Sunday, November 23, 2014

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.

Read an extended version of this argument in J. Bradford DeLong’s blog post, “Barbers on the March.”

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    1. CommentedZsolt Hermann

      There is no easy, or pleasant way to go around this: we are not in a depression, macroeconomic crisis, but we are in a system failure.
      The whole socio-economic system, based on the dream of infinite, constant, quantitative economic growth has reached dead end, since such a system is without any natural foundations, thus the model cannot be sustained within a natural system.
      This model is based on inventing and then implanting artificial desires, cravings for pleasures in people in order to keep consuming, changing goods, pleasures they do not have natural inclination, need for.
      And they are forced to keep consuming beyond their means which lead to the present unsolvable debt burden both for individuals and nations alike.
      Even if we had unlimited natural resources to drive such system, the human resources are already exhausted, indicated by rising unemployment, especially among the youth, social inequality, loss of purchasing power and confidence, not to mention other worsening social statistics related to health, family, human relationships, culture, education and so on.
      Although the article claims that there is no credible war chance on the horizon to give a reviving shock to the economy, we already have experience that the major power brokers in the world, especially the US can design and initiate a war whenever it wants to, but on one hand such adventures became more and more unpredictable in the present global, interdependent system, and since the problem is a fundamentally wrong direction for the whole of humanity, even a war could not change that unless we change ourselves, our attitude, lifestyle, and how we relate to each other.
      Now this will be the most difficult to accept in the US, since it is this country who "perfected" the constant quantitative growth model, and the "American Dream".
      But if we do not face the facts, and start understanding the closed, finite natural system we exist in, and the fully interconnected human network, meaning that the whole of humanity moves together, either developing or sinking, the worsening crisis and inevitable meltdown will force us to do the same but in much worse and highly unpredictable conditions.

        CommentedEdward Ponderer

        Paradigm shifts are very hard to recognize -- and here it is often one's very expertise in the field that set them up for not catching something completely new. It is often only the young child, eyes wide-open without prejudicial blinders that can blurt out that the emperor is naked.

        The tell-tale signs are dimensions of the problem unseen -- constants of the model that weren't -- only made known by approaching a limiting boundary.

        And we have reached the greatest such boundary ever in history and ever in any system. This being that it is the limit of the globe itself, and the system so limited is the system of all natural and man-made systems. These are now "stepping on each others toes" and so the dance no longer goes well. Point in fact, human socio-economics and Nature's homeostasis are spinning out of control and heading for a crash to the dance floor.

        This is the time not to try to fix our Harlem Shake, but to move our way into a waltz as elegantly as possible. The transition is played by playing down artificial consumerism, bring the unemployed into integral education classes under stipend, and slowly move society through a paradigm shift from every man for himself to mutual responsibility.

        In the end, distribute work according to such models as crowd sourcing -- in some way incorporating everyone in an effort of a couple of hours a day. As we see just how much wasteful duplication of efforts and ab initio needless product has been produced in the past, we'll know what direction to course correct into.

        -- And therein lay the essence of the paradigm shift, the hardest thing of all for the emperor to realize, but obvious to the child. The process will not ultimately be by simple model planning by the know-how of upper echelon experts, but rather by the seat-of-you-pants sense how of an interconnected Humanity. That is, the will to balance globally by individuals in mutually responsible connection.

        We must adapt to survive and thrive...

    2. CommentedDavid Wetzell

      I believe that we must subvert the cut-throat competitive nature of US politics so it no longer tilts to single-party rule and there are more checks and balances. The use of low-number proportional representation elections for "more local" elections seems a simple solution that would have far reaching consequences, enabling solutions to be worked out simply by changing the incentives of the major parties...

      This is a conservative solution, since we used 3-seat quasi-PR for state assembly elections in IL from 1870-1980 and it made it so neither major party could dominate the state assembly or IL politics. This can be done again (and improved on) so that there will be a trickle-up effect to make other elections more competitive. If neither major party can dominate the state assembly then neither will be able to leverage their control of the state assembly. If interests groups then have to hedge then there'll be more equity in the state-level party infrastructure that affects nat'l elections

      There will be more diversity within the major party leadership, more moderates from both parties will get elected and if an expectation is established that neither can dominate, so both will have more incentive to cooperate on many fronts, then it will spill over to change economic expectations for the USA.

      This is what I believe is the most important area for change in the USA. Campaign Finance Regulations are hard to enforce in our current system. Realistic regulations will be easier to work out if the system itself is harder for major intere$t$ to manipulate.

    3. CommentedWill Fletcher

      One slight flaw...the US is broke! Your national debt increased 75% in 5 you think that will continue ad infinitum?

      Total debt, including unfunded liabilities almost $60 TRILLION..the $ will soon be dispensed in Walmart on a cardboard tube to hang in the 'rest room' - along with all other FIAT currencies.

    4. CommentedColin Wiles

      You raise many good questions but don't give any answers. Are you calling for a drift away from inflation and employment targeting and more towards a form of NGDP targeting?

    5. CommentedAvraam Dectis

      "Barring a wholesale revolution in thinking and personnel at the Fed and in the US Congress"

      There are only about 600 people in the Congress and important FED positins.

      If every competent economist would throw his hat into the local Congressional primary, and make a good economic argument, enough would win to influence policy.

      The well known economists, no names needed, should be running for President.

      The circumstances make it the patriotic duty for competent economists to run for office.

    6. CommentedJoshua Ioji Konov

      An excelent article, the observation is precise under the tricle-down used economics there is no way out of the last recession's lost of equity...., only major macroeconomic enchancements and changes coulf stir up the needed business activities to prompt faster rebuilt...

    7. CommentedRichard Foosion

      The standard counter-arguments are (1) the Fed is artificially lowering interest rates across the yield curve and (2) markets are not great at forecasting the future.

      (1) is clearly wrong. Rates are low throughout the world. Rates seem appropriate given the state of the economy.

      (2) seems could be a reason for optimism. Markets may be hard to beat, but the notion that market prices (and therefore yields) are correct is not very popular.

      Why did you choose 1975 as the base for the statement that the nominal annual premium on the 30-year Treasury bill has averaged 2.2%?