We’re In a Depression, Not a Recession: Here’s Why
There is a reason why he’s Captain Carnage. Even now, Bernanke can’t admit a mistake:
He was armed with sharp rejoinders, too. Asked whether it was a mistake to let Lehman Brothers fail, he shot back: "Well, the word ‘mistake’ implies choice or an option."
Once a Bushite, always a Bushite. Having been the architect of the economic policy that lead directly to the housing bubble, and been a member of the policy making apparatus at the Federal Reserve while a flood of accomodative money ballooned the world’s economic system, Bernanke will go to his grave not admitting that he is the worst economic policy maker of the last generation. Republicans and stupidity are like baseball sluggers and steroids. They are all on it, they all deny it, and newspapers fawn all over them for it until it is obviously too late.
Lehman was a zombie company for months, and it was Bernanke and Paulson that bungled a strong dollar play that was the proximate cause of the credit implosion. Credit where credit is due: we hired an expert on Depressions, and it worked – we got one:
Members of the Federal Open Market Committee expect that the economy will ultimately rebound from a recession that began in December 2007, and will grow at a pace of 2.5 to 3.3 percent two years from now. But even as the economy heals, the Fed expects unemployment to remain near 8 percent.
But there are more sensible voices.
Depression is a word
The colloquial definition of an economist is a person who can get the commonly acceptable wrong answers. However, when it comes to hard realities, economics, which is capable of defining isoquant analysis of diminishing marginal productivity, is rather incoherent on the subject of what the word "depression means." We live in an era where the word is starting again, to have a meaning, because developed countries are starting to see two distinctly different kinds of business cycles:
First, comparisons between today and the deep recessions of the early 1980s are utterly misguided. In 1981, US private debt was 123 per cent of gross domestic product; by the third quarter of 2008, it was 290 per cent. In 1981, household debt was 48 per cent of GDP; in 2007, it was 100 per cent. In 1980, the Federal Reserve’s intervention rate reached 19–20 per cent. Today, it is nearly zero.
When interest rates fell in the early 1980s, borrowing jumped . The chances of igniting a surge in borrowing now are close to zero. A recession caused by the central bank’s determination to squeeze out inflation is quite different from one caused by excessive debt and collapsing net worth. In the former case, the central bank causes the recession. In the latter, it is trying hard to prevent it.
Martin Wolf, Financial Times
This hits the policy difference between depression and recession. I would quibble here. A better way to look at it is that in a recession the shock to aggregate demand is disinflationary; in a depression, the shock becomes deflationary. In one inflationary expectations are slowed, in the other deflationary expectations are created. The central bank may or may not be the cause, but the converse is true: in a recession the central bank has the power to stop the suffering, in a depression it does not. In a depression, the central bank can’t give money away.
It is a topic which Paul Krugman has been thinking about for over a decade, and he adds more recently:
I’ve been saying for a long time that this isn’t your father’s recession — it’s your grandfather’s recession. (I actually used the phrase about the last recession, too.) That is, it isn’t something like the 1981-82 recession, which was brought on by the Fed to control inflation, and ended when the Fed decided that we had suffered enough. Instead, it’s like the 1929-33 recession — or the recession of 1873-1879 — a slump brought on by the collapse of an investment and credit bubble. And monetary policy, at least in its conventional form, has already reached its limits.
That’s where the graph comes in. The last two completed economic downturns have taken longer to get back to the previous peak of employment than any in an generation. In fact, the only downturn after the Great Depression that took longer than either of them was the demobilization of World War II. They are qualitatively different from the others.
Up until recently there wasn’t a good definition of even the word recession: the standard definition is two consecutive quarters of negative GDP; however, GDP and GDI (Gross Domestic Income) measure the same thing in theory, but not in practice. Is it a recession if one says so and the other does not? The National Bureau of Economic Research recently had to make up their minds on this, and answered "yes." Sort of.
The way out of this confusion is to start labeling correctly. The NEBR marks downturns in months, not quarters. Since the end of World War II, there is a close correlation between a period of rapidly rising Unemployment Rate, that is U-1 from the Bureau of Labor Statistics, and a declared "downturn." The correlation isn’t quite exact, but for a formal definition, one could do much worse than saying that a "downturn is a period of rapidly rising unemployment, confirmed by contraction in national accounts such as GDP and GDI."
Note I say "downturn." This is usually read "recession" because that is the only kind we had in the post war era in the US. Recessions were followed by rebounds. That is, in the phrase we all read in our text books: "A recession is when the central bank notices inflation pressures and accumulating inventories, and raises interest rates and constricts money supply to combat inflation, causing a contraction in the economy." This is what Krugman, Wolf, and others are getting at. In a recession there is still forward momentum in the form of suppressed demand, and it is ready to come back as soon as people have credit again. A recession then is "a downturn plus the early parts of the recovery, caused by a disinflationary shock." That’s a bit dense, but it can be summarized by saying that a recession is when someone hits the economy over the head with a blunt instrument to slow it down. And, just like banging your head against the wall, it feels good when you stop. As soon as the disinflationary shock goes away, the economy rebounds sharply.
Now the impulse has been to call a depression a "very bad recession." However, there is no good reason to do this. In fact, we now have a very good reason not to: namely that the recessionary business cycle of inflationary pressures, disinflationary shock, contraction, easing, rebound, is not happening. In fact, it has not happened several times. Instead there is a sharply different kind of business cycle. There were early indications that this would be the case in the 2000’s down turn, from the number of long term unemployed. Taking long term unemployment statistics, I noted that in almost every other recessionary cycle, the number of people out of work for a long time fell sharply as soon as the expansion hit. That is, as soon as there were jobs, the people out of work for a long time did whatever they had to do to get one, even if it meant taking much lower wages.
However, that’s not always the case. In the 1960’s there was a very slow rebound from the close together recessions in the late 1950’s, and the economy did not really start to hire until the Kennedy Administration engaged in Keynesian stimulus. At this point hiring took off again.
So what is a depression? A depression is a downturn plus a period of convalescing caused by deflationary expectations. This has micro-, macro-, and meso- implications. Why is that? Because in any recession, some parts of the economy are going to go away, there are genuine deflationary expectations. Parts of the economy will be "in depression," and will act like it. Rather than rebounding, jobs will go away, and they will not come back. There is a complex marginal scatter argument to be made about inflation rates and Copulas; but the gist of it is this: while the macro-economy is about the general level of prices, the levels of different sectors and different places will be scattered around that general level. Some prices will be going down, even when most prices are going up. This is because when most prices are going up people have to make hard choices about what to keep paying for. They pay for what they have to pay for, or think they can’t live without, and stop paying for what they don’t care about.
This means that even when there is a macro-recession, there can be micro- and meso- depressions. The same can be said of depressions, some things bounce back faster than the rest of the economy, because the demand is still there. That means that even in a depression, there can be a recessionary cycle. This also means that there is no correlation between the depth and breadth of a downturn, and whether it is a (macro)-recession, or a (macro-)depression.
And we are in one
Back to Captain Carnage, who is clearly surly because he’s been given a hunting license from someplace, in contrast to the very deflated and nearly invisible self that he was for some months. What happened with this particular downturn is that there were two forces: there was the inflationary pressure of resources – oil was rocketing up to the stratosphere – and the deflationary pressure of the implosion of housing. These were related: the inflation of resources was killing the sprawlconomy that drove the housing market.
He would like to say that there was a choice about Lehman, and there were several, and he made some of them. His attempts to evade responsibility are sadly typical of our post-accountability America. Elites never really pay for their blunders.
The key blunder was made last spring when the downturn was starting. It was not yet long enough to be a downturn declared by the NBER. Looking back at the data one can see a few places where there was a short spike in the U-1, but not enough or long enough to become a recession. The policy undertaken was two shots of stimulus: a tax cut, and another war bill, and an attempt to contain oil inflation by strengthening the dollar. This worked, in that it killed resource inflation, oil, for example, stands at 35 dollars a barrel today; but it also starved for dollars the credit system. The problem is that the relationship between resources and credit went both ways: it was resource and consumer production profits that were the investment demand for the credit. Basically, oil and tv profits were lent to build houses, that were filled with televisions, and consumed oil.
The result turned a garden variety downturn into a deflationary spiral. We went from micro-deflation of houses, to meso-deflation of the entire banking sector. From a micro-depression in housing, that is we were doomed to have a period where home building was going to take a long time to come back, to a meso-depression in the financial sector.
The Cult of Price Stability
So why have we been getting more and more depressions, and fewer and fewer recessions? In a few words: debt, and price stability, and they fit together.
In a typical recession, one of the things that the inflation before the recession does, is obliterate much of the debt. That’s part of the work of a recessionary cycle, it lightens the debt load automatically, and then high interest rates act as a disincentive to borrow. However, in a depressionary cycle, the inflationary spike is small, or localized, or not sustained. Balance sheets stay loaded with the old debt. Instead of borrowers drying up, funds dry up. In a recession, the disinflationary shock ends with a lower debt to GDP ratio, and in effect, all lenders have been taxed by the inflation rate. In a depression, the losses are more localized. Specific banks are hit much harder than others. Balance sheets are cratered.
But balance sheets are important because in a depression, lenders believe they can still collect. The ultimate source of the loanable funds were not banks, but investors. Either depositors, or buyers of securities. In general, it is the buyers of securities that drive the bulk of lending. In a recession, investment demand for capital abates, but investment demand for lending does not. This means that the central bank tends to maintain control over monetary policy in a recession, because holders of currency want to participate in the higher interest rates. In a depression, by contrast, rates are at or near zero, the central bank is having trouble giving money away.
So to understand the real end to this crisis, we must understand that every depression ends only when either lenders are crammed down, or consumers are. If consumers are, it creates a prolonged series of failed climbs out of the slump. Since Great Depression analogies are in vogue, let me underline one of the most important. In the Great Depression, gold was the problem. In our present circumstances, as every article on mortgage relief states, it is protecting the bond holders which are the "Gilt fetters" of the age. In the Great Depression, the gold standard was the "barbarous relic." In our own age, the hard basis of money is petroleum, and the ability of the economy to turn petroleum into consumption was the process of creating wealth. Carbon is our barbarous relic, in that it is also choking our civilization on the longer term.
The reason the cult of price stability is the threat, then, is that by creating an environment where euphoric lending is never discounted, but is held as a club over the economy; it both makes it very difficult for monetary policy to ease sufficiently, and it means that lenders attempt to monetize a rent through policy. This argues strongly that if we want to go back to the era of recessions, we should go back to the era of higher inflation during recoveries, which rapidly discounts the past, and gives monetary policy room. If, on the other hand, we continue with price stability, part of the built in cost must be changing our expectations, and our models, to reflect that down turns will drag on and on.
- Right now economic terminology is confused on the subject of recessions and depressions.
- A broad range of economists have recognized that there are two distinct kinds halts to economic growth.
- The word "downturn" should be applied to a period of rapidly rising under-utilization of the labor force, and "contraction" to falling Gross Domestic Effort, that is GDP & GDI.
- If a downturn and contraction are driven by an inflationary wave being met by a disinflationary shock, and which ends when the disinflationary shock ends and policy eases, this should be termed a recession.
- If the downturn and contraction is driven by deflationary expectations and a collapse of revenue streams, then it should be termed a depression.
- A depression then is not deeper by definition than a recession, but it is marked by a much longer recovery to previous employment. It is also marked by large sectors of the economy being in meso-deflation, even if there is nominal inflation or price stability.
- In both cases "macro-" is silently prepended here.
- Within a (macro) recession there can be sectors in meso-depression, and vice versa. That is, in a recession some sectors will be creatively destroyed, and within a depression, some sectors will resume growth, and are still locked in inflationary expectations. See Health Care, Homeland Security, and Luxury goods.
- Not all slowdowns become downturns, and not all downturns are destined to become a recession or depression in particular. Depressions are general marked by the administration of a disinflationary shock that causes a cascading collapse. A micro-depression, that is a falling price of a class of goods, becomes a meso-depression, and if large enough, drags the entire economy into a depression.
- A recession or depression then is defined by whether easing arrives both quickly enough and strongly enough to bounce the economy, and if all important sources of meso-inflationary expectation are ended before deflationary expectations have set in.
- Price stability dramatically increases the chance that a downturn will become a depression, because it both creates a strategic possibility of lenders attempting to hold on to fictional gains, and because it limits monetary policy easing.
- Ben Bernanke is still Captain Carnage, because even though he is doing more, he refuses to learn from his blunders, and is down right surly if they are even pointed out.