The Great Depression II meme

Last night I wrote an article reminding you that downside risk remains in the global economy.  While I have been singing a more bullish tuneregarding the prospect of a technical recovery in 2009, I am concerned about a double dip as a likely outcome.

And for the record, I have said I see a recovery happening probably in Q4 2009 or Q1 2010 (see my post “The Fake Recovery”).

The real question is how robust a recovery are we going to have and this is directly related to why the jobless claims series has been sending a false signal.  Now, initial claims has been sending a recovery signal since January. Yet, continuing claims continued to rise more quickly until last week.  In the past, one had seen these two series as harbingers of imminent recovery.  But, I am talking Q4 here.  Why? Deleveraging.

In the end, consumers are going to be forced to reduce debt and save more in this more cautious financial environment.  Team Obama does seem intent on re-kindling animal spirits but the personal savings rate has gone up nonetheless.  This will be a drag on GDP growth going forward and means that the economy’s rebound will be more tenuous and slower to develop.  In my view, this means recovery will be delayed and once it gets going it will be weak.  The potential for a double dip is very high.

So, to be clear, first derivatives are starting to turn up and since recession is a first derivative event, we are probably going to see an end to this recession soon enough.  But, with structural problems still remaining, the U.S. economy will be weak for a long time to come.

The major reason I see a double dip as more likely than most is the policy response. The Munchau post I highlighted last night certainly should leave you with the impression that policy makers are not taking continued downside risk very seriously.  But, I tend to see this as very much a predictable outcome.  Back in November I wrote a post called “Beware of deficit hawks” in which I argued that a now-we-can-normalize-policy meme was sure to take hold as soon as the first signs of recovery appeared.

Recently, deficit hawks have been pushing a nefarious line of argument that I need to debunk right here and right now. The line goes as follows: we need to spend government monies now to get the economy back on its feet. In a couple of years, we can signal all clear and then raise taxes on the middle class in order to reduce the deficit again, much as we did in 1993.

While I agree that deficits will need to be eliminated, this line of thinking risks a repeat of 1937-38 in the U.S. and 1997 in Japan and must be refuted.

This line of argument, entirely predictable, does seem to be exactly what is taking place right now.  Witness Paul Krugman’s remarks in his most recent post Stay the Course.

The debate over economic policy has taken a predictable yet ominous turn: the crisis seems to be easing, and a chorus of critics is already demanding that the Federal Reserve and the Obama administration abandon their rescue efforts. For those who know their history, it’s déjà vu all over again — literally.

or this is the third time in history that a major economy has found itself in a liquidity trap, a situation in which interest-rate cuts, the conventional way to perk up the economy, have reached their limit. When this happens, unconventional measures are the only way to fight recession…

The first example of policy in a liquidity trap comes from the 1930s. The U.S. economy grew rapidly from 1933 to 1937, helped along by New Deal policies. America, however, remained well short of full employment.

Yet policy makers stopped worrying about depression and started worrying about inflation. The Federal Reserve tightened monetary policy, while F.D.R. tried to balance the federal budget. Sure enough, the economy slumped again, and full recovery had to wait for World War II.

The second example is Japan in the 1990s. After slumping early in the decade, Japan experienced a partial recovery, with the economy growing almost 3 percent in 1996. Policy makers responded by shifting their focus to the budget deficit, raising taxes and cutting spending. Japan proceeded to slide back into recession.

And here we go again.

You will notice that Krugman is making the exact point I made seven months ago – testimony to how inevitable this all is.  I suggest you read his post in full because his arguments need to be taken seriously if we are to avoid a repeat of 1937 and 1997.  Quite frankly, I am not particularly optimistic that we are going to see policy makers stay the course.  After all, the budget deficits in the U.K., the U.S., and Ireland (to name three of the four original bubble economies – Spain is the other) are exploding.  Willem Buiter has already warned that the U.K. and the U.S. cannot credibly maintain these deficits (see his U.K. post here and U.S. post here).

Pre-Lehman, I was very much in the deficit hawk camp (see my post “Confessions of an Austrian Economist”).  But, those days are over, Lehman’s bankruptcy was the shock that guaranteed a debt deflationary outcome in the U.S. and for the global financial system.  If we are to deleverage, credit is going to contract and that will mean recession.  The only way to avoid this – and a potentially destabilizing deflationary spiral – is for government to temporarily fill in the gap until we reach a sustainable point of recovery.  We are nowhere near that point now.  I warned in November that

…the Obama administration is going to be beset by parties using the immediate deficit reduction line of argument: Can we really balloon the deficit to $1 trillion and expect business as usual in 4 to 5 years given the precedents and given the low savings and high debt?

My answer is no. The U.S. economy cannot possibly work itself out of the greatest financial crisis in some 70-odd years in a mere 4 years and then expect to raise taxes on the middle class without a major recessionary relapse.

So, when you hear policy makers talking about reducing the deficit as soon as possible, what you should think is 1938 and continued depression. While all of this is still a number of years off, we need to nip this talk in the bud now before it becomes orthodoxy.

Buiter’s view of the U.S. and the U.K. as Banana Republics demonstrates that there really aren’t very many policy options available here.  But, that is the outcome of years of bubbles and unbalanced growth.  Think of the United States as Argentina or Latvia writ large. The U.S. does need to demonstrate a longer-term path to fiscal policy normalization to maintain investor confidence.  This is something that is not happening. (see David Leohardt’s piece from last week).

Going forward, in all likelihood, we are going to see a move toward fiscal prudence and policy normalization.  Stimulus will be seen as irresponsible.  This is already the view amongst many politicians in the U.K., the U.S., and Germany (and the Czechs have been making the same noises in Central Europe).  So, when the U.S. and global economy relapse into depression because we did not stay the course, you will know why.

  1. Kristina says

    I love your blog, keep up the good work!

  2. Bob_in_MA says

    This, to me, sums up the fallacy of Krugman’s argument: “The U.S. economy grew rapidly from 1933 to 1937, helped along by New Deal policies.”

    He skips over the period of 1929-1932 when all assets fell precipitously, equities by 89%, real estate by 30%. GDP, Blue collar wages and general price levels all fell by about 30%.

    The recovery in asset prices began nine months before Roosevelt took office, and GDP just as he took the oath. In other words, a large part of the recovery occurred before the New Deal had any real effect and was simply a result of things having bottomed.

    Krugman’s certainty in every opinion he expresses should give pause to those who hang on his every pronouncement. Yes, I know, he has a lovely graph to prove every point.

    If 2009 were 1929, we entered 1930 with a New Deal on steroids, at a time when our fiscal position was an order of magnitude worse. We are resuscitating bubbles, like commodities, that never even existed in 1929.

    Krugman’s analogy to 1937 is nonsensical.

  3. Cityunslicker says

    It is a nice argument, but I have to disagree. We are due a double dip recession, but not because Government spending is too low.

    It is becuase the bubble was so nig, the burst has to be just as big. the government spending puts off the inevitable. We would have done better to let Lehman fail. Now we have debt forever and still a weak recovery at best that will faulter.

    We are all Japanese now and they are a serioulsy unhappy bunch of people, after all the Nikkei is only 80% off its all time high!

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