests the US has a 1-in-5 chance of a depression.
The U.S. macroeconomy has been so tame for so long that it's impossible to get an accurate reading about depression odds just from the U.S. data. My approach uses long-term data for many countries and takes into account the historical linkages between depressions and stock-market crashes. (The research is described in "Stock-Market Crashes and Depressions," a working paper Jose Ursua and I wrote for the National Bureau of Economic Research last month.)
The bottom line is that there is ample reason to worry about slipping into a depression. There is a roughly one-in-five chance that U.S. GDP and consumption will fall by 10% or more, something not seen since the early 1930s.
What about the government policies designed to avoid a depression? Barro doubts these policies will help.
I wish I could be confident that the array of U.S. policies already in place and those likely forthcoming will be helpful. But I think it more likely that the economy will eventually recover despite these policies, rather than because of them.
One has to look at parallels. The 3 month T-Bill rate is at its lowest level since the Great Depression. Look at the graph on that page. We only came that close once since the Great Depression in 2002. If we do go into a depression a global saving glut should be noted as one of the causes. The East Asian money that flowed into the US caused an asset bubble that led to this crisis. There's a lesson here for laissez faire libertarians (not that they'll learn it): free trade and a floating currency do not prevent foreign governments from causing massive distortions in our capital market.
On the bright side the odds are against a repeat of the Great Depression. My guess is the US economy by itself won't go into a depression. The Federal Reserve could go on a massive buying spree and inject tens of trillions of dollars into the economy if that started to happen. But suppose economic panic brings down some other nations into depression. That could pull still more other countries down. A dominoes depression starting on the periphery (e.g. Eastern Europe and other smaller economies) is the one I still worry about.
Update: The Intrade betting market currently puts the odds of a depression at 38%. Another Harvard economist, Kenneth Rogoff, thinks we might just stagnate for a decade.
Fellow Harvard economics professor Kenneth S. Rogoff wrote in an e-mail yesterday that he found Barro’s analysis “highly informative” and “certainly more credible” than quantitative economic forecasts circulated by the Federal Reserve.
“I would guess that the risk of the US having a Japan-style lost decade, where the economy goes in and out of recession for years on end, is more likely than the risk of a catastrophic double-digit output collapse,” Rogoff wrote.
Rogoff and Carmen M. Reinhart argue that banking crises lead to prolonged slumps.
Think snowballing dominoes.
“There’s a domino effect,” said Kenneth S. Rogoff, a professor at Harvard and former chief economist of the International Monetary Fund. “International credit markets are linked, and so a snowballing credit crisis in Eastern Europe and the Baltic countries could cause New York municipal bonds to fall.”
Rogoff says inflation is the cure to prevent for deflation and depression. My guess is he's right.
Professor Kenneth Rogoff, former chief economist of the International Monetary
Fund, said the threat of debt deflation called for revolutionary measures as
an insurance policy.
"Excess inflation right now would help ameliorate the problem. For that
reason, it would be far better to have 5pc to 6pc inflation for a couple of
years than to have 2pc to 3pc deflation," he told the Central
Banking Journal. The Fed has shifted tentatively to an inflation target,
but one anchored nearer "stability".
At some higher level of unemployment the Fed will pull the emergency lever and inflation will burst forth from its den. Alternatively, maybe Obama will copy the FDR policies that prolonged the Great Depression.
"If we do go into a depression a global saving glut should be noted as one of the causes. The East Asian money that flowed into the US caused an asset bubble that led to this crisis. There's a lesson here for laissez faire libertarians (not that they'll learn it): free trade and a floating currency do not prevent foreign governments from causing massive distortions in our capital market."
I don't think it would be accurate to blame this on "free trade" and a "floating currency." Nor would it be accurate to portray the US as passively being affected by the massive distortions in the capital markets by foreign governments, namely China, Japan, and the Mideast oil states. The distortions that have been built up in the system are the direct results of US monetary and financial policy. Asset bubbles in general are indeed bad for the economy as a whole, but not for US financial interests. Asset price inflation is not even considered in the Fed's narrow analysis of inflation and is often perceived to be evidence of "growth." US financial hegemony has been disastrous for the US's long term prospects (and the world's for that matter), as it is becoming clearly evident every day now, but for the past few decades it has served American finance, and to a lesser extent America's population, well. It has enabled asset price inflation while at the same time hampered consumer goods and wage inflation (cheap imports/low wage foreign labor). US corporations have been able to engage in labor arbitrage through outsourcing. So the US has been able to enjoy foreigners' production at little to no cost, as consumer goods are produced by very low wage labor, and the profits are recycled back to the US which subsidizes the consumption. US finance has been able to enjoy this regime as it takes a cut of all the capital recycling back and forth.
The asset price inflation couldn't, and didn't, last forever, and because the asset price inflation can no longer outstrip the pace of debt accumulation by US households and businesses, demand has just collapsed overnight. Because domestic wage inflation has been targeted by US policy, real wage growth has been stagnant in the US for decades, so US household incomes just can't support the world's supply capacity. That's why asset price inflation and debt was necessary to fuel the demand in the first place.
This had nothing to do with free trade or floating currencies. There's little chance that US policy makers and finance would have allowed the "savings glut" to not be in the form of US dollars. It's benefited US finance, subsidized consumption, allowed massive gov't spending. Think of it as a tributary system, or the Mafia's protection money. For all the pride the Chinese have for their rapid growth, they have, along with the rest of world, been huge suckers, slaving away for US paper.
Theoretically, free trade and floating exchange rates reflecting actual trade realities would not result in distortions such as these. Practically, of course, they end up reflecting policies undertaken by the US to maintain financial and dollar hegemony, resulting in distortions.
Also, Robert Barro was on CNBC today and said that factoring in the recent stock declines he would raise the probability above 30%. The article in which he argues for a 1 in 5 chance of depression was written before the recent declines.
You said "The Federal Reserve could go on a massive buying spree and inject tens of trillions of dollars into the economy if that started to happen."
Do you mean to imply that such a move would prevent us from having a depression?
A president ROMNEY doesn't seem like such a bad idea NOW does it?
Yes, inflation would prevent a depression.
Yes, inflation would prevent a depression.
Hope you're right, because that is what is going to happen. We'll be Weimar America.
Sorry if I don't share your view. There is a very real difference between the terms "real" and "nominal". Printing might prevent a depression when defining it in nominal terms, it would do absolutely nothing (and in some ways would destroy trust in the system which is never good) in real terms. I think Mish has done a very good job of educating all of us on this fact. http://globaleconomicanalysis.blogspot.com/2009/02/fiat-world-mathematical-model.html (this is just one of many posts on this topic).
One cannot print one's way to prosperity in ANY way shape or form.
Another way of looking at this http://www.technologyreview.com/Biotech/11541/?a=f