Guest post: The Great Recession: Past, present and possible futureBy Ahsan Butt Sep 13, 2011 8:33PM UTC
I’m delighted to have Rohit “Noompa” Naimpally use all his political economy wiles to talk about why the economy sucks, and what can be done about it. Rohit is someone I know from his time at Chicago, and he knows this stuff inside out. You can follow him on Twitter here, and read his blog here. Without further ado…
Thanks again to Ahsan for giving me this opportunity to write on his terrific blog. It has now been three years since the collapse of Lehman Brothers in September 2008, an event informally recognized as being one of the proximate causes of the financial crisis and subsequent economic slump in the United States. Since then, we have seen large parts of the Western world engulfed in economic crises, from the PIIGS (Portugal, Italy, Ireland, Greece and Spain) in Europe to Iceland and indeed, the United States. Although the USA is technically no longer in a recession according to the National Bureau of Economic Research (NBER), the authority generally cited on recession identification, economic conditions remain poor. The national unemployment rate remains above 9%, while the GDP growth rate was a sluggish 0.4% in the first quarter of 2011 and 1% in the second quarter. With unemployment and the Great Recession – as the period since 2008 has come to be known – likely to be key factors in the 2012 Presidential race, understanding the current economic situation has never been more important. In this post, I shall highlight some key aspects of the Great Recession. Although the discussion will be at a non-wonkish level, clicking through to the numerous links should provide additional reading material for readers interested in going deeper into the issues.
By way of introduction, let us briefly consider the origins of the Great Recession. I recently came upon this terrific series of slides by UC-Berkley Econ Professor (and popular blogger) Brad Delong. It is a short summary of some widely cited theories of the Great Recession that are wrong, while also explaining what Delong considers a correct theory of the crisis. Since I hold a very similar view of the crisis as Delong, I shall summarize here. In effect, households in the United States became heavily leveraged (i.e. heavily indebted) during the Bush-era boom years. Easy credit courtesy low interest rates during Alan Greenspan’s tenure at the Federal Reserve helped fuel a boom in household borrowing. Coupled with the shockingly lax lending practices of mortgage originators, this easy credit helped fuel a housing bubble. Borrowing against the inflated values of their homes, consumers were able to spend. Wall Street shops like Merrill Lynch kept fueling the subprime boom in ways that would make anyone’s head spin, further inflating the housing bubble. Ultimately, the entire stack of cards came crashing down as fundamentally risky assets failed to come good on their AAA, super-safe credit ratings, prompting a tail-spin across the various financial institutions that held these toxic assets on their books. As the economy panicked, there was a flight to safe assets and credit became tight (even as the Fed continued to slash interest rates to near-zero levels). The very plumbing of the economy ran dry, with institutions choosing to hoard safe assets and cash in uncertain times, rather than invest and/or lend.
These facts have been mobilized in the aid of different narratives. One popular meme amongst conservative economists has been to criticize government regulation and its role in contributing to the housing bubble. In his mostly-solid book Fault Lines, UChicago Booth School’s Raghuram Rajan faults the government’s Community Reinvestment Act, essentially an affordable housing mandate, for driving the subprime boom. This view has been debunked repeatedly – from its misunderstanding of the CRA’s operation over the years to its mischaracterization of what constitute subprime loans and which parties were most responsible for subprime originations during the go-go days. However, this wholesale rebuttal has not prevented the view of regulatory excesses from motivating the Republican Party and conservative think tanks to advocate for a lighter government hand. Evidence has come to light that a calculated disinformation campaign is being waged by elements of the right- such as the American Enterprise Institute’s Peter Wallison- even on purportedly bipartisan platforms.
Conservatives are also fond of mobilizing the Fed’s purportedly easy money policy during the boom years as evidence against Quantitative Easing and keeping target interest rates at near-zero levels for too long. However, as Scott Sumner has pointed out, while nominal rates may have been low during the boom years, real rates were soaring in the lead-up to the crisis; the upshot of this slightly technical point is that interest rates by themselves do not tell us whether the Fed’s monetary policy is appropriately loose, or tight in relative terms. Thus, arguing against Quantitative Easing ex ante is flawed. Furthermore, with expected inflation at record-low levels, there is little to suggest that further Fed action would feed into 1970s-style stagflation. Indeed, one could make a good argument that what the US needs now is precisely a good dose of inflation and an uptick in inflation expectations. If people expect prices to be higher in the future, they are more likely to spend today, thereby boosting demand in the economy, which in terms spurs investment, thereby spurring more demand and so on.
Because, the key to the current recession is aggregate demand i.e. cumulative economy-wide demand for goods and services. Or rather, the shortfalls in aggregate demand. One story of the current economy that I find compelling is the idea of a debt overhang facing households, giving us a “balance-sheet recession”. Richard Koo of Nomura Securities, who identifies a situation in the US analogous to Japan’s Lost Decade, has popularized this view. If there is one video related to the Great Recession that you watch, it should be this one of Richard Koo explaining a balance sheet recession. As noted earlier, households were overleveraged leading into the crisis, borrowing against the values of their homes, the very values of which have now collapsed. Many households are “underwater” on their mortgages i.e. the sum of mortgage payments owed exceeds the value of the home. As households seek to deleverage, a greater portion of income goes towards paying off debt. This means lower aggregate demand, which in turn dampens sales expectations for firms. In addition, hiring and firing times are much lower for firms nowadays, so they can sail much closer to the wind by waiting for better signs of recovery before rehiring. A key figure in this story comes from a chart late in 2009, summing up what small businesses identify as their biggest concerns:
Looking at that, I see “poor sales” going from ~10% pre-crisis to ~30% post-crisis. Of course, there are folks that differ: Russ Roberts, James Hamilton and Tyler Cowen all argue that taxes and govt. requirements form pretty sizeable chunks as well. And just like that, we have arrived at our favorite conservative meme once again: “the government did it!” Myth busting is a pretty simply task here: what we should be focusing on is the change in concerns, not so much the absolute levels. As I noted here, businesses are always bothered by taxation and government requirements! In their ideal world, they would not have to pay taxes and not be subject to any regulations, much as in my ideal world, I would be married to Ellen Page and be opening bowler for the Indian cricket team. This constant concern with taxes and regulation is reflected in the graph: if businesses had no problem hiring pre-recession, why should regulation and taxes suddenly make them bearish?
Ideally, in this situation, we would want a party to step in and stimulate the economy by boosting aggregate demand. Said party could spend on programs that directly hire unemployed workers, putting more people to work (a concern in itself, given the serious consequences of long-term unemployment.) A large majority of these people would use this income to deleverage, but given that the unemployed are more likely to be lower down the income ladder and that the marginal propensity to save is lower for such individuals, significant portions of the income would also go towards boosting demand further. There has been a precedent for such an effort in New Deal-era policies such as the efforts of the Works Progress Administration. Returning to our mysterious demand-stimulating, employment-boosting savior: ideally, said party would also be able to fund such an effort by borrowing on the cheap. If the borrowing costs- say the yields on bonds issues by said party- were at record lows, it would almost be a no-brainer to fund such a program, right?
Those of you following along will have realized that I have been prescribing a dose of good old-fashioned fiscal stimulus. The Federal Government has the ability- Congress willing- to directly invest in the economy and launch employment schemes. Conservatives worry about big government, but the story of the Great Recession has been the decline in Government employment. “Bond Vigilantes” notwithstanding, the US government currently has the opportunity to borrow at historically low rates. Despite the ongoing freakout over the National debt, the priority should be job creation and boosting the economy; indeed, there is strong evidence to suggest that running a short-term deficit to boost growth could ultimately be an effective way to reduce the long-run deficit. Conservatives worry that government spending could crowd out private investment, a pretty, textbook theory that has little practical relevance in the hyper-low interest rate world that we currently live in.
Another popular conservative meme, mobilized against stimulatory measures, concerns the nature of the unemployment problem. I shall dwell on the nature of the unemployment problem at some length here, since it is the single most striking feature of the recession. At the risk of oversimplifying, there are two broad ways in which one can think about unemployment: cyclical, or structural. Cyclical unemployment is unemployment that occurs over the course of the business cycle and can be corrected for. Say a credit crunch has resulted in consumers buying fewer goods, prompting businesses to lay off workers. Boosting demand in this situation, through something like fiscal stimulus, would boost sales prospects and kick-start businesses into hiring once more. That is, the unemployment level is not at a “naturally” high level that cannot be brought down through active monetary or fiscal policy. The other way of thinking about unemployment is as structural unemployment i.e. unemployment that comes about as the economy undergoes structural changes and has to go through some necessary purging. The view that the unemployment problem is largely structural has found some traction amongst conservative thinkers, with many pointing to the construction bust following the housing bust as the sort of structural change that would cause such unemployment. Most importantly, structural unemployment leaves very few options for corrective action, consigning the government and the Fed to sit on their thumbs and wait for the long, drawn-out process to come to an eventual end. One prominent advocate of the structural unemployment viewpoint is Minneapolis Fed President Narayana Kocherlakota (see his FOMC speech from last year here). At best, people like Rajan argue for worker retraining programs to prepare workers with skill mismatches- such as a construction worker looking to get into a non-construction job- as a possible antidote for the unemployment problem.
It should already be apparent as to how much is at stake here: if we grant that the current unemployment level of >9% in the US is largely structural, further stimulus measures would prove largely futile. In effect, we would be conceding that there is very little to be done and that an entire generation of working-age adults may have little option but to see a large chunk of their lives destroyed. So if you worry about what we could be doing to address the unemployment situation, this should be an issue that greatly concerns you.
Thankfully, there is an overwhelming amount of evidence to indicate that the unemployment problem is largely a cyclical one. Consider the following two graphs (via):
There is no doubt that a construction bust has occurred. However, this has rippled through the economy, dampening sales prospects across the board and prompting layoffs/sluggish hiring in other sectors as well. The chief sectors identified as drivers of structural unemployment- finance and construction- track other sectors remarkably closely when it comes to underemployment. The reasons for focusing on underemployment instead of unemployment are a little wonkish, but interested readers can go to this Mike Konczal post. More evidence comes from the folks at the IMF, who do some neat stats work to arrive at an estimate for structural unemployment of 1%-1.75%. Again, the unemployment rate has been well over 9% for a while now; focusing on something like worker retraining is the equivalent of using a bandage to cover a foot-long gash. Since this debate is especially dear to my heart, here is some additional reading: These three Konczal posts are all a tad wonkish, but superb nonetheless: one, two and three. I have also written about this issue elsewhere: here and here for instance. Finally, if you read just one piece on the structural-cyclical debate, read this EPI publication (pdf) by Mishel et al.
With private investment proving wholly inadequate to the task of boosting the economy, the government needs to step in with a big dose of stimulus. The Jobs Act recently proposed by President Obama goes some way towards pushing back against the austerity advocates, an encouraging sign in these desperate times. With the plethora of possible “worlds” that we can live in, economic models are only as good as the world around them. In the current world, one characterized by the paradox of thrift, high unemployment and low interest rates, old-style Keynesian prescriptions are called for. The model exists; all that remains is that the ideologically blinkered right wing recognizes the urgent need for enacting the correct prescriptions before it becomes too late.