Saturday, April 19, 2014
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The Shadow of Depression

BERKELEY – Four times in the past century, a large chunk of the industrial world has fallen into deep and long depressions characterized by persistent high unemployment: the United States in the 1930’s, industrialized Western Europe in the 1930’s, Western Europe again in the 1980’s, and Japan in the 1990’s. Two of these downturns – Western Europe in the 1980’s and Japan in the 1990’s – cast a long and dark shadow on future economic performance.

In both cases, if either Europe or Japan returned – or, indeed, ever returns – to something like the pre-downturn trend of economic growth, it took (or will take) decades. In a third case, Europe at the end of the 1930’s, we do not know what would have happened had Europe not become a battlefield following Nazi Germany’s invasion of Poland.

In only one instance was the long-run growth trend left undisturbed: US production and employment after World War II were not significantly affected by the macroeconomic impact of the Great Depression. Of course, in the absence of mobilization for WWII, it is possible and even likely that the Great Depression would have cast a shadow on post-1940 US economic growth. That is certainly how things looked, with high levels of structural unemployment and a below-trend capital stock, at the end of the 1930’s, before mobilization and the European and Pacific wars began in earnest.

In the US, we can already see signs that the downturn that started in 2008 is casting its shadow on the future. Reputable forecasters – both private and public – have been revising down their estimates of America’s potential long-run GDP.

For example, labor-force participation, which usually stops falling and starts rising after the business-cycle trough, has been steadily declining over the past two and a half years. At least some monetary policymakers believe that recent reductions in the US unemployment rate, which have largely resulted from falling labor-force participation, are just as valid a reason for shifting to more austere policies as reductions in unemployment that reflect increases in employment. And much the same processes and responses are at work – with even greater strength – in Europe.

Most important, however, has been what looks, from today’s perspective, like a permanent collapse in the risk-bearing capacity of the private marketplace, and a permanent and large increase in the perceived riskiness of financial assets worldwide – and of the businesses whose cash flows underpin them. Given aging populations in industrial countries, large commitments from governments to social-insurance systems, and no clear plans for balancing government budgets in the long run, we would expect to see inflation and risk premiums – perhaps not substantial, but clearly visible – priced into even the largest and richest economies’ treasury debt.

Sometime over the next generation, the price levels of the US, Japan, and Germany might rise substantially after some government short-sightedly attempts to finance some of its social-welfare spending by printing money. The price levels are unlikely to go down. Yet the desire to hold assets that avoid the medium-term risks associated with the business cycle has overwhelmed this long-run fundamental risk factor.

But the risk that the world’s investors currently are trying to avoid by rushing into US, Japanese, and German sovereign debt is not a “fundamental” risk. There are no psychological preferences, natural-resource constraints, or technological factors that make investing in private enterprises riskier than it was five years ago. Rather, the risk stems from governments’ refusal, when push comes to shove, to match aggregate demand to aggregate supply in order to prevent mass unemployment.

Managing aggregate demand is governments’ job. While Say’s law – the view that supply creates its own demand – is false in theory, it is true enough in practice that entrepreneurs and enterprises can and do depend on it.

If the government falls down on the job, John Maynard Keynes wrote 76 years ago, and “demand is deficient…the individual operating with the odds loaded against him. The game of hazard which he plays is furnished with many zeros,” which represent “the increment [by which] the world’s wealth has fallen short of...savings,” owing to “the losses of those whose courage and initiative have not been supplemented by exceptional skill or unusual good fortune. But if effective demand is adequate, average skill and average good fortune will be enough.”

For 62 years, from 1945-2007, with some sharp but temporary and regionalized interruptions, entrepreneurs and enterprisers could bet that the demand would be there if they created the supply. This played a significant role in setting the stage for the two fastest generations of global economic growth the world has ever seen. Now the stage has been emptied.

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  1. CommentedJohn Doe

    Prof. DeLong, thank you for a very thoughtful essay which gets right to the point. You are absolutely dead on with your central idea. Government's function is to provide confidence. The President is a "Confidence Man."

    I depart with you on two points.

    First, the solution is not "Keynesian." That makes the solution too easy and destroys confidence. The solution requires us to recall history. The United States was made by three men (Hamilton, Franklin, and Washington who were great economists). They formed the nation to pay its revolutionary war debts and were opposed by, interestingly, the predecessors intellectually to today's right wingers, who didn't want to pay the taxes necessary to do such.

    Our "crisis" is one induced by the no new taxes, starve the beast attack of the last 35 years.

    Second, I am a firm believer in the great man theory of history. Obama is a nice man, but he has no Hamilton or Franklin and he is woefully ineffective compared to Washington. You and Krugman are hitting him at the wrong point. You need to make you attacks more fundamental. Taxes are not about the 99% v 1%. They are about paying your debts. We cannot give people earning less than $200K a free lunch. We have just fought a War. We need to admit such and admit that we will all be paying taxes in the future to pay for it. Obama inspires no confidence because he talks that the future will be like the past, when we all know it isn't so.

  2. CommentedJonathan Lam

    Gamesmith94134: Coronary capitalism

    Kenneth Rogoff,

    In studying life or economic,” too much of a good thing is not a good thing” indicated one may overwhelm with the good thing. I recalled once Mr. Zsolt mentioned Homeostasis in physics of body governance; so, it does apply to health and economics too since each could have its own capacity to growth and risk factors to defects. Just like the perpetuity on growth imperatives, it must give in after it lost its balance; its desire surpassed its capacity either to the body or economy. Because we are in a very physical and finite world; it dictated the limitations based on its physique. Obesity is the outcome of its imbalance to health, so is depression to economy.

    There are no defects on the principles of capitalism or socialism till someone applies them to their systems with lesser acknowledgement of its capacities to growth, because both theories have its advantages and disadvantages and its limitation based on its physique that is relatively the contention of its populace. They paraphrased the paternalism and consumer sovereignty as the water mark which lost its significance. The water mark you intended to search on the wrecked ship which have already landed on the sand bar, like coronary capitalism your described or depression is already shown from fatigue. This is the same as the food and nutrition that are regulated in the industry or media that promoted or served on its own purpose rather than the welfare or health of an individual that many of various physique pursuit.
    “The pathological regulatory-political-economic dynamic that characterizes these industries is far broader. We need to develop new and much better institutions to protect society’s long-run interests.”

    It mainly falls on a mutual understanding of the exposure on the specifics that are being evaluated. Each, like the paternalism and consumer sovereignty, is attempted to influence the government to legislate and manufacturers to produce food or goods that suit for consumers under the commercialism. Perhaps, capitalism is not dead after all; it is just have to change itself to gain its consumers in order to survive. If most understand process food cause obesity, the producer should change its menu before it is thinking to open its doors next month. If government realizes what the 99% to 1% means for its citizens, it must find its way to cool them down or they may be occupied and replaced. May be capitalism or socialism is just another excuse to revolt. Open doors to acknowledgement in all sides is the best solution just prior the disaster occurs; if we all understand our physique, capacity, appetite, digestion and consumption are bounded to a finite and physical world.

    May the Buddha best you?

  3. CommentedErnest Lowe

    Zsolt Hermann comment cuts through to the core issue: we're in the midst of a systemic crisis in which the model of continuous growth runs into the hard wall of finite natural resources. For 3 decades ecological economists like Herman Daly have been building an alternative model of a steady state economy.

    Please view this page of resources and links on their work.

  4. CommentedJames Stedronsky

    1. Keynes. It’s always refreshing to read an article by someone who has actually read Keynes. (As it’s equally amusing to read commentary by a supposed anti-Keynesian who clearly never has.) Keynes makes the important and, hopefully, obvious observation that one of the reasons that growth cycles stall is because the richest, who tend to accrue a larger share of the newly made wealth, consume proportionately less than the middle class. Consumer demand thereby slackens. This is almost a picture perfect description of the 90’s with wealth being accumulated by the richest and earning power of the middle class eroded.

    The answer: government taxes the riches proportionately higher and spends the money on socially productive investments such as roads, health and schools.

    2. Systemic risk: As our world economy becomes increasingly complex it becomes increasingly susceptible to systemic shocks. In 2008 the shock was the massive leveraged investments on US mortgages and the various derivative bets placed on those securities. Now? Not sure, but through various grapevines I understand that the massive hedge funds are investing massively into each other. I can’t do the math, but I’m sure this is not healthy. Our system has not yet been politically able to control and oversee these funds. So I’m not sure anyone can quantify the risk or what would trigger a systematic failure of the hedge fund “industry”, but the risk is there and probably growing.

    3. Japan’s depression. It’s not clear that there ever was one from the perspective of the Japanese population. That country and the people I know there have always seemed to do just fine. Example: We deplore the historically low interest rates that have been paid. But, when their savings accounts in Yen are measured against their world purchasing power, those savings have probably done quite well as the yen increased in relative value year after year. Likewise on deplorable corporate earnings…In Japan stockholders and their stock prices are not King. They are one constituency of the corporation. As are the employees and even the retirees. The overriding driving force of the Japanese corporation is not shareholder return, but the long term well being of the corporation. Hence stock prices seem depressed from our perspective but the system as a whole was fine.

    4. Conservative Economic thought: There really isn’t much. Rather conservatives attempt to legitimate any short term policy that will put money into the hands of the top .1%.

  5. CommentedProcyon Mukherjee

    The bursts of pessimism that abounds for the motion or against is a confounded accessory to the moral judgment that every stakeholder is drawn into a bottomless pit of controversy around the way forward to bring out the bigger economies from the harangues of perpetual rigidity on policies and prescriptions. One is reminded of Montesquieu who reminded us of the fruits of democracy in the benefits of frugality and not in the pursuit of net worth that arguably never triumphed over the more seminal economic analyses of our times, supply, demand, et al. If practice triumphs over theory, so be it, as long as we find a lasting solace that job creation cannot be honed with an irrational assumption that ‘trickling down’ provides; drawing from the future cannot be the polity’s only buttress either.

    Procyon Mukherjee

  6. CommentedDave Thomas

    When will the advocates of Keynesian macroeconomic nonsense be run out of the academy like the charlatans that they are?
    I especially love the quote from Dr. DeLong "While Say’s law – the view that supply creates its own demand – is false in theory, it is true enough in practice that entrepreneurs and enterprises can and do depend on it."

    What does that tell you about economic theory? It is utterly worthless. What works in real life in business is what people should study and emulate. After reading this article I can only ask how and why are my tax dollars, I live in California, paying for Dr. DeLong's salary, benefits and pension?

    Keynesian macroeconomic policy has never ever worked in real life. I guess it works in theory if you've smoked enough joints and drank enough wine. It didn't work in the Great Depression. Robert Higgs, Harold L. Cole and Lee E. Ohanian have all shown what a disaster the New Deal was during the Great Depression.

    Dr. DeLong completely ignores the historical alternative to Keynesian macroeconomic policy that did work in practice. The supply-side policy prescription of Dr. Robert Mundell that dramatically ended the 1981-83 recession. This is exquisitely document by Dr. Domitrovic in Econoclasts. Reagan's policies turned around a recession that was worse than the one Obama encountered, and the recession Reagan dealt with came at the end of 12 years of stagflation, 1969-1981.

    Cutting marginal tax rates and raising interest rates to attract capital was and is the ticket!!!!!!
    Government is not the solution it is the problem. The private sector needs the government to quick picking winners and losers. That's the ticket.

    Enough, enough, enough of this Keynesian theoretical fantasy that has never, ever worked in the real world.
    Reduce the size of government, eliminate crowding out caused by government, eliminate the dead weight of massive public union compensation and pension that threatens to destroy out economy, cut marginal tax rates, pursue sound dollar policies. That's the ticket.
    Good grief!!!!!!!!!!!!!!!!!!!!!

  7. CommentedMark Pitts

    As the author asserts, since WWII governments in the US, Europe, and Japan have indeed created above trend growth via massive deficit spending – in fat years as well as lean. There is nothing in Keynesian theory that implies this can go on forever. In all three countries we may be beginning to see what happens when Keynesian theory has been grossly over-applied and run its course.

  8. CommentedZsolt Hermann

    One important factor which more and more politicians or financial experts recognize is that the present global crisis is not really a crisis, not even depression but it is a system failure.
    We are many times forgetting that we are in an evolutionary process, and just because recently humanity felt that we achieved very good living standards, and at least in the developed world most people felt good in their skins before 2008, it does not mean evolution has stopped. Moreover although we like to think this way, humans are not above the vast natural system we exist in, but we are simply a single species in it, the continuing change of the system around us continuously affects us.
    The recent large natural catastrophes reminded us how helpless we are in the face of those forces we cannot even comprehend.
    So if we want to solve our present problems we have to understand some important points:
    1. We do not have historical perspective on the present crisis, because we are in a situation we have never been before.
    2. We are not in a crisis that could be corrected by known economical, financial or political means, but we are in a system failure, as our present constant growth, overproduction/over-consumption model has become unsustainable, moreover it has started self destructing. The same drive that gave us all our achievements through our history became a cancer destroying the whole system. None of the basic principles of a constant growth expansive system exist any more, no free markets, no strong and confident costumer base, the mass hypnotic media and marketing system brainwashing people to keep buying products they do not need for money they do not have is falling apart, and the public is becoming more mature and has become fully aware of the false system they have been living in, and we are fast depleting all our resources.
    3. With all our present attitude and behavior we are in complete opposition with the vast natural system around us, and as with our global organization and population growth we achieved a certain saturation, today we are directly in crisis with Nature which turns back on us with its force. While the whole system thrives for an overall balance and homeostasis we with our fragmented, competitive, exploitative attitude are going against it.
    Our next moves need to be based on the above, we need to update ourselves the whole population about the true factors influencing our lives, what it means we live in a closed, integral and interdependent world, thus we can prepare the people to the transition to the necessity and resource based life that is required for our survival.
    Only a factual, transparent and scientific global education program can create a situation where people join a new system willingly without coercion, also such an education program could prevent global scale rioting and revolutions due to the continually worsening living conditions. Based on such information we can clearly show people without further political trickery that we have unlimited potential a,d a bright sustainable future as long as we keep ourselves to the natural laws governing our system.
    And we can only achieve this with mutual responsibility and taking into consideration each and every element of our global system.

  9. CommentedPeter Me

    The simpilist way to understand Economics is that change in growth = chang in population + change in productivity.

    Throughout human history society has advanced because the population has grown and most importantly because PRODUCTIVITY has increased.

    BIG GOVERNMENT has contributed zero to growth and in fact has hurt growth because it hinders productivity growth.

    Therefore, the US needs to focus on producing the same amount of goods & services but in a cheaper means.

    If we reduce the cost of the total energy needs by $500B these savings can be used to consumer other goods or serve as savings.

    If we force society to use wind & solar which increases total energy by $500B then consumers and businessers will be forced to cut back on other items which will cause a downward spiral in the economy !

    This is very simple.....I dont have a Masters or a PHD.

    I think Professor dislikes objective thinking so that he can promote the liberal agenda of BIG GOVERNMENT telling us what is bets for us !

  10. Portrait of Michael Heller

    CommentedMichael Heller

    If “managing aggregate demand is governments’ job” they make a bad job of it. The political cycles of welfare states and populist states produced premature demand in western countries and left them deficit-ridden and debt-laden and vulnerable to black swans. I could more easily accept the argument that in an emergency government should balance demand if in the same breath its proponent offered ideas for doable retrenchment and institutional reform to reduce moral hazard and the overloading of the political sphere and ensure financial crises will not be systemic in the future. Good reasons would also need to be given for not *first* pursuing reforms to incentivize enterprises to put their *enormous* cash piles to work. Demand management can in effect be privatized by maintaining and creating employment in flexible labour markets with reduced tax burdens. I would like to hear also in the same breath an exhortation for government to cover emergency spending by committing itself irreversibly to future spending reduction by measures like indexing entitlements and raising retirement ages. Government has natural monopoly discretion in monetary and fiscal policy that it used irresponsibly in the past; it can use other powers now to embolden entrepreneurs and enterprises to take risks through job-creation and cost-cutting. Until I hear more liberal market friendly talk from those who rely on holistic central planning of demand conditions and no longer speak of ‘creative destruction’ as eagerly they did before the crisis, I’m more likely to listen to Robert Barro than to Brad DeLong.