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Haunted by the Shadow
of the Greater Recession
J
. Bradford DeLong
U.C. Berkeley
Economics and Blum Center, WCEG, and
NBER
http://bradford-delong.com
brad.delong@gmail.com
@delong
2018-06-16
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2986 words
1
I. The Great Depression and the Great
Recession
Your parents’
—
more likely your grandparents’
—
Great Depression
opened with the then-biggest ever stock market crash, continued with the
largest sustained decline in GDP, and ended with a near-decade of sub-
normal production and employment. Yet eleven years after the 1929 crash,
national income per worker was 10 percent above its 1929 level. The next
year, twelve years after, it was 28 percent above its 1929 level. The
economy had fully recovered. And then came the boom of World War II,
followed by the “Thirty Glorious Years” of post-World War II prosperity.
2
The Great Depression was a nightmare. But the economy then woke up.
And it was not haunted thereafter.
Our “Great Recession” opened in 2007 with what appeared to be a
containable fi nancial crisis. The economy then danced on a knife-edge of
instability for a year. Then came the crash—in stock market values,
employment and GDP. The memory of the Great Depression, however,
gave policymakers the knowledge and the running room to keep our
depression-in-the-making an order of magnitude less severe than the Great
Depression.
That’s all true. But that is not the whole story: The Great Recession has
cast a very large shadow on America’s future prosperity. We are still
haunted by it. Indeed, this is the year, the 11th after the start of the crisis,
when national income per worker relative to its pre-crisis benchmark
begins to lose the race to recovery relative to the Great Depression.
This year income per worker will be 7.5 percent higher than in 2007—
compared to 10.5 percent 11 years after 1929. And next year, if we are
lucky, income per worker be 9 percent higher, compared to a remarkable
29 percent higher 12 years after 1929.
But, you may ask, didn’t World War II come along to “rescue” the U.S.
economy after the Great Depression? Isn’t the fact that output per worker
in 1941 vastly surpassed the 1929 benchmark explained by circumstance –
by the reality that the United States was urgently mobilizing for a war of
necessity against Nazi Germany and imperial Japan?
Not so fast. Defense spending was only 1.7 percent of national income in
1940, and grew only to 5.5 percent of national income in 1941. The near-
total mobilization that carried production above its long-term sustainable
potential did not begin until after Pearl Harbor in December 1941.
3
Seen from this perspective, we seem to have somehow fumbled the
recovery from the last recession. To be sure, anti-cyclical policies – fi scal
stimulus under two presidents and an unprecedented effort to drive interest
rates below zero by the Fed -- have been broadly successful in the years
since 2007. The Great Depression was far deeper than the Great
Recession, losing an extra full year’s output before recovery. But now we
are haunted by our Great Recession in a sense that our predecessors were
not haunted by the Great Depression-era. Looking forward, it appears that
we will be haunted for who knows how long. This year begin losing the
race to recovery from the Great Recession. Nobody projects anything
other than slow growth—much slower than growth during and after World
War II. Nobody is forecasting that the haunting will cease—that that
shadow left from the Great Recession will lift.
II. How Did This Happen?
Policymakers in the 1920s are, rightly, judged harshly for not seeing the
vulnerabilities to the economy that were emerging. They are, rightly,
judged harshly then not reacting both swiftly and massively to offset the
damage done by the stock market crash in 1929.
I predict, though, the economic policymakers in the pre-October 2008
collapse will be judged more harshly by historians.
The policymakers of the 1920s had little idea that a collapse in production
of anything like the magnitude of the Great Depression was even possible.
Earlier downturns, though often quite deep, were brief. The policymakers
of the 2000s, by contrast, knew very well that catastrophe was possible.
Then there’s the issue of what the policymakers thought they could do to
counter the business cycle. The men (yes, just men) in charge in the 1920s
knew about and ought to have depended for fi nancial crisis management
4
on what’s referred to as the “rule” of Walter Bagehot, the editor of the
Economist in the 1860s and 70s, set out in his book Lombard Street: A
Study of the Money Market: in a crisis, lend freely, at a penalty rate, on
collateral that is good in normal times, and strain every nerve to keep the
collapse of a systemically-important fi nancial institutions from producing
contagion and panic.
Bagehot’s rule, in fact, wasn’t a bad place to start. But for economists of
the era there was also the "liquidationist" intellectual tradition of Friedrich
von Hayek, Herbert Hoover, Andrew Mellon and Karl Marx to be
reckoned with – what amounts to economic Darwinism. The "cold
douche" of large-scale bankruptcy, as Joseph Schumpeter called it, would
ultimately be good for -- and was perhaps essential to -- the ongoing
health of a market economy. Thankfully, after the Great Depression,
survival of the fi ttest was no longer economic gospel.
Oddly though, the Federal Reserve and Treasury of 2008 clung to a overly
literal and partial reading of Baghot’s rule. Both stood by as Lehman
Brothers, a systemically-important fi nancial institution if there ever was
one, was headed for bankruptcy with no option for reorganization. And the
event did, indeed, lead to large-scale contagion and panic.
The Fed and the Treasury have claimed they had no choice in the fall of
2008. Lehman Brothers, you see, was not just illiquid but insolvent. It had
no good collateral. The federal government lacked the legal authority to
lend to an insolvent institution, and thus could not apply the Bagehot Rule
—unless you remembered that the collateral only had to be “good in
normal times”.
If this is, in fact, the real explanation for their inaction, it seems to me an
astonishing admission of incompetence in fi nancial crisis management and
central banking. For authorities to allow a systemically-important fi nancial
player to linger, mortally wounded, while it goes from barely to deeply
5
insolvent, is malpractice of a very high order. If any too-big-to-fail
institution cannot be backstopped in a crisis, it must be shut down the
moment it begins to unravel under stress. It is, after all, too big to be
allowed to fail in an uncontrolled manner.
However, after the 2008 crisis grew to economy-shaking proportions and a
genuine depression seemed imminent, policymakers did redeem
themselves. The deciders of the early 1930s had stood by wringing their
hands and doing nothing productive as the economy collapsed. By
contrast, their counterparts of the late 2000s swung into action with the
right policies at the right moment—albeit policies of insuffi cient scale and
force.
But I get ahead of myself. By 2009, the recession was being compared to
the Great Depression. Barry Eichengreen, my Berkeley colleague, and
Kevin O’Rourke (Oxford) crunched the numbers, concluding that the
fi nancial crisis and recession had led to as big a downward shock to global
industrial production in 2008 as the 1929 fi nancial crisis, and had pounded
stock market values and world trade volumes harder in 2008-9 than in
1929-30. Thus, from the perspective of the magnitude of the initial shock,
the global economy was in at least as dire shape after the crash of 2008 as
it had been after the crash of 1929.
6
To be sure, nothing happened in the years after 2008 that compares to the
four-year slide after 1929, when U.S. non-farm unemployment rose to 28
percent and German joblessness topped out at 33 percent. The numbers on
output reveal much the same story. Four years after the business cycle
peak of 1929, national income per capita was down 28 percent, and it did
not return to 1929 levels for a full decade. By contrast, after the fi nancial
crash in 2008, per capita income fell by only fi ve percent and was back to
its pre-crash level in six years.
The Great Recession was thus not a repeat of the Great Depression. And
for one reason: Activist, expansionist fi scal and monetary policy worked.
The response to monetary stimulus after 2008 was not as salutary as
Milton Friedman would have guessed. In his famous treatise with Anna
Schwartz, he laid much of the blame for the Great Depression on the Fed’s
lack of response. On the other hand, there’s no doubt that fi scal stimulus
made a big difference. But it was undertaken on an insuffi cient scale.
Overall, of course, the monetary and fi scus effort was far, far better than
nothing.
Thus when Eichengreen and O'Rourke revisited the comparison three
years later, the Great Recession looked a whole lot better than the Great
Depression.
7
The Hoover Administration and the Fed have been judged harshly for their
actions and inactions during what Friedman dubbed the Great Contraction
(1929-1933), and it’s a stretch to hold out any hope that revisionist
historians will ever come to a different conclusion. By contrast, the
policymakers of the 2000s will receive relatively high marks for how they
acted from October 2008 until recovery seemed well established—and the
turn to austerity began.
Early in the recovery left-center economists (like me) warned that cutting
off stimulus prematurely in the name of defi cit reduction or inflation-
fi ghting would ran huge risks. Yet the idea that the world economy must
unwind debt, public and private, was widespread.
Just why debt management became priority-one represents the triumph of
dogma over the facts on the ground. There was no debt crisis to face in the
immediate future. Households, corporations and Asian governments with
surplus liquid assets were still willing to lend money to European and
North American governments at rock-bottom interest rates. This should
have given the chicken-littles pause: When the fi nancial markets are
telling you that dollars, euros and yen are in scarce supply, the logical
response is to create more, not less, of them.
To put that another way, owners of liquid assets were suffi ciently worried
about losing money in private investments (and correspondingly sanguine
about inflation) that they accepted very low (sometimes negative) returns
on U.S. Treasury bills. Yet for reasons not clear, conservative talking
heads (who sounded eerily like the clueless bankers of the 1930s) told
anyone who would listen that reducing government spending would
somehow speed the recovery. None of them could point to historical
examples in which fi scal contraction in an economy operating well below
capacity and no inflation to speak of had led businesses ramp up
production – most likely because there aren’t any.
8
So here we are, with the Great Recession that started in 2008 still casting a
shadow on the North Atlantic economies. There has been no catchup on
the ground lost in 2008-2010 as was routinely expected after the nadir of
previous economic downturns. The best one can say is that the North
Atlantic economies have returned to the mediocre growth rates of recent
decades.
Fifty years from now, historians will contrast policy responses after 1933
with those after 2010. They will write that President Franklin Roosevelt,
Congress, and the Federal Reserve provided a policy response that was, if
not optimal, at least respectable. They will write that the government laid
the foundations for rapid recovery and for a sustained period of high
growth (and even declining inequality).
By contrast, they will write that the policy response of President Obama,
the Congresses elected by American voters, and the Federal Reserve did
not come up to the standard of the mid-1930s policymakers, who were
working without the insights gained from the successes and failures of
post-war macro policy. They will write that Washington failed to lay the
foundations for rapid recovery or equitable long-run economic growth.
III. Hysteresis and/or Incompetence?
Why has our Great Recession cast such a substantial shadow on our future
prosperity, while the Great Depression did not? We do not really know for
sure – but there’s plenty to talk about, anyway.
Economists talk about "hysteresis"—the idea that what happens in the
short run has a substantial and permanent impact on the long run. And,
indeed, in the context of recessions, there are powerful channels that
generate such hysteresis.
9
-- Workers without jobs for years lose their skills, their morale, and their
attachment to the social networks that help workers fi nd jobs.
-- Investments not made during a recession cannot all be made up
thereafter. Investments must come in sequence, and so investments not
made in the past, even if investors make up the ground, still delay
productivity growth.
-- Experiments in new sorts of business organization and in unproven
technology that are not undertaken due to the unfavorable conditions of a
recession rob the economy of capabilities it would otherwise have years
later.
There is little question, then, some of the damage done during economic
downturns can’t be washed away by growth. The problem is that
hysteresis ought to apply to the Great Depression era as much as to our
own. Was the 1920s economy of mass production and electrifi cation so
much more dynamic than ours? You can make that argument, but barely:
At least until the past decade, the productivity growth trend in America
has been a steady two percent annually since 1870, with no big speedups
or slowdowns. But, then, there is that last decade to ponder.
Christina and David Romer, both economists at Berkeley, tell us that in the
post-World War II period, economies that run into a serious fi nancial crisis
have GDPs a decade later that are fully 10 percent lower if they faced
political or economic limits on the exercise of monetary or fi scal policy.
The U.S. did run out of room on conventional monetary stimulus this last
time around. And while all the non-standard monetary policy moves by the
Federal Reserve did no harm -- there was no hyperinflation or drop in the
currency exchange rate as skeptics had prophesized—the best guess now
is that they did little good. Perhaps the Fed could have done more. But a
central bank that was always expecting a strong recovery to begin any day
now (and was already operating well beyond its comfort zone) did not try.
10
