The Great Recession and Beyond--11/17/10

[The following is a revised and slightly expanded version of a talk I gave to the Polytechnic Retired Professors on November 8, 2010.]

“The Great Recession and Beyond: A Pessimistic Perspective”

1. CAUSES of what Paul Krugman and Robin Wells call “the great North Atlantic real estate bubble” in The New York Review of Books (9/30/10). They argue that the 1997-8Asian financial crisis induced East Asian and Middle East countries to accumulate large hoards of foreign assets as insurance against another debacle. And so they bought US bonds. Add in China’s doing the same with its enormous export receipts and what resulted were low long term interest rates. These led to low mortgage rates and a real estate boom. And then “animal spirits” (in Keynes’ words) took over. Financial shenanigans were the icing on the cake–they made the bubble much bigger, the complications greater and the recovery much harder.

2. STIMULOUS–now a bad word, like liberal and government was $787 billion. It was too low. Christina Romer, chairwoman of Obama’s Council of Economic Advisers (but unfortunately without much clout), argued for $1.2 trillion, but key figures on the Obama team vetoed this effort. There are two possible reasons: (a) conceivably, Larry Summers and Timothy Geithner felt it wouldn’t fly politically. I suspect, however, given the bully pulpit that a new president has, $990 billion was possible, or thereabouts, and a 30 % increase in the stimulus would have helped.
b) Apparently, Summers and Geithner thought unemployment would peak at 8 % (although 9 % is occasionally mentioned) and then apparently felt the recovery would be stronger. In other words, a larger stimulus was not needed.

Geithner, and especially Summers, are extremely smart men, but neither saw, apparently, the seriousness of the housing bubble. Both have an unrealistic faith in market solutions but, apparently, they didn’t realize this recession was different. Instead of Summers and Geithner, we would have been better off had Obama chosen any two of the following for his chief advisers: Joseph Stiglitz, Christina Romer, Alan Blinder (former VP of the Federal Reserve, from Princeton), or former Berkeley Professor, Laura Tyson (who was also Chairwoman of Clinton’s Council of Economic Advisers).

3. HAS the stimulus worked? Tyson says that without it, the unemployment rate would be about 11.5 %. She, Stiglitz and Krugman, and many others, argue for a large 2nd stimulus, but that’s politically dead or so it appears. A spurious argument against a 2nd stimulus is that the problem is structural–jobs here, people there--or jobs needing skills A, B & C, when what exist are skills X, Y & Z. But this argument is unconvincing and Paul Krugman, on a recent blog posting, offered a convincing statistical analysis that refutes it.

Krugman has written that he hopes that Peter Diamond, who recently won the Nobel Prize in Economics for his work on structural problems, and whose appointment to the Federal Reserve is being blocked by Republicans, can get by their obstructionism. Then he will be in a position to explain why the current situation is not a structural problem, but one in which there is a lack of demand, although structural elements always exist, but at present only to a small degree.

Fresh water economists, from Carnegie Tech or Chicago (as opposed to salt water economists from Berkeley, MIT, Harvard or Princeton), argue more Government leads to less Investment, an argument of merit, perhaps, when we are at full employment, but not very convincing when both unemployment and excess capacity is high. Conservative Nobelist Robert Lucas believes people cut their spending, when the deficit increases, because they believe they need to save for future increases in taxes. I highly doubt this can be significant and I have a bridge for him to buy.

4. UNEMPLOYMENT. The publicized rate of unemployment (U3), as I write, is 9.6 %. But this is a gross understatement as it leaves off so many–those who have given up looking for a job, because they feel no jobs are available, and those who work part time but who want to work full time, both included in U6. Although there are debates about the various measures of unemployment, U6 seems appropriate. Published by the government, it is about 17 %, more than 75 % higher than the publicized figure.

Actually, the rate of unemployment was, for a while, higher in 1982, than it was a year or so ago, at the peak of the Great Recession, but virtually everyone believes that this past recession was more severe than that one. The unemployment of 1982 was brought about by the tight money policy of Federal Reserve Chairman, Paul Volcker. He sought to reduce the inflation caused by OPEC, ultimately a more tractable problem than a bubble with excessive leveraging, credit default swaps, collateralized debt obligations and the rest of the financial kit and caboodle.

The Fed’s job was made harder when Ronald Reagan pushed through a tax cut that began in 1981, arguing it would lower our deficits. Bush senior was right: voodoo economics, justified by the laughable Laffer Curve. Volcker was forced to adopt an even tighter money policy out of fear that inflation, already in, or just out of, double digits, would increase even more because of the tax cut. (He pushed the prime rate up–briefly–to over 21 %.) I have a friend who says he is a Republican because he is a fiscal conservative. But he has it wrong. On fiscal irresponsibility, Reagan takes the cake. He quadrupled our national debt from about $1 trillion to $4 trillion during his two terms, a record increase, if we exclude major wars. And a case can be made that George W. Bush comes in second. His tax cut reversed the huge fiscal surplus of the ending years of the Clinton Administration and created its opposite, a huge increase in the National Debt, although there were other factors at work–the recession and Iraq.

5. TWO VIEWS: (A) Fiscal Hawks. These are persons who believe the deficits will weaken the dollar and cause inflation. They want to cut government spending–now–to avoid the threat of future inflation, even though inflation is only about 1 % and has been declining. There are two nasty precedents: 1937-38, the recession within the Depression. Unemployment had dropped since its trough, in 1932-33, from 25 % to 13 %. But the fiscal hawks reduced the deficit from about 5.5 % in 1936 to virtually 0 % in 1938 and this (along with some monetary tightening) sent unemployment soaring to 19 %. Had the fiscal hawks not had their way it is conceivable–even likely–that we would have been out of the depression before WW II (and not had this stigma hanging over us, that capitalism depends on war to get us out of depressions).

The second nasty precedent is Japan, 1997. Fiscal hawks, by raising taxes in that year–designed of course to reduce the deficit–only succeeded in pushing the Japanese economy back into its decline. The lost decade continued and another lost decade followed.

But why are the hawks fearful? Treasury interest rates are at, or near, record lows–5 year notes are 1 % and 30 year bonds are 4 %. There are no signs of interest rate increases. Moreover, inflation rarely or never rises when unemployment is very high. Critics of fiscal hawks, like Paul Krugman, think that in the future, if needed (and almost surely at some point will be needed), the Fed can beat down inflation. There is an asymmetry: the Fed can stop inflation with tight money, but it can’t jump start the economy with easy money. As Keynes said, in a “liquidity trap,” when interest rates do not lead to greater investment, making money easier is “like pushing on a string.” It simply doesn’t work.

Deficit hawks and others point to the fact that our national debt is rising compared to our Gross Domestic Product, and at this point is about 70 % of GDP, if you exclude debt owed to the Social Security Administration. This could be, in truth, a matter of long term concern. But it depends. After WW II, for a few years, our national debt was more than 100 % of our GDP. By the mid-1970's, however, it was down to only about 30% of our GDP. There are three reasons the percentage dropped. First, there was the post-war inflation, approaching 40%. (Arithmetical explanation: double the GDP through inflation and the national debt as a percentage of GDP is halved.) Also, GDP grew fast enough, in the 25 years after the war, to lower the debt/GDP ratio and interest payments were low enough as well.

The difference now is that it is unlikely that our growth rate (of GDP) will be as great as it was during the period from 1945 to 1970. Also, there is a reasonable fear that interest rates will rise considerably above the low levels that exist now. But keep in mind that as of the day I am writing this, core inflation is about 3/4 of 1 %, and has been heading downward since 2006. Recovery must be our priority, if utter disaster is to be avoided. Implicitly, what this means is that sometime in the future--maybe years down the line--we will probably have to have modest increases in taxes to keep the debt/income ratio from rising. However, nothing I have seen indicates this will be a big problem, unless we live in a world where Republicans rule and they continue to believe that under no circumstances can taxes be raised. If so, this might lead to cutbacks in medicare, medicaid and social security (and maybe the Department of Education) that will be serious or, if unable to do this, and unwilling to raise taxes, the national debt as a percentage of GDP will eventually rise to unsustainable levels. But this is long term and as Keynes once said, in exasperation, with those opposing what was needed immediately, “In the long run we are all dead.”

Until recently, Paul Krugman hoped that raising the acceptability of the inflation rate from 2 % to 3 % would help. But on his blog posting of November 1, he writes: “What I’d do if I were really in charge of the Fed, however, is the same thing I advocated for Japan way back when: announce a fairly high inflation target over an extended period, and commit to meeting that target. What am I talking about? Something like a commitment to achieve 5 percent annual inflation over the next 5 years.” He hopes investors will invest more because they would not fear that the Fed will choke off the recovery because of a small rise in inflation.

Bernanke is in the process of instituting QE2–a 2nd attempt at quantitative easing. This means the Fed will buy more long term bonds, although from what I read not really long term bonds–15 or 30 year bonds--but shorter period bonds and notes of 5 and 10 years. The hope is to lower long term interest rates even more, thereby stimulating investment. To the extent the Fed buys 5 year notes, it’s hard to believe we’ll have more investment if this rate declines from 1 % to 4/5 of 1 %. Similarly, for longer length bonds. I think Paul Krugman agrees since his latest argument, knowing all about QE2, is to raise the inflation target to astronomical heights–just quoted–implying that he doesn’t believe very strongly in QE2. I doubt he believes very strongly in an astronomical target for inflation. But he’s stuck–what he wants is another stimulus and these are weak substitutes for what seems to be politically unreachable.

(B) The anti-fiscal hawks–the deflationists (which include Krugman). Deflation means declining prices–we’re not there yet, but, at 1%, it seems to be around the corner. (Disinflation is a declining rate of inflation, from say 4 % to 2 %.) Deflation means prices actually go down, below zero. So why is deflation bad? First, people might postpone purchases, to enable them to buy goods in the future at lower prices, but I suspect in America this is limited. It will also be harder for debtors, just as inflation makes it easier for debtors. Mostly, I think, deflation reminds Krugman, and others, of Japanese stagnation–the lost decade--in the 90's and even the last decade, and is mostly an expression of their fear of stagnation.

6. STAGNATION. In 1938, the president of the American Economic Association, Alvin Hansen delivered his presidential address and warned of “secular stagnation.” (In this usage, secular means long run.) Hansen argued that the end of colonialism would slow down foreign exploitation, profits and national income. Indeed, with the recent rise of China and to a lesser degree many other former colonies (or near-colonies), including India, the world is changing, seemingly along Hansen’s lines.

200 years ago, 60 % of the world’s GDP was developed in Asia. By 1950, that figure had dropped to 18% (interesting figures thanks to Stiglitz’ “Free Fall”). Clearly, as China rises, that 18% is being increased, and a lot (especially if one adds in India, South Korea, Bangladesh, Indonesia and Singapore). In short, we are probably seeing the relative decline of Western Europe, the US and other first world countries and the relative rise of what hitherto had been considered the 3rd World. (Relative or absolute decline is a big difference, with enormous significance, but an alternative only the future will reveal.) Recently, China’s GDP surpassed Japan’s and maybe it will surpass ours by 2050 (if not sooner), though it will take at least a century or two, one assumes, before it surpasses us in living standards. Obviously, this is conjectural, but the signs surely point in this direction.

Hansen worried about the sufficiency of new investment. That is, as the economy grows over time, one needs ever greater generators of growth. Railroads did it for us in the 19th century and automobiles to a great extent did it for us in the 1920's and (unbeknownst to Hansen) would do it for us in the 50's and 60's. But a larger economy needs an ever larger new industry to stimulate sufficiently the economy. I think Hansen had a point. In short, a big new industry like computers (for example), and the accompanying software, didn’t bring prosperity to America, partly because the economy is much bigger now than it was 50 years ago and partly it was not as big an industry as automobiles. Also in large part these products are sold here (and of course elsewhere) but produced, in large part, elsewhere.

The United States has been having recessions since before the Civil War and while many different and often contradictory explanations exist as to why this happens under capitalism–there is no consensus–it seems that one factor always lurking around is that the ability to consume is almost always a problem. By 1970, it seemed the problem was reappearing. The 70's were complicated by OPEC and high oil prices and the tight money policies by the Fed to counter this inflation and the recessions these created. But I pick this period for two reasons–(1) real wages–wages adjusted for inflation--haven’t risen since about 1972. And to the extent median income is rising, it is mostly the effect of a greater number of hours worked. (Oh, to have the lengthy vacations our European friends have!) The 2nd reason, in a moment, after the aside.

[Aside: recessions are different. They used to be, in general, two or three years of “prosperity” followed by one year of recession. But since the 1960's–but not counting the 1970's–upswings have lasted close to a decade, including a record upswing in the 1990's. Leave off the 1960's. This upturn lasted a long time because the economy was stimulated by the Vietnam War. To some extent, a similar argument can be made of the 1990's, in that the weakness from 1990 to about 1995 ended because of the dot-com bubble. Why, though, are we having long upturns? The optimistic answer is that the economy is performing better. But I think this answer is, well, too optimistic. The pessimistic answer is that the upturns were not strong enough to generate inflation, so that the reason upturns in the past turned into recessions was the tight money policies of the Fed. Of recent, the Fed’s policies have not been as tight since inflation was not appearing (at least as strongly as in the past) and the reason for this is that the economy was, decade by decade, getting weaker, ultimately (in my view) because the ability to consume problem had reasserted itself.]

What was needed, as the ’70's began, was a new solution, to the ability to consume problem. And, inadvertently, it was found. What it was, curiously, is that the haves loaned their money to the have-nots and thus the ability to consume was increased. Prior to 1970, Carte Blanche, Diner’s Club and other credit cards were for the elite and, except for air fare, required that its users pay in full each month. These were convenience cards. But then, in about 1970, Visa and MasterCard appeared and consumer indebtedness took off. Credit cards helped solve the problem of the inability to consume, on the part of the average American, and in doing so gave new life to old-fashioned capitalism, at least here in the United States. This past decade, of course, the loaning practice spread to borrowing on the value of the house one owned. Of course, this borrowing has all come crashing down.

As international trade and investment soared these last 2 or 3 decades, the problem got more complicated. US corporations increasingly built their factories in 3rd world countries. The result is that manufacturing as a percentage of total GDP has dropped to just over 10 %, last time I looked, from over 20 % a decade or so ago and about 40% just after WW II. This increased the problem of the ability to consume. Wages in Wal-Mart, where persons now work, are much lower than wages in manufacturing–where one used to work.

But we’re also talking about the soaring incomes of executives–the ratio of what the top CEO of a large corporation makes to the average worker’s income is more than 13 times what it was 45 years ago. In addition, there are the astronomical incomes of the hedge fund operators and financial firms. As Bob Herbert reports–column of November 2–these increases are no accident. He cites a new book, Winner-Take-All Politics, by Yale professor Jacob Hacker and Berkeley professor Paul Pierson, both political scientists, who argue that the policy changes that made it this way “were the result of increasingly sophisticated, well-financed and well-organized efforts by the corporate and financial sectors to tilt government policies in their favor, and thus in favor of the very wealthy.” (I am reading this book and highly recommend it.)

The result is that income inequality is undoubtedly at a record high. As Robert Reich sums it up, “In the late 1970's, the richest 1% of American families took in about 9% of the nation’s total income: by 2007, the top 1 percent took in 23.5 percent of total income.” Or, as Bob Herbert writes, the “richest one-tenth of 1 percent, representing just 13,000 households, took in more than 11 percent of total income in 2007.” That is a fourfold increase since 1974. The top 1/100 of 1% garnered 1% of income in the 70's and 6% of income in 2008.

In summary, what is new? (1) Income inequality, the huge trade deficit and the enormous growth of the financial sector and each undermines the ability to consume, and with it, prosperity.

Conclusion: Looking at things from the GDP perspective: It is highly unlikely that exports will do much for us in the foreseeable future, with Europe and Japan in trouble, and the Chinese unwilling to adjust their currency to allow for increased imports of goods produced here. Investment is low because there is excess capacity, consumers aren’t buying and producers find they can get more out of their frightened workers than they used to be able to get and therefore don’t need to invest in new plants. But I would agree that one never knows in advance what might come along, but nevertheless, pessimism seems justified.

Moreover, a principal component of investment, in the GDP accounts, is housing construction and I suspect we are talking about something that, as the expression goes, is as dead as a door nail. Consumption is low because people are unemployed or working fewer hours, because many are trying to replenish their nest eggs which were hit hard, because people, understandably, are saving for a rainy day and, finally, because of more stringent credit card and home borrowing standards. In addition, consumers just 5 years ago “only” owed 80 % of their incomes, on average, while in 2009 they owed 110 % or their incomes. They are, more or less, being forced to save. The only area left, as economists define the GDP, is government spending and we are not likely to have the politics that increases this sector. And if Republicans take power, cutting government spending while lowering taxes for the wealthy, the mildest feeling one should have is alarm.

Or as Krugman puts it–column of October 29: “Right now we very much need active policies on the part of the federal government to get us out of our economic trap. But we won’t get those policies if Republicans control the House. In fact, if they get their way, we’ll get the worst of both worlds: They’ll refuse to do anything to boost the economy now, claiming to be worried about the deficit, while simultaneously increasing long-run deficits with irresponsible tax cuts. So if the elections go as expected next week [and of course they did], here’s my advice: Be afraid. Be very afraid.” Is his “be afraid” more optimistic than my alarm? I suspect so. But let’s not quibble.

Conclusion Part 2: To the income mal-distribution argument as a cause of stagnation, I would add the cheap wages in China, and elsewhere, and finally, perhaps, the problem of Bubble Recoveries. Burst bubbles provoke unusual caution in consumer buying and in investment spending that seems unusually hard to reverse. Secular stagnation does not mean there will be no ups and downs. But stagnation does mean that living standards for the average family are unlikely to increase very much and more likely to erode. It also means that unemployment is likely to remain high. High unemployment and stagnant or lower living standards have political repercussions that are extremely dangerous, including erosion of things we take for granted, such as our civil liberties and our democratic processes. If we’re lucky we’ll have the British experience of the 20th century–downhill but liveable–but if we’re very unlucky we might have the experience of the country that in 1939 was ranked 10th in GDP per person–Argentina. And Argentines for decades then went through Hell. Virtually no one who is knowledgeable is optimistic–including or especially the Fed–read its latest report–NY Times, p A3, 11/4/10.

November 17, 2010

Suggested Books: Joseph Stiglitz, Free Fall; Jacob Hacker & Paul Pierson, Winner-Take-All Politics; Web Sites (all preceded by http://): krugman.blogs.nytimes.com (top choice); baseline scenario.com; calculatedriskblog.com; nakedcapitalism.com (often excellent); delong.typepad.com (often excellent); robertreich.org; Movie: Free Fall; Also: (highly recommended): www.dailykos.com and www.openleft.com