brad delong is an economist at the University of California (Berkeley) and creator of the blog “Grasping Reality.” He was deputy assistant secretary of the Treasury in the Clinton administration.
Published October 29, 2018
Your parents’ — more likely your grandparents’ — Great Depression opened with the then-biggest-ever stock market crash, continued with the largest-ever sustained decline in GDP, and ended with a near-decade of subnormal production and employment. Yet 11 years after the 1929 crash, national income per worker was 10 percent above its 1929 level. The next year, 12 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.
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 financial crisis. The economy subsequently danced on a knife-edge of instability for a year. Then came the crash — in stock market values, employment and GDP. The experience of the Great Depression, however, gave policymakers the knowledge and running room to keep our depression-in-the-making an order of magnitude less severe than the Great Depression.
That’s all true. But it’s 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 eleventh 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 will 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 to only 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 the bombing of Pearl Harbor in December 1941.
Seen from this perspective, we seem to have fumbled the recovery from the recession. To be sure, anticyclical policies — fiscal 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 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. Looking forward, it appears that we will be haunted for who knows how long. No unbiased observer projects anything other than slow growth, much slower than the years during and after World War II. Nobody is forecasting that the haunting will cease — that the shadow left from the Great Recession will lift.
How Did This Happen?
Policymakers in the 1920s are rightly judged harshly for not seeing the vulnerabilities in the economy that were emerging, and 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. Those in charge in the 1920s knew about — and ought to have depended on — what’s referred to as the “rule” of Walter Bagehot. The editor of The Economist in the 1860s and 70s, Bagehot set out the principle in the 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 systemically important financial institutions from producing contagion and panic.
Bagehot’s rule, in fact, isn’t a bad place to start in a financial crisis. 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 fittest was no longer economic gospel.
No unbiased observer projects anything other than slow growth, much slower than the years during and after World War II. Nobody is forecasting that the shadow left from the Great Recession will lift.
Oddly, though, the Federal Reserve and Treasury of 2008 clung to an overly literal and selective reading of Bagehot’s rule. Both stood by as Lehman Brothers, a systemically important financial institution if there ever was one, 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 since 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 financial crisis management and central banking. For authorities to allow a systemically important financial player to linger, mortally wounded, while it went from barely to deeply insolvent is malpractice of a very high order. If a too-big-to-fail institution cannot be backstopped in a crisis, it must be shut down the moment it begins to unravel. 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 insufficient 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 (at Oxford) crunched the numbers, concluding that the financial crisis and recession had led to as big a downward shock to global industrial production in 2008 as the 1929 financial 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.
To be sure, nothing happened in the years after 2008 that compares to the four-year slide after 1929, when U.S. nonfarm 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 financial crash in 2008, per capita income fell by only 5 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 fiscal and monetary policy worked. Yet 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 fiscal stimulus made a big difference. Though it was undertaken on an insufficient scale, overall, the monetary and fiscal stimulus 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.
The Hoover administration and the Fed have been judged harshly for their actions and inactions during what Friedman dubbed the Great Contraction (1929-33), 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 perverse turn to austerity began.
Early in the recovery, left-center economists (like me) warned that cutting off stimulus prematurely in the name of deficit reduction or inflation-fighting would run 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 financial 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 sufficiently 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 fiscal contraction in an economy operating well below capacity, and with no inflation to speak of, had led businesses to ramp up production — most likely because there aren’t any.
Just why debt management became Priority One represents the triumph of dogma over the facts on the ground.
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 2008-10, 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 collective 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 responses of President Barack Obama, Congress 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 postwar macro policy. They will write that Washington failed to lay the foundations for rapid recovery or equitable long-run economic growth.
Hysteresis, Incompetence or Both?
Why has our Great Recession cast such a pall on our future prosperity, while the Great Depression did not? We do not really know for sure — but there’s plenty to mull.
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.
- Workers without jobs for years lose their skills, their morale and their attachment to the social networks that help them find 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 that 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 electrification 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 had been a steady 2 percent annually since 1870, with no big speedups or slowdowns. But, then, there is that last decade to ponder.
Christina Romer and David Romer, both economists at Berkeley, tell us that in the post-World War II period, economies that run into a serious financial 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 fiscal policy. The United States 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 prophesied — 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 operating well beyond its comfort zone) did not try.
The United States did have wiggle room on tax cuts and government spending, but did not use it. Ironically, it was not a Republican or a captain of Wall Street but President Obama who said, in his 2010 State of the Union Address:
Our efforts to prevent a second depression have added another $1 trillion to our national debt. … That was the right thing to do. But families across the country are tightening their belts and making tough decisions. The federal government should do the same. … Like any cash-strapped family, we will work within a budget to invest in what we need and sacrifice what we don’t.
Compare Obama’s rhetoric to that of, say, John Maynard Keynes, for whom the purpose of economic management was not to balance the budget but to generate employment and opportunity — without which entrepreneurship and enterprise are doomed to be feeble:
If effective demand is deficient, not only is the public scandal of wasted resources intolerable, but the individual enterpriser who seeks to bring these resources into action is operating with the odds loaded against him. … Hitherto, the increment of the world’s wealth has fallen short of the aggregate of positive individual savings; and the difference has been made up by the losses of those whose courage and initiative have not been supplemented by exceptional skill or unusual good fortune.
Could we have avoided a too-long and too-slow recovery if the Obama administration had not retreated to the balanced budget nostrums of the past? We do not know.
Right now, however, my biggest concern in this context is somewhat different: the past decade’s policies of anemic recovery are apparently not perceived as a failure by either those at the tiller at the time or by their successors. With a few honorable exceptions, Fed policymakers tend to say that they did the best they could, given the fiscal headwinds imposed on them. With a few honorable exceptions, Obama administration policymakers say that they stopped a second Great Depression, and that during the recovery they did their best given how they were hobbled by the Republican majorities in Congress.
For their part, conservative economists tend to either be silent on the subject or say that the policies — both fiscal and monetary — pursued by the Obama administration and by the Bernanke Fed were dangerously inflationary, and that we have been lucky to escape the fate of Greece — or Zimbabwe.
Economic analysis has made the rise and fall of economies easier to understand and easier to manage — or at least I thought it had. Yet once again, policymakers (including the decision makers at the top in the Obama administration) abandoned modern economics in favor of discredited policies born of a mixture of so-called common sense and 19th-century misunderstandings. We are all paying the price — well, the bottom 99 percent of us, anyway.