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We’d forgotten what a depression looks like
Sunday, Nov. 27, 2011 | 2:03 a.m.
If you think this recession has been going on far too long, you are right.
Economists define recessions as the period of actual decline in real economic activity, which we generally measure with gross domestic product. The recession, which began in early 2008, was officially over by the middle of 2009. Adjusting for price inflation and population, real per-capita GDP normally grows about 1.5 percent per year. Instead, it fell by 6.4 percent.
That doesn’t sound so bad, considering how we were looking into a deep abyss in the fall of 2008.
But even though real per-capita GDP has grown by 3.2 percent since the middle of 2009, we are still 8 percent below where we would have been without the housing and banking crisis that Wall Street helped create. Adding it up, we have lost almost $4 trillion in income since 2007. As our annual GDP is $15 trillion, you can see we are talking about a lot of money. As a robust recovery is still several years away, this loss will only keep rising.
Normally, recessions last a year or less, and recovery takes another year or so. Why is this recession so different?
Let me let you in on a poorly kept secret: This is a depression. Some economists prefer to call it a “balance sheet” recession, so we don’t frighten the children (or consumers, or investors, or voters) and so people don’t think we are comparing this to the whopper of the early 1930s, when government did everything wrong in response.
People assume a depression is just a word for a bad recession, but those who know the history of recessions define it as a downturn caused by a financial crisis. What makes that different?
In a financial crisis, banks and other financial institutions become extremely concerned about the poor quality of the debt they hold, and are afraid to take on any more risk. As a result, they collect reserves to offset their bad debt instead of lending it out. Firms won’t hire or invest if demand is weak and they can’t get loans.
Consumers lose much of their wealth in depressions, permanently depressing their spending habits. Because our financial crisis involved housing, the biggest asset most people own, homeowners are substantially poorer than they were five years ago. Firms that depend on old consumer spending habits struggle to survive.
Contrary to recessions caused by tight money, depressions tend to push interest rates toward zero. Price deflation is also a danger, since falling prices make debt harder to repay, and encourage banks to hold cash and bonds instead of making loans like they are supposed to do. Unless stopped, deflation creates more deflation, causing a downward spiral.
Governments tend to become the borrower of last resort in depressions, as investors flee other assets and look for somebody relatively safe to hold their money. As the Euromess is now demonstrating, however, even governments may not be safe bets.
When the recession is short, state and local governments with falling tax collections, increased spending needs, and balanced budget requirements can raid rainy-day funds and other balances. But if the recovery is slow, financial distress forces these governments to cut spending or raise taxes at exactly the wrong time. Though the private sector was hit first by the recession, the contraction of the public sector substantially slows down the recovery.
In normal times, things are different. When the economy is near full employment and markets are working well, an increase in government demand only crowds out private demand. Firms sell more to the government and less to private investors or consumers. If government borrows to pay for its spending, this bids up interest rates, reducing borrowing by the private sector. If those borrowed funds come from abroad, then exports fall instead, since every dollar we borrow from a foreigner is a dollar not spent on our goods. In normal times, the multiplier is near zero, so that an extra dollar spent by government has very little net effect.
In a typical recession, there is slack in the economy and crowding-out is not complete, so the multiplier is positive if still not very big. But fiscal policy often requires a legislative decision, and implementation takes time; by the time government acts, the economy is well on its way to recovery. The private sector can generally create enough growth on its own, if government doesn’t make things worse.
In a depression, however, the economy’s normal recuperative powers are weak. Fiscal policy becomes the only tool government has left, even if its effectiveness is limited. In essence, government spending is a parachute, slowing the economy’s decline, not a rocket to return us to full employment. With it, the recession won’t be as deep, but the damage is still substantial and recovery still takes years.
International evidence shows that recessions caused by financial crises are deeper and longer. Fiscal intervention can reduce the severity but can’t make it all better. Even seven years later, on average, economies are 10 percent below where they should have been.
Why don’t most people understand this difference? We have forgotten our past. Those who lived through the Great Depression will never forget it and know that this one now is much less nasty. But before that big one, depressions occurred with some regularity, and they were twice as long and twice as deep, on average, as other recessions.
The institutions and rules we created after the big one prevented it from happening again. In time we came to think depressions were just a scary tale our grandparents told us so we would behave. Eventually, we came to believe we didn’t need no stinkin’ rules anymore, as the bandit in “The Treasure of the Sierra Madre” might have said.
Now most of us still don’t know what hit us, or who to blame.
Elliott Parker is a professor and the chairman of the economics department at the University of Nevada, Reno.
Discussion: 5 comments so far…
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If a professer of economics doesn't know what hit us or who to blame is there anyone out there who has a reasonable explanation? I notice he also avoids any mention of what it takes to end a depression or how the last ended. At least he is smart enough not to credit the "new deal". It is also obvious that no one in the current administration has any answers when it comes to ending the current economic problems, whatever you wish to call it.
Mr. Parker, a fine column.
Quite frankly I would like to see other viewpoints from Austrian Economists such as Hans Herman Hoppe who was at one time at UNLV. I do respect the comments made by Elliott Parker; a professor and the chairman of the economics department at the University of Nevada, Reno. That said, I do think that the comments and observations that have been made by Ron Paul over the past many years, on the cause and effect of our current DEPRESSION, lead me to believe that the Austrian School may just have the right answers, and that the Keynesian School, our government and the FED have all the wrong answers. That said, we do have a government and FED that are debasing our currency and causing our economic bubbles, inflation and the general wrecking our economy. Of course the government and the FED didn't do this wrecking intentionally as they thought they were doing us all a favor, while they made for themselves incredible wealth. And now the FED and the Government are looking for suckers to hang the blame on. Who we do have to blame are our Congressmen, certainly since the Woodrow Wilson presidency, both Republican and Democrat. It is they, who have sowed the seeds of the bitter fruit that we now eat.
the multipliers are generally nonsense. Macroeconomists make a lot of assumptions and, as in this case, when the predicted results don't appear they don't toss out the model and say "sorry we were wrong." Nope, they still claim success and just revise their numbers backwards...ie make the assumptions that fit the results.
After several trillion dollars it seems pretty clear the government spending hasn't done much of anything.
Government appears so ineffective that the multiplier might actually be negative. In other words, increased intervention by the government may actually retard recovery making our recession even longer than it otherwise would be. Indeed, there are many economists who believe government intervention made the depression last far longer than it otherwise would. I recall a recent UCLA economist who noted the depression lasted about 8-9 years longer than it would have BECAUSE of the heavy government intervention.
I ignore theoretical economics since I know little about the subject.
The local and Fed govt is systematically busy making small business investment basically unattractive and even scary for the investor and businessman. money is hiding. Uncertainty is deadly to investment in small business which is one basic economic engine driving America's larger businesses growth.
The Vegas situation is horrible in part because we had been busy building excess houses to put construction workers families in for the 3 years before the bubble burst. The pols and developers refused to bow to reality and now we have a BIG Depression locally that eclipses the national problem. The Pols and developers that are still standing refuse to get it and continue to sanction and build excess overpriced box houses; based partly on the fake housing sales generated when small investors hide their capital in buying up leveraged and dirt cheap houses.
Rentals are blooming everywhere as a blight on neighborhoods devaluing the rest of the houses again. The limited market for them should sooner or later result in massive losses due to an excess of product and a lack of people willing to pay excessive rental prices demanded by stars in their eyes investors. Then will come a new series of foreclosures as investors realize they have expensively leveraged white elephants on their hands that have excessive tax costs EVEN if they are paid off which many are NOT.