Another Great Depression?

What’s the difference between a financial crisis and a Depression? At least initially, the symptoms appear similar. Banks won’t lend to one another, even overnight. Strong and respected businesses cannot borrow short-term money in the commercial paper market even though their default rates are negligible.

The banking systems in many countries have ceased functioning and required major government intervention. It is like a patient experiencing multiple organ failure because the basic circulatory system has gone kaput. Despite urgent measures, the patient appears unresponsive.

Yes, it’s that bad … but is it the beginning of another Great Depression?

That question has been posed repeatedly–and often feverishly–over the past several weeks. The answer–and I don’t mean to be theatrical–is “No … but …” So first, let’s talk about the “no,” and then we’ll come back to the “but.”

The current situation in the U.S. economy is not even slightly good. The financial crisis is global, and real. Nevertheless, the impact on the “real” U.S. economy is not yet dire. To date, more than 700,000 jobs have been lost, and we can expect more, but some perspective is in order.

The losses to date represent less than .5% of the work force. In the relatively mild recession of 2001 to 2002, job losses equaled about 1% of the work force. In the much more severe recession of 1981 to 1982, job losses totaled nearly 3% of the labor force–six times today’s figure. And in the (truly) Great Depression–invoked, now, with an alarmist frequency–job losses between 1929 and the trough in 1933 were 21% of the labor force; and by 1939, total employment remained 13% below 1929 levels.

Output in the Eurozone economies, as well as Britain, Japan and others, is shrinking; but measured output in the U.S. has yet to decline in the current slowdown. I believe it will shrink, but in the Great Depression, real output shrank by 38% between 1929 and 1933 and remained well below trend for a decade.

Evidently, we are a long way from a Great Depression.

Now, given the amount of hand wringing that is going on, some of you will assume that I’m channeling Mr. Micawber, one of literature’s most hapless optimists. The situation is serious, and something has to be done. Unlike Mr. Micawber, I don’t expect that “something will turn up.”

Rather, I want to ask the more important question: What do we know about the road that leads from a financial crisis to a severe and prolonged downturn–and how can we avoid it?

The American Great Depression of the 1930s is the most familiar–and most studied–economic collapse, but it is important to know that it is not the only one. Other countries suffered prolonged downturns in the 1930s, and many, including Japan, Mexico, Chile, Argentina, Brazil, New Zealand, Switzerland and Finland have experienced prolonged episodes of below-trend output in the period since the Great Depression.

The book Great Depressions of the Twentieth Century, edited by Timothy Kehoe and Edward C. Prescott, contains studies of depressions in 14 countries. Harold Cole and Lee Ohanian have done the most in-depth recent research on the American Great Depression, as well as the long decline in the U.K. economy. There is also a terrific book by Amity Shlaes, The Forgotten Man, which reexamines the roots of the Depression.

With all of this scholarship, what do we know about why depressions–whether in upper, or lower, case–occur?

Not surprisingly, there isn’t one story that fits all of them, but there’s a common theme that emerges: It is that unwise policy choices made in the throes of a crisis exacerbate and prolong the real downturn associated with the crisis. In particular, government policies that affect productivity and hours of work are most often responsible for throttling economic growth.

That this was true in our Great Depression is now clear. While earlier historians focused attention on the failures of monetary policy, and on the distortions caused by the Hawley-Smoot tariffs, evidence now points more strongly to policies that tried to keep wages artificially high (under Hoover and then Roosevelt) and to cartelize industry (under Roosevelt).

OK, now here’s the “but” part: Policies matter. Roosevelt was viewed as a great activist leader during the Depression. In fact, he was a great experimenter, willing to try one thing, then another, to turn the country around. The result was an economic downturn that lasted for many years longer than it might have.

For many decades following the Great Depression, conventional historians viewed the crash as a failure caused by laissez-faire policies, rampant speculation and the incompetence of people like Hoover and Andrew Mellon. They attributed the subsequent recovery to the inspired leadership of Roosevelt and to the role of the government in directing economic activity. We are beginning to hear these rumblings again, along with rhetoric that is hostile to trade, globalization and immigration, not to mention a mounting distrust of markets.

These are easy populist positions to adopt, but they are dangerous and false–even dangerously false–because policies matter. They matter deeply, and once adopted, it is extremely hard for the country to change course. Can the current leadership in Washington right the ship enough to forestall a head-long rush into a catastrophic storm? This writer is optimistic–guardedly–that good sense will prevail. But he is not, as yet, a Micawber.


Originally published at Stern on Finance blog and reproduced here with the author’s permission.

13 Responses to "Another Great Depression?"

  1. ME   October 21, 2008 at 3:27 pm

    i do not get it OKAY LOSER!

    • Anonymous   November 17, 2008 at 10:33 pm

      Did any of consider that this is all part of God’s plan to bring this evil system to an end ?

  2. Gloomy   October 21, 2008 at 4:02 pm

    If depressions result from policy misteps, then we are in big trouble. Our leaders, notably Paulson(overseeing massive CDS expansion at Goldman), Greenspan and Bernanke (both of whom supported ridulously low interest rates in 2002 and lack of regulation of real estate lending and CDS’s) have caused the asset bubbles we are now bursting and have misjudged the severity of our current calamity from the beginning as many have documented (“subprime is contained” will be well remembered for decades). In fact, I think it is fair to say they have all flunked the practical portion of their economics examination. To be blunt they have demonstrated near complete incompetence in understanding what was happening and taking appropriate action (the idea that this was a liquidity and not an insolvency crisis is central to their misunderstanding). So you believe these clowns who have caused and mismanaged our economy will be able to fix it? Micawber indeed!!!

    • Anonymous   October 21, 2008 at 7:47 pm

      You have not mentioned the incompetence of S E C’s honcho Cox or the failures of our Congress Guess they were all dining @ table of special interests,lobbyists & big $$$ Wall St firms

  3. Guest   October 21, 2008 at 5:06 pm

    micawber schmilawber I’m knocking together my crate and collecting a basement full of apples

  4. artichoke   October 21, 2008 at 5:09 pm

    If you let wages fall to real value, then all the highly trained Realtors, Amway salesmen and hamburger flippers who form the backbone of the American economy will get zero. They will be unable to eat or have shelter.Next idea?This is so awful because we’ve got such an essentially unproductive economy. We didn’t have that problem in the 1920’s.

    • Guest   October 21, 2008 at 11:45 pm

      I agree! Huge percentage of an american work force can be easily dispensed off, as it totally unproductive. The next great revelation after “deregulate everything” theory collapse, is the busting of the “We can prosper as a service economy” myth.

  5. koen   October 21, 2008 at 5:57 pm

    yes, there is one story that fits them all: the root cause of these prolonged economic crisisses was a credit bust, the ‘machine’ that generates money was bust, it’s the fractional reserve banking system itself that generates these busts, the result is that the market generates much less money to chase goods and services than it usually does, this can then lead to price-deflation

  6. bg   October 21, 2008 at 11:07 pm

    You have described an antibiotic which might (in hindsight) have cured the Great Depression. Can you really be so sure that the bug hasn’t evolved faster than our understanding?Asset Deflation is a disease that will adapt to any cure.

  7. koen   October 22, 2008 at 8:18 am

    Mr. Cooley seems to me to be one of those free market ideologists. Economy is not a science, but a bunch of conflicting schools. If it were a real science, we would know exactly what to do. Just like physics tells you what to do if you want to fly to the moon. Or we would know for sure that not much can be done within the context of the current financial system (fractional reserve banking).

  8. Guest   October 24, 2008 at 3:31 am

    Dear Mr. Cooley,I fail to see your ‘but’ in the above article, except for some rather ianccurate hints like ‘policies matter’.The question that should bea sked is this: how can a very deep deflation bes softened – beacuse deflation was the name of the game from 1929-33, a deflation following an enormous inflation of the economy.Now, this inflation is even worse now – and from 1929-33 the dollar gained 22% in value. Why? Because the market had too much to offer at the same time.This problem has grown significantly with globalization – an incredible output of cheap goods have flooded the western world and caused a builtup of debt at unprecedented levels. This has to deflate … that is the frightening stuff here.As early as 1999 the recent Nobel Prize laureate Paul Krugman wrote this article; ‘Can deflation be prevented?’http://web.mit.edu/krugman/www/deflator.htmlThat is the question we should ask ourselves – buying toxic assets out of the market is by the way the first and simplest move against deflation.

  9. Farrar   October 24, 2008 at 7:22 am

    I can’t understand why Roubini lets people post crap like this on his site.

  10. Anonymous   February 27, 2009 at 11:23 pm

    With the modern world we have nowadays we cannot deny the fact that there are lots of innovations exist especially in the field of Science. Various researches and experiments are conducted. Of course it requires a longer period of time and a greater amount as well to justify a particular study. Despite the advances in Science, some of our fellows still can’t get rid of the superstitious beliefs.Although there is reported to be no primary source for it, there is a Chinese curse of sorts, “May you live in interesting times,” that rings pretty true in this day and age when there is so much rampant layoffs. The “5 stages of Grief” is a part of job loss psychology, derived from the “5 stages of grieving (or death)” from Dr. Elisa Kubler-Ross. Once job loss has happened, there are stages of denial, anger, bargaining, depression and finally acceptance. Just as there is survivor’s guilt, which are feelings of guilt from the survivors of war and accidents, there is also survivor’s guilt on the part of those partiesnot affected by massive layoffs.