The Story So Far

The economic downturn is routinely billed as the most perilous since the Great Depression. What exactly does that mean?  What is most likely to happen next?  As it happens, fundamental aspects of the situation lend themselves to portraiture.

Sometimes a picture really is worth a thousand words. Have a look at this history of American economic growth and business cycles over the last 135 years.

(Figure missing, same as cover of Jones’ Introduction to Economic Growth)

The figure, which can be found in Charles I. (Chad) Jones’ new intermediate textbook, Macroeconomics, illuminates several dimensions of the current situation. (Robert Gordon’s intermediate text makes the same visual point early on in a case study, but Jones puts the story on the cover of his book and repeats it as a design leitmotif throughout.)

(Never mind that the illustrator of this particular version, which is not in the book, carelessly shifted the dates about five years to the right, and elongated the horizontal scale in the years between 1970 and 2000. The discrepancy was discovered only after EP appeared, and does not change the point.  The shape of the line is correct.)

First, the graph clearly presents the fundamental relationship between business cycles and the trend of growth, expressed as gros domestic product per capita. As Jones says, “Three features of the graph stand out: (1) the overall upward trend due to economic growth, (2) the short-run fluctuations in economic activity, and (3) the suggested question of what the future holds.”  The fact that expansions and recessions are somewhat difficult to see is itself worthy of note, he adds: “Over the long term, economic growth swamps economic fluctuations.”

Second, the data convey a very clear idea of why we call it the Great Depression. Between 1929 and 1933, the American economy shrank by 30 percent. Its foreign trade slowed to a crawl. Unemployment reached 25 percent in 1933 – fifteen million people were out of work. Not until 1940 did output regain its level of 1929, and then only because preparations for World War II were underway. There has been nothing else remotely like that decade in 135 years.

Third, the graph tells something worth knowing about before and after World War II. Determined to avoid a post-war return to Depression conditions, Congress passed the Employment Act of 1946, mandating a broad government economic policy and creating the President’s Council of Economic Advisers. Economists soon discovered that a number of “automatic stabilizers” had been created as part of the New Deal. Before 1946, business cycles were more frequent, the swings were greater, and the economy often operated below the 2 percent growth rate that now seems to be its long-term norm; after World War II, recessions became milder and less frequent and growth steadier.

Fourth, history suggests a way of thinking about the magnitude of the current situation. Some people compare the US to Japan, which suffered nearly a decade of stagnation in the 1990s, after more than thirty years of uninterrupted growth.  But if you stick to the American experience, the two previous recessions that stand out are those of ’81-82 (associated with the Volcker disinflation) and ’74-75 (associated with the OPEC price increases and a commercial real estate crash), each of which lasted 16 months from peak to trough. The current contraction almost certainly will be worse than either of them. Suppose that it lasts another year; that the economy doesn’t resume its upward path before next December. At 24 months, the current recession would be 50 percent worse than either of the two earlier episodes, both of which are remembered as bruisers (you still have to look pretty carefully though to see either one in the overall story), and well short of the 43-month contraction of the ’29-33 depression and its 13-month coda in ’37-38.

Fifth, the graph provides some insight into the differences of opinion among the various economists who have signed up to deal with this event. Arguments are nearly as intense as ever among economists about the origins of the Great Depression and what the profession has learned since. The Keynesians and Monetarists of the ’60s slowly morphed into, first, New Classicals and then New Keynesians (and some influential Still-the-Same Keynesians) of the ’80s and, in the ’00s, into something else again – the new axis of disagreement will come clear only as the crisis is worked through and the next generation of macroeconomists leaves graduate school and makes its way in the world.

At the moment, New Keynesians dominate the debate. The consensus is that the economy requires a considerable jolt in order to resume growing again, whether a program of massive government spending, as favored by economists including Lawrence Summers and Paul Krugman, or still more tax cuts designed to pump up demand, as preferred by economists such as N. Gregory Mankiw. The other camp, in which Keynes is not the overarching figure, is more diffuse, precisely because there is no overarching figure; besides, in an emergency, the tendency is to rally round the consensus.

Whatever label eventually attaches to this other camp, contributors to the dissent are present, too, all around the edges of the policy debate. Among the most prominent are John Taylor, of Stanford University; Nancy Stokey, of the University of Chicago; Kenneth Rogoff, of Harvard; Robert Barro, also of Harvard; just possibly Fed chair Ben Bernanke, as a result of his recent experiences, though he is too heavily encumbered now by his responsibilities to speak frankly; and, presumably, Chad Jones, whose text, with its emphasis on long-run growth, affords a glimpse of a fundamentally different way of looking at the tasks of macroeconomic management. (Earlier this month, Jones left the University of California at Berkeley for Stanford’s Graduate School of Business.)

True, the graph offers no information about the bewildering circumstances that contrived this mess – the series of asset bubbles, culminating in an unsustainable run-up in residential housing prices around the world; the wave of financial innovation that produced debt securities that even the most sophisticated institutions failed to understand; the resulting doubts about counterparties’ financial condition that led to paralysis among banks, especially after the US government permitted Lehman Brothers to fail and thereby demonstrated that it had no clear idea of the extent of systemic risk; the global trade imbalances that might yet the crisis to a new level through dramatic currency swings.

It does suggest that having created the banking panic through inept regulation, the government probably possesses the means to dispel it, once the transition to a new administration is complete. The American economy hasn’t gotten stuck for eighty years.

For Jones’s exercise in perspective conveys the reassuring fact that US growth routinely has returned to its long-term trend, whatever the political regime of the moment happened to be. As Jones says, “Another wonderful thing about the picture is that it makes the point that even something as earth-shaking as the Great Depression really left the long-run future of the US largely unaffected.  Something so seemingly world-changing was, in the end, only temporary.”

Whether or not the future will run along the lines of the past remains to be seen. It is not surprising, however, that people are frightened. My friend Peter Renz, the mathematician and editor, puts it this way: “We live in the present and our concerns are weighted towards the near future, with the horizon of planning dependent on how close to the financial edge we feel ourselves to be.”

This, however, is a column for the winter solstice.


One response to “The Story So Far”