Re-considering the Great Depression II Meme
What Happened To The GDII Meme?
Early in 2009 I caught an article from the Canadian daily National Post about David Rosenberg and wrote up a post about it. Here’s what the National Post wrote:
Now, he predicts the carnage will cause a 2.5% contraction in gross domestic product in 2009, and sees historians calling the current era “GDII,” a reference to the Great Depression.
“We came off a prolonged period of prosperity that was fueled by excessive leverage and an asset bubble of historical proportions,” Rosenberg said in an interview. “Either you believed that this was sustainable or you didn’t. I came to the conclusion that this was going to end very badly.”
GDII. That was a meme that had a lot of currency early in 2009. But no one is really talking about this now. Because of the recovery which began in mid-2009, more likely people are calling this period the "Great Recession." But, frankly there is more downside to come in my view. I will try to bring this across here.
Now, last week was a pretty awful week but this week was better with the markets, jobless claims and consumer confidence showing improvement. Nevertheless, I still want to concentrate the narrative for this week around a weak recovery or double dip scenario and what that would mean for the economy.
Revisiting The Origins of Recovery
About this time last year I was taking a lot of stick for calling for an imminent recovery. I flagged this in April of 2009 saying:
This is a fake recovery because the underlying systemic issues in the financial sector are being papered over through various mechanisms designed to surreptitiously recapitalize banks while monetary and fiscal stimulus induces a rebound before many banks’ inherent insolvency becomes a problem. This means the banking system will remain weak even after recovery takes hold. The likely result of the weak system will be a relapse into a depression-like circumstances once the temporary salve of stimulus has worn off. Note that this does not preclude stocks from large rallies or a new bull market from forming because as unsustainable as the recovery may be, it will be a recovery nonetheless.
The question since that time has been: when does the salve of stimulus wear off? Well, recovery is a self re-enforcing phenomenon. We start from a depressed level of employment, of consumer demand, of production, of inventories, of taxes, and of financial asset prices. This is where we were in April 2009. As things pick up, all of these things feed upon one another. More retail sales means more production, which means more workers, and more tax revenue, and more sales, and so on. This is what recoveries – even fake ones – are made of. Multi-year recoveries are the norm, double dips are not. So, that has to be your baseline – even if you think there are underlying systemic issues.
I made this point in September, saying:
It is pure speculation whether the upturn that underpins this dynamic has legs. I see an even chance that it does, which is why, despite my recent mild bearishness, I am a lot more upbeat about the economy and markets than a lot of others in the blogosphere.
The comments on this post were universally negative i.e. of the doom and gloom variety. But, as we see today, even this recovery has shown GDP growth for 4 consecutive quarters. This particular quarter would make five. And unless recession is coming any day now like the Consumer Metrics Institute says, that certainly qualifies as a multi-year recovery, doesn’t it?
Austerity is Coming
Here’s the thing. People are fairly predictable. When things are at their worst, everyone does their Seventh Seal projection. And, when things suddenly start turning up, everyone is in disbelief. Later, when people accept that recovery is for real, the cries for fiscal prudence start up again. I flagged this as far back as November 2008. As I said in my first GD II–themed post in June 2009:
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.
Isn’t this exactly what’s happening? I still talk a good stimulus game from time to time. But in general I have long since given up the stimulus rhetoric in favour of pointing out the malinvestment.
First, I have come to see the fiscal prudence angle as inevitable. I came to this conclusion in October. People have tired of all of the bailouts and sucking up to special interests. If the economy is still weak in the US and Europe, people want to know everyone is sharing the burden. Hence, the desire to impose fiscal discipline.
Just to be clear, austerity decreases demand, decreases employment and decreases GDP. It increases the potential for recession. And with massive debt levels and financial sector interconnectedness, the potential for a serious downturn is great.
But, second, when the sovereign debt crisis hit the next month, it made people’s desire for austerity that much greater. In Europe, austerity is a necessity to avoid sovereign debt defaults. The time for stimulus is over everywhere else too. US states are doing fiscal prudence. Japan is doing it. Europe is doing it too. In fact, the whole G-20 is doing austerity. For those looking to turn this thing around, it’s too late. Austerity is a done deal.
Paul Krugman is a notable holdout. He even suggests the US threaten the Germans and the Chinese with anti-dumping duties – you know, so we can re-live the 1930s. And he will eventually get his wish because that’s how it works when the chips are down.
The Relapse Is Coming
Here’s what I said more than two years ago about depression economics and politics:
The asset bubble of the late 1990s was one of the largest in history. Rather than allow this bubble to fully unwind, the Greenspan Fed created more asset bubbles, especially in housing, leveraged finance, private equity and asset-backed securities. It is possible that the U.S. will escape with a garden-variety downturn, but, in the face of one of the largest asset bubbles of all time, this is unlikely…
…Ultimately, the economic malaise created by this confluence of events will take years to unwind. A positive outcome to this process is dependent wholly on liquidation of excess credit and consumption.
This process will be extremely painful in the short term, but will lead to a healthy economy long-term. Unfortunately, experience shows that these painful steps will only be taken as a last resort. Moreover, geopolitical events become volatile in a world of economic insecurity, leading to political upheaval and protectionism. Protectionism is a natural outgrowth of nationalist economic policy as it transfers wealth from foreign producers to domestic producers by cutting off access to lower cost excess capacity in the goods in service sectors. However, this also serves to transfer wealth from domestic consumers to domestic producers by increasing the price of goods in the protected sectors, ultimately reducing consumption demand.
For these reasons, I am cautious about the long-term outlook for the global economy and the U.S. economy in particular. The likely outcome for the next decade is one of sub-par global growth with short business cycles punctuated by fits of recession. [emphasis added]
For most of the last year and a half since Lehman collapsed, I have been hoping this view was wrong. Specifically, I had hoped that beggar thy neighbour, economic nationalism and protectionism would not re-visit us. However, my early view is being increasingly validated by events. It’s clear to me that I have the psychology of depression economics right and that makes a relapse into depression probable.
Yes, I know this is a very bearish post and I have been very positive about the near-term economic data. And yes, recoveries are self re-enforcing. And yes, I want to be more positive generally, 100%. But, I am looking out to Q4 in a world of fiscal austerity and beggar thy neighbour. The self-re-enforcement of recovery breaks down under that scenario. Right now Albert Edwards is looking mighty prescient.
Can someone convince me this recovery has legs or that policy makers can deal with the fallout of a weak 2011? Seriously.
Update: I am seeking counterfactuals. But since no one is making them, let me add a few other comments.
Just to be clear, I tend to think a double dip, whether that be immediate or in 2 years (see What is a double dip recession?) necessarily means higher unemployment, lower inflation-adjusted stock prices and lower real GDP.
There’s nothing axiomatic about this. But if you told me I had to choose a likely scenario, it would be double dip in 2011 (or 2012 at the latest), debt deflation, lower bond yields and a worse outlook on most measures of economic performance.
Of course, I am hoping this is wrong which is why I am asking for a variant perception. Remember, even the ECRI Leading Indicators are only showing slowdown not recession. But, a cyclical peak in corporate profitability seems to be upon us as profit margins are both high and mean reverting. I see weaker earnings as a harbinger for market declines and continued low business capital spending. If you couple this with the other things I spoke of here and the lingering real estate difficulties, I find it hard to believe we are going to pull a 1977, 1987 or a 1998 and resume on a growth path.
I hope we do though. My concern is that austerity globally at this particular juncture makes a recession in 2011 or 2012 that much more likely. I hope that adds a bit more colour.
Great post. As I have struggled to understand the events of the past couple of years, your line of reasoning seems to make sense, and importantly has been right on the money. This scenario is very difficult for me as I have 2 kids who will be looking for work in the next year – I badly want you to be wrong. I hope you are. But I doubt you will be.
I keep getting a popup error on your site: “Overflow at line 15”. It occurs on all of the computers I use at home and at work. Can you fix it please?
I don’t know where that error is coming from. Can you try flushing your browser cache and see if that helps.
The popup title is “Message from WebPage”
Below it says “Stack overflow at line 15”
Clearing my browser cache did nothing. It doesn’t happen to me on any website but yours.
Best analysis I’ve seen of the macro situation, although I believe you are too hard on Krugman. China and Germany need to adjust and there is a difference between protectionism and protecting your economy from the meltdown that even you (Ed Harrison) see coming. With a very high level of structural unemployment, the situation is already bad for many in the U.S. Fundamental adjustment begins with some restrictions on mercantilism…
Here’s how I think this is different from the 1930s in the U.S.:
Then, asset and consumer prices fell precipitously for almost three years before reaching a bottom. Real stimulus didn’t begin until after they bottomed.
The stimulus spending was too low and inconsistent at a time when the government had he capacity to have done much more.
This time, massive stimulus was applied before assets and commodities bottomed and much of it was explicitly used to support asset prices.
Now we find ourselves running out of stimulus steam and with asset prices that are still artificially high.
We were unlikely to make the same mistakes they made in the 1930s, but it was naive to think we wouldn’t make our own.
The best illustration of this point is the FHA. It was founded in the 1930s after home prices had bottomed. At that time, 20% down was required and it was limited to moderately priced homes.
This time, it is financing homes as high as $720,000 and with just 3.5% down, and prices have yet to bottom. And then we’ve given people an $8,000 tax credit to apply against that meager 3.5% down payment.
The FHA in the 1930s didn’t lose a penny. I think we can guess how this time will turn out.
Ed Harrison: “Paul Krugman is a notable holdout. He even suggests the US threaten the Germans and the Chinese with anti-dumping duties – you know, so we can re-live the 1930s.”
You’ve got it backwards – we already have a 1930’s style trade situation and Krugman says we should use credible threats to change that. If they don’t succeed then we have to protect ourselves by enacting them.
In the 1930’s the US was a big net creditor and enacted Smoot-Hawley as a protectionist measure (although even before that, in the 1920’s, we had 40% average tariffs). Nowadays China is a big net creditor and uses currency manipulation (as well as high tariffs in some areas, export subsidies and domestic content requirements) as protectionist measures. The protectionist measures that other countries enacted in response to Smoot-Hawley were rational given that we didn’t tear down our trade barriers. While far from ideal they had to protect themselves under the circumstances. Krugman is suggesting that we get China, etc. to tear down their versions of Smoot-Hawley. If that fails then we have to protect ourselves.
Note that the big impact from Smoot-Hawley did not occur until the US/FDR abandoned the gold standard. The subsequent devaluation had huge multiplier effects on tariffs that were already in place. It’s one thing to have a 15% import tariff, but then add on a 40% currency devaluation.
Prior to the devaluation, the effects of SH were in line with what it was designed to do (moderately reduce imports). Either by design or neglect, once the devaluation took place, SH was not restructured and ended up being the poster boy for bad policy. I think that criticism is a little misplaced.
Good point – I’d never considered that. “Smoot Hawley” has become such a standard “protectionism is bad” chant that I tend to forget about more important factors.
In fact I’ve long believed that the importance of SH in worsening the GD is greatly exaggerated, as trade was a much smaller part of our economy then. Also, while SH raised average tariffs to 60%, they were already around 40% in the 1920’s. I’m no die hard free trader, but I think those kinds of barriers are ridiculous, especially when the US was a major net creditor.
Just to be clear, I tend to think a double dip, whether that be immediate or in 2 years (see this post: https://pro.creditwritedowns.com/2010/05/what-is-a-double-dip-recession.html) necessarily means higher unemployment, lower inflation-adjusted stock prices and lower real GDP.
There’s nothing axiomatic about this, but if you told me I had to choose a likely scenario it would be double dip in 2011 (or 2012 at the latest), debt deflation, lower bond yields and a worse outlook on most measures of economic performance.
Of course, I am hoping this is wrong. But, the cyclical peak in corporate profitability seems to be upon us and I see weaker earnings as a harbinger for market declines and low business capital spending. If you couple this with the other things I spoke of here and the lingering real estate difficulties, I find it hard to believe we are going to pull a 1977, 1987 or a 1998 and resume on a growth path. I hope we do though. Hope that makes adds a bit more colour.
Soros echos your thoughts
But, as we see today, even this recovery has shown GDP growth for 4 consecutive quarters. This particular quarter would make five. And unless recession is coming any day now like the Consumer Metrics Institute says, that certainly qualifies as a multi-year recovery, doesn’t it?
No. As I believe you noted GDI does not track GDP. But the official arbiters at the NBER have less simplistic criteria than simply x consecutive quarters of positive GDP.
Finally, the business cycle is broken. This is noise from the stimulus. Does “recovery” have any meaning outside the business cycle?
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