So let’s see if this stuff really works

Baruch, like everyone partially sane with an ounce of historical awareness, finds his thoughts drifting more and more to the Great Depression. Books with “depression” in the title seem to attract his eye and his browsing fingers. Just what, he wonders, was it like to live through? What did 25% unemployment actually feel like? What was it like to invest through? What percentage of people who had a job in finance at the start of it ended up employed at the end of it? Most of all, my question is: are we going to have a great depression of our own? Or are we somehow going to wriggle out of it?

As you know, Baruch is only an amateur economist, though he once took a class in “Advanced Topics on Macro-economics”. Technically, his masters’ degree has the word “economics” in it, but as this was at an American university this means he should probably be ignored on the subject; he has forgotten much of what he was spoon-fed. Since then, however, he has had lots of economists present him things in the course of his work, and has picked up just enough of the subject to be dangerous to others. Greater economic brains than his have much deeper thoughts on this than he has, so these jottings are much like an aide memoire, to answer the question of a future self, “what did I actually think at the time,” rather than, “OK chaps this is what we should be doing now”. Reader, be warned. Do not take this too seriously.

Anyway, to work: is it relevant to think about the Great Depression at all? Joe Wiesenthal  at Clusterstock (HT Abnormal) doesn’t think so. Neither does John Kay at the FT . On his reading, 2008 could just as easily be 1938, ie near the end, as 1931, the start of the whole mess (which is where I would have guessed). In 1937, after a gradual recovery, US GDP finally reached the level it had reached in 1929. Then, devastatingly, it fell back and didn’t recover again until 1941, led by war spending.  According to Kay,

From this perspective, we are not at the start of the crisis but several years into it. The analogue of the 1929 Wall Street crash is not the 2007 credit crunch, but the bursting of the New Economy bubble in 2000. The follies of the 1990s resembled those of the 1920s, as Galbraith’s readers know. The underlying structural weaknesses of the world economy – US budget and trade deficits financed by Asian surpluses – re-emerged in 2000 after being disguised by the imaginary wealth of the New Economy.

Unlike in the 1930s, we had the policy response to be able to deal with it, in the form of Greenspan’s big rate cuts, but it went too far. Kay continues;

The difference between the years after 1929 and the years after 2000 is that the policy mistakes were almost opposite. This time monetary and fiscal policies were strongly expansionary from the outset. These measures led to a wide boom in asset prices, extended unsustainable credit levels and induced further growth of the fundamentally flawed financial infrastructure on which the 1990s boom had been based.

We could argue that as we are “in 1938” we only have a few more years of generalised crapness to go. But doesn’t that mean this all ends with a global megawar that kills millions? In the end John Kay basically agrees with the conclusion that we can’t draw any concusions from the Depression;

Our capacity to learn from the Great Depression is limited because we do not know how economies would have evolved after 1938 if politics had not supervened. Life, said Kierkegaard, is understood backwards but must be lived forwards.

But if we can’t usefully make head or tail of the Depression in the context of our own current difficulties, it struck Baruch, then we may be in very serious trouble indeed. Almost all of modern economics is built, more or less, on interpretations of the Great Depression. Keynsian reflation is the key weapon in our arsenal for getting out of our slump, but Keynes’ theories were a response to the Great Depression and the lack of traction of what passed for economic policy at the time. As it is the key reaction to Keynsianism, so is monetarism, therefore; the Friedmans cut their teeth on arguing that the Depression was a largely monetary problem; the initial battles in the 1970s with the then-dominant Keynsian consensus was all about its cause.

The Depression is the ur-event of the last century, economically speaking; there had been depressions before, as Clusterstock guy says, 15 of them, apparently, but this was the first one where there were proper economists around to record it; this was the first one where we had data. More than that, we know or knew people who lived through it; my grandparents did, and  annoyed the crap out of my mum and dad banging on about it (ooh we lived in a box, it was terrible, you young people have it so easy. . .). My mum and dad’s generation rebelled against this constant moaning, became the most profligate and debt-loaded in modern history, and now we’re paying for it. It’s in our popular consciousness in a way the arguably worse depression in the 187os is not, and we’re still reacting to it.

So forget forgetting the Great Depression. We couldn’t do it even if we tried.

But then again, perhaps we should. The real point I think Joe Wiesenthal and John Kay may be making, is that if we base our response to the shit creek we are paddling up on a 1930s analogue, and it is not very much like the 1930s, or indeed our understanding of the Depression is at fault, why then, we may be making some very big policy mistakes.

Because more than anything, none of this has ever been really tested. Economics is a pseudo-science, one where we just can’t do controlled experiments so that where we have results, no-one seems to able to agree on what they mean. In macroeconomics, avoiding and getting out of depressions is more or less the whole point of the subject; so the Depression is the original petrie dish, the first cloned sheep, the example of what it is we have to avoid. We only have had one of them, yet we’ve constructed our policy response based on it.

We all seem, amazingly, to agree on what this policy response should be: we could call it the “London Consensus” after the wonderful G20 meeting which, I have to admit, cheered me (and a few others) up a bit. What are the basic elements of this consensus? Primarily we know we have a problem with global aggregate demand, that we are in a liquidity trap and the downturn is co-ordinated internationally; so therefore must be the policy response. The right thing to do is maintain high levels of government spending to compensate for lower private consumption and prevent meltdown, and we have to construct new roads, bridges, power grids and electric cars (and create consumption in China). We need to reconstruct the banking system. We need bold, dramatic policy intervention, both monetary and fiscal, which was of course lacking in the 1930s and why those years sucked so much.

I see some problems with this. Not least of which is that, indeed, we all agree, and in my professional experience that’s hardly ever a good thing. But never mind that. When, if ever, did a set of proposals like this work? Some say (see John Kay above) the eventual and “correct” policy responses of FDR’s administration from the mid 1930s didn’t work. Only after WW2 did we see a proper recovery in growth (the war doesn’t count) globally. Japan? Belatedly, in the mid-late 1990s, they quantitatively eased, and had massive fiscal expansion; London Consensus politics again. Result? Still in the crapper. The mini-boom of 2003-2007 was a fakeout, or an export-led response to the external shock of Americans suddenly buying whatever the Chinese made for them, using Japanese components, with money leached off their bubblicious houses. Not a victory for the London Consensus. The Asian and Latin American crises were met by not Keynsian expansion, but IMF-imposed austerity. Exactly what Hoover and the Fed were supposed to have done wrong, worked great. What about the 1970s stagflation? That discredited Keynsian solutions for a generation.

Sure, none of these episodes matches the conditions of the 1930s, nor our current issues. So they don’t disprove the idea that London Consensus policies won’t work. Which is sort of the point. Can someone more knowledgeable help me here? Is there a relevant historical example of  this stuff working? Certainly the 1980-81 recession shows that deliberate fiscal and monetary contraction does work in the manner intended, ie it fucks you up properly (that’s a technical term, used by us amateur economists). Logically, then, this episode strongly implies that London Consensus policies should work: the opposite of what causes recession should cause recovery, no? Easy. And in fact, Reagan’s defence spending on a deficit and Volcker’s rate cuts ushered in a boom that started in 1983 and which never really ended until last year.

But again, is it relevant for us? The 1980s recession was designed (designed by Austrians). It was about cutting out the “dead wood”. It was about destruction of the inefficient plant that was being supported by expansionary policies, regulations, price controls and government interventions long past their sell-by date. My favourite metaphor is the leukemia treatment that kills off diseased bone marrow so hopefully good, new marrow will grow in its place. Don’t we have “dead wood” now? Semi fabs and assembly factories in China built to make 30% more stuff than anyone needs for the next 5 years; shopping malls in the US built to serve a level of domestic consumption that probably won’t return for a generation; those godawful Virginia macmansions 2 hours commute from Washington, DC, the ones I drove past in 2006. All this crap we made, and I helped finance it by buying shares in the companies building it in my fund. Oh, we’re all complicit.

There’s no destruction in the London Consensus. It’s about keeping businesses in business, homeowners in their homes. Politically, I understand that arguing for anything else is suicide. Morally it feels pretty horrible, as well. We’re talking ultimately about families’ homes, jobs and financial security, and in the US that can mean their health, too. But my fear has to be that we are just keeping the dead wood alive, and postponing the reckoning , exchanging a short, sharp shock for a long drawn out one. Worse, what if we get the point, finally, where all the marrow is gone, bad and good, and the economy is finally receptive to a spending stimulus, but we’re blown up fiscally. We can’t borrow more to give the economy the final boost it needs without interest rates spiking in a contractionary way.

It’s clear to me that we can’t have the conviction of science behind what we’re doing here. But the feeling I get is that there is a widespread faith that this is a done deal, that we have seen the end of the bear in financial markets. I hear talk of “generational lows“. This faith is based on economic theories that feel pretty robust, but ignores the fact there is only mixed data in support. We might also need a more substantial period of weakness before these policies gain traction. In fact, the coming years are probably going to prove once and for all whether this stuff really works or not. And me, what the hell do I know? We’re likely in a debt-deflation cycle, and as such 1980s analogue fits much less well than the debt deflation cycles of the Depression and Japan. I have no real conviction either way. I just can’t join in the general rejoicing, and you won’t catch Baruch assuming that the worst is over. We are now taking part in a vast economic experiment with an extremely uncertain outcome, and if anyone thinks it is anything different, they’re suffering from a comforting misapprehension I wish I shared.


9 thoughts on “So let’s see if this stuff really works”

  1. The economics of a depression are not so hopelessly hard to discern.

    This reminds me of when I was a practicing economist in a developing country. People avoided coming to me for advice when they could (which suited me just fine) not because they thought I wouldn’t have solutions which could get them out of whatever fix they were in, but because they knew there would be things they really didn’t like in the answers I had for them.

    Recovery from a severe economic downturn is all about resources being reallocated from sectors in which they have become unproductive into sectors in which they are more productive.

    We can alleviate the dead-weight loss associated with unemployment and low capacity utilization while this reallocation occurs, and we can in theory at least accelerate helpfully the resource reallocation (by for example making labor mobility easier).

    If on the other hand the measures we implement to stimulate demand in the short term slow and obstruct the necessary resource allocation, by for instance propping up industries which will never reattain their former levels of competitiveness (cars? banks?), then while reducing the short term impact of the recession we are simultaneously prolonging it and quite possibly deepening it.

    That seems to me a good description of where we are (and of much of the 1930’s).

    Eventually unsubsidised price signals will redirect resources in economically positive directions, but in the meantime our politicians may get in the way, and thrash around trying to look good by preventing the inevitable for some considerable time.

  2. Neville says:
    “Recovery from a severe economic downturn is all about resources being reallocated from sectors in which they have become unproductive into sectors in which they are more productive.”
    Cash suggests:
    What about reallocating resources from countries which are unproductive into those which are productive? “Productive” not being meant to include Financial Services, Entertainment and the like. Just a thought.

  3. Cash, you’re exactly right. Part of the reason developed country governments are going to have to reduce the regulatory and ‘tax-and-spread the money around’ burden on their economies (i.e. move in the opposite direction to where they are going right now) is that unless they do, resources and eventually young people with skills are going to flow outwards, towards more competitive countries.

    Western Europe in particular is edging towards the kind of vulnerability to large scale youth emigration which tipped Eastern Europe’s economies over the edge in the late 1980’s.

  4. I see the current depr/rec-ession, as the classic over-leveraged readjustment at the end of the long business cycle, (Kondratif wave)… Essentially, when loans exceed the ability of the economy to service the debt, defaults and bank losses will occur. Recovery happens after the losses are actually realized.

    The current policies of the Treasury and the FED, are like Japan’s: Paper up the Zombie Banks with subsidies and accounting deception. The result will be a more protracted economic downturn. The current plotocracy will remain in place, until they are replaced by generational attrition.

  5. I too share the author’s unease at the G20’s response to the current crisis. However, my feeling is that this could be much, much worse than the Great Depression.

    In 1930 there were not the population pressures or energy constraints we currently deal with. The fact is that a good portion of the world’s population is leveraged on fossil fuels. Any ‘recovery’ with a significant uptick in growth and we will again be at $150/barrel oil.

    Recent retirees are un-retiring. Those approaching retirement age are going to have to keep working. The labor pool is swelling to such a proportion that people with advanced degrees will soon be fighting over minimum wage jobs.

    We have saddled our kids and grand-kids with a whole lot of problems….

    1. That is an interesting point you make about oil, Galen. I think I read somewhere that it was commodity price hikes that stifled the 1937 recovery.

      Neville, don’t let’s be beastly to the Europeans; lots of Euro-yoof stay in their home countries. Anyway, where can they emigrate to? Where will the high paying jobs be? I don’t think the capacity of Asia to integrate millions of affluent, non-huddled masses in a way they have grown accustomed to is very high. The USA? I don’t think the Americans will want them. No they will have to stay at home, and in the case of Italians and Southern Europeans, literally stay at home, like with their mum.

      Any commenters with a positive bias? I just bought a bunch of stock; I’d like it to go up. Is there anyone out there who can tell me it is going to be OK?

  6. Most of the bubbles seen before have been asset bubbles. The problem this time is that it is a consumption bubble. We have increased our consumption based on increased borrowing (often by “cashing out” house equity). So this time it is not a question of reallocating resources from inefficient sectors, it is about cutting consumption down to a size that fits our wallets. And this is really hard to do without cutting consumption, and cutting consumption without cutting demand is even harder. The really hard part is cutting demand without cutting employment, which is close to impossible. But without cutting consumption, we will default on our debt, and then those we owe money will be bankrupt as well, and the people working there will loose their jobs. Let us not fool our selves to believe in quick fixes.

  7. As usual, thought posting with some thoughtful responses/comments.

    1. Baruch: You are good – at least for the time being with your stock purchases. There is so much money flooding the system that, some of it is spilling over to stocks, particularly financials. As to whether this is the rebound that optimists talk about, I doubt it, for all the good reasons posted here.

    2. GSo: I am with you. But also to borrow from the good commenst of Neville and Cash, my hpes is that the Asian consumers will step in to do part of what the western world did for so long and giving the western world a respite to rebuild its stamina again. A $100 spending voucher to each Chindian could go a very long way to get us out of the hole.

    3. Gallen: Interestingly enough, this is a crisis that has hit those with financial assets (i.e., upper income) harder. Those that did not have to begn with, continue not to have. and those that had a lot, have less. That is why, you are not seeing the huge impact – yet. I still cannot get restaraunt reservations either in London or in NY – sign that it has not really hit thsoe that have that hard.

    Having said that, and in most scenarios that I can think of, the western consumer is and will be hosed for some time to come, with all the negative consequences for the demand. Plus he has to repay all the money he owes (as well as the pile of debt the governments are currently adding these days).

    All-in-all, continued uncertainty and in all likelihood protracted weakness in the years to come.

  8. “But my fear has to be that we are just keeping the dead wood alive, and postponing the reckoning , exchanging a short, sharp shock for a long drawn out one.” Wouldn’t one be entitled to say that were we embarking on a long, drawn-out period of weakness we would be merely following the same path that we have been on for the past few decades?

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