The Baseline Scenario
By Simon Johnson
With the US and European economies having slowed markedly according to the latest data, and with global growth continuing to disappoint, a reasonable question increasingly arises: Are we in another Great Depression?
The easy answer is "no" – the main features of the Great Depression have not yet manifest themselves and still seem unlikely. But it is increasingly likely that we will find ourselves in the midst of something nearly as traumatic, a long slump of the kind seen with some regularity in the nineteenth century, particularly if presidential election-year politics continue to head in dangerous direction.
The Great Depression had three main characteristics, seen in the United States and most other countries that were severely affected. None of these have been part of our collective experience since 2007.
First, output dropped sharply after 1929, by over 25 percent in real terms in the US (using the Bureau of Economic Analysis data, from its website, for real GDP, using chained 1937 dollars). In contrast, in the U.S. we had a relatively small decline in GDP after the boom peaked. According to the BEA's latest online data, GDP peaked in the 2nd quarter of 2008 at 14.4155 trillion and bottomed out in the 2nd quarter of 2009 at 13.8541 trillion; a decline of about 4 percent.
Second, unemployment rose above 20 percent in the US during the 1930s and stayed there. We experienced record job losses for the post-war US, with around 8 million jobs lost. But unemployment only briefly touched 10 percent (in the 4th quarter of 2009; see the Bureau of Labor Statistics website). Even if we include the highest estimates – which include people discouraged from looking for a job, thus not registered as unemployed – the jobless rate reached around 16-17 percent. It's a jobs disaster, to be sure, but not the same scale as the Great Depression.
Third, in the 1930s the credit system shrank dramatically. In large part this is because banks failed in an uncontrolled manner – largely as a part of panics that led to retail depositors running to take out their funds. The creation of the Federal Deposit Insurance Corporation (FDIC) put an end to that kind of run and, despite everything, the FDIC has continues to play a calming role. (Disclosure: I'm on the FDIC's newly created systemic resolution advisory committee, but I don't have anything to do with how they handle small and medium-sized banks.)
But experience at the end of the 19th century was also quite different from the 1930s – not as dramatic, yet very traumatic for many Americans. The heavily leveraged sector more than 100 years ago was not housing but rather agriculture – a different play on real estate.
There were booming new technologies in that day, including the stories we know well around the rapid development of transportation, telephones, electricity, and steel. But falling agricultural prices kept getting in the way for many Americans. With large debt burdens, farmers were vulnerable to deflation (a lower price level in general or just for their products). And prior to the big migration into cities, farmers were a mainstay of consumption.
According to the NBER, falling from peak to trough in each cycle took 11 months in 1945-2009 but twice that amount of time during 1854-1919. The longest decline on record, according to this methodology, was not during the 1930s but rather during October 1873 to March 1879 – more than 4 years of economic decline.
In this context, it is quite striking – and deeply alarming – to hear a prominent Republican presidential candidate attack Ben Bernanke for his efforts to prevent deflation. Specifically, Texas Governor Rick Perry said earlier this week, referring to Mr. Bernanke,
"If this guy prints more money between now and the election, I dunno what y'all would do to him in Iowa but we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in American history is almost treasonous in my opinion."
In the nineteenth century the agricultural sector, particularly in the west of the country, favored higher prices and effectively looser monetary policy. This was the background for William Jennings Bryan's famous "cross of gold" speech in 1896; the "gold" to which he referred was the gold standard, the bastion of hard money – and tendency towards deflation – favored by the east coast financial establishment.
Populism in the nineteenth century was, broadly speaking, from the left. But now the rising populists are from the right of the political spectrum and they seem intent on intimidating monetary policy makers into inaction. We see this push both on the campaign trail and on Capitol Hill – for example in interactions between the House Financial Services Committee, where Ron Paul chairs the monetary policy subcommittee, and the Federal Reserve.
The relative decline of agriculture and the rise of industry and services over a century ago was long believed to make the economy more stable – as we moved away from cycles based on the weather and global swings in supply and demand for commodities. But financial development creates its own vulnerability as more people have access to credit for their personal and business decisions. Add to that the rise of a financial sector that has proved brilliant at extracting subsidies that protect against downside risk – and hence encourage excessive risk-taking. The result is an economy that is at least as prone to big boom-bust cycles as what existed at the end of the nineteenth century.
The rise of the tea party has taken fiscal policy off the table as a potential counter-cyclical instrument; the next fiscal moves will be contractionary (probably more spending cuts), irrespective of whether jobs start to come back or not. In this situation, monetary policy matters a great deal – and Mr. Bernanke's focus on avoiding deflation and hence limiting the problems for debtors does not seem inappropriate (for more on Mr. Bernanke, his motivations and actions, see David Wessel's book, In Fed We Trust).
Mr. Bernanke has his flaws, to be sure. Under his leadership, the Fed has been reluctant to take on regulatory issues – continuing to see the incentive distortions of "too big to fail" banks as somehow separate from monetary policy, its primary concern. And his team has consistently pushed for capital requirements that are too low relative to the shocks we now face.
And the Federal Reserve itself is to blame for some of the damage to its reputation – although it did get a major assist from Treasury in 2008-09. There were too many bailouts rushed over weekends, with terms that were too generous to incumbent management and not sufficiently advantageous to the public purse.
But to accuse Mr. Bernanke of treason for worrying about deflation is worse than dangerous politics. It risks returning us to the long slump of the late 1870s.
An edited version of this post appeared this morning on the NYT.com's Economix blog; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.
