Another Great Depression?
November 26, 2008 – The evidence is now clear that the global economy is falling into recession.  Japan has announced that its economy is already in recession.  The United States economy is on the brink of two consecutive quarterly declines in real GDP.  The Economist Magazine predicts that the U.K. economy will decline by at least 1% next year.  Unemployment in the Euro area has reached an average of 7.5% and as high as 11.9% in Spain.

Given the high probability of a global recession, the obvious questions are “how deep and for how long?”  Is it possible that the global economy could sink into a Great Depression II like the 1930s?  A decade ago, most economists would have considered that to be highly unlikely.  Today, many economists are predicting something like the Great Depression, although perhaps not quite as severe.

The problem is that the world’s capitalist economies are experiencing what could be construed as a perfect storm of deleterious events – falling real estate values, stock market declines, insolvent commercial and investment banks, evaporating pension fund wealth, declining consumer confidence and spending, and crashing auto and durable goods sales.

Economists have known for a long time that capitalism was imperfect and probably more so in the macro than the micro.  Marx thought capitalism was unfair to the working class.  Schumpeter wrote that competition sows the seeds of its own destruction.  He called it the “process of creative destruction.”  Kondratiev saw 50-year waves of cyclical fluctuation.  Von Hayek feared that capitalism was not as appealing as socialism to voters in democracies.  But it was John Maynard Keynes (The General Theory, 1936) and his followers who really explained the flaw that we are now experiencing.

Capitalism is inherently prone to boom-bust cycles.  Over investments and optimism eventually create surpluses that cause disinvestments and pessimism.  Part of the problem is freedom, part of the problem is the important role of expectations, and part of the problem is greed.  For a while, everyone tries to be a greater fool without becoming the greatest one.  At some critical point, greater fools become the greatest as the market psychology reverses course.

Keynes explained that the Great Depression was caused by a decline in consumer spending and private investment to such a degree that unemployment reached 25% and underemployment was prevalent.  American Nobel Prize winning scholar Paul Samuelson (who had studied under Alvin Hansen – a.k.a. “The American Keynes”) wrote a dissertation early in his career demonstrating that consumer spending need only to slow down its rate of growth to cause private investment spending to fall and a recession to follow.

When this happens, there’s really nothing inherent in the capitalist system to correct it.  Consumer spending is down, so investment spending is down and unemployment rises.  As unemployment rises, incomes fall, consumer spending falls some more, etc.  Families sit around the dining room table talking about how they can cut back their spending and avoid any more debt.  [Note: Prior to Keynes, the classical and neoclassical economists had argued that the system could/would self-correct if prices and wages were allowed to fall far enough.  That simply won’t work in a modern mixed capitalist system with agricultural price floors, minimum wage laws, powerful labor unions, and chronic government budget deficits].  Another side effect of unemployment could be a rise in criminal activity. Those charged with crimes would still require an experienced law firm. A criminal defense attorney Cincinnati would be able to assist with most cases.


Why Obama’s Economic Stimulus Plan Is Needed

Keynes argued that what is needed to reverse this downslide is an increase in government spending – a stimulus package of spending increases, tax cuts, and deficits that would initiate a spending multiplier effect throughout the economy.  Government could even build bridges to nowhere, although bridges to somewhere would be better.  Two bridges would be better than one, and one would be better than no bridge at all.  When workers are paid for building the bridge(s), they will buy goods and services in the private sector of capitalism; and it would begin to recover.  Businesses will begin to prosper and hire more workers, who will in turn spend more money, etc.

U.S. President-elect Barack Obama has announced that he will propose a stimulus package, perhaps in the vicinity of $500 - $750 billion.  Many economists have argued that when private sector spending is falling dramatically, then more government spending is needed to fill the void – and the sooner, the better -- to avoid a second Great Depression.  It could perhaps be on a scale of World War II military spending beginning in 1942, which brought the unemployment rate in the U.S. down from double digit to less than 2% in 1944.  One of the reasons that the Great Depression lasted so long is that the government was timid about deficit spending.  However, during WWII the U.S. federal government ran enormous deficits for the war, which not coincidentally pulled the economy out of the depression.

[Note: In 1929 total government purchases of public goods and services in the U.S. was $9.4 billion.  The public debt was 16.3% of GDP.  By 1939 government purchases had only increased to 14.8 billion annually, the debt was 52.2% of GDP primarily due to falling tax revenues (not tax cuts), and the unemployment rate lingered around 20%.  In 1942 government purchases jumped to $62.7 billion and the unemployment rate fell to 4.7% in that same year.  By 1946 the national debt was 122% of GDP and the economy was running on all cylinders].

The reason that the 2009 stimulus package has to be so large is that the problem is rapidly becoming more serious. The stimulus should be proportional the GDP gap, which is the difference between the actual GDP and the GDP at full employment.  The further we go into recession, the larger the stimulus package needs to be.  Unfortunately, we have not yet begun to see just how bad the U.S and the other economies can get.  And the longer we wait to do something, the worse it will get before it gets better.  It should come as no surprise to anyone when the unemployment rate in the U.S. reaches 8% or higher next year.

We cannot depend on monetary policy and financial bailouts to solve the immediate problem.  The federal funds rate in the U.S. is already close to zero.  Interest rates can’t get much lower, and lower interest rates are unlikely to stimulate the economy to any great degree.  If the economy falls into a liquidity trap, then monetary policy simply won’t work.  Troubled banks have a hard time lending to troubled borrowers.  Monetary policy is notoriously impotent when it comes to stimulating an economy, and its upside lag times are very long.  The deeper the recession, the weaker monetary policy becomes.  Although low interest rates and bank liquidity and solvency may be necessary conditions for recovery, they are not sufficient.

The Figure below shows the playing field of The Global Economics Game.  It indicates that the United States, the United Kingdom, Japan, and the Euro area countries are already in a recession and heading toward a depression in the lower left hand corner of the playing field.  The Economic Indicator points in the direction of the current trend in 2008.

[Note:  As an economy moves from left to right on the playing field it grows faster. As it moves up it gets more inflation; as it moves down it gets disinflation and deflation. Black numbers in the playing field indicate a positive score.  Red numbers indicate a negative score.  The further into a corner an economy goes, the worse its macroeconomic performance and the lower its score.  The best score is in the very center where there is full employment and other macroeconomic goals are in balance].

The Figure also shows that the most direct counter-cyclical policy tools to get out of or to avoid a recession are:  1. Increase the Money Supply and, thereby, lower interest rates to indirectly stimulate consumer and business investment.  2. Increase Government Spending for public goods and services like infrastructure that will directly create new jobs. 3. Depreciate the Currency, which stimulates exports and curtails imports.

We’ve already noted that monetary policy may not be powerful enough to keep an economy out of or to get it out of a recession or depression.  And the problem with depreciating a nation’s currency is that it exports the recession to the other country, which in turn, will want to depreciate its currency to avoid recession.  Two countries can’t depreciate their currencies simultaneously.  That leaves fiscal policy as the best and most effective policy – especially if all countries cooperate.  If all of the countries were to initiate stimulus packages simultaneously, then they could change the economic indicator away from recession and toward full employment at the center of the playing field.

What the Critics Will Say

What about driving up the national debt?  Isn’t that bad?  The U.S. national is debt nearly $10 trillion, which is about 70% of its GDP.  A major stimulus package would increase the national debt/GDP ratio, because the debt would initially grow faster than the GDP.  It is a legitimate question to ask whether this would be good or bad.

There is probably no other topic in economics that is less understood and more misunderstood than the national debts of nations.  People tend to draw comparisons between their own ability to manage debt and the government’s ability.  The comparisons break down under close scrutiny.  The common denominator is basic economic reasoning:  If the marginal benefit of the debt is equal to or exceeds the marginal cost, then the debt is worthwhile.  If, on the other hand, the benefits are less than the costs, then it’s not worthwhile.

Sending a son or daughter to college on borrowed money is worthwhile if they study and become successful.  It is a mistake if they don’t study, flunk out and remain a low productivity worker or chronically unemployed.  The same is true of governments.  It makes sense to incur debt and spend money to defend freedom or to avoid a depression if the alternatives are to lose freedom or to live in abject poverty.

Beware of those who will criticize President-elect Obama’s stimulus package on the grounds that we can’t afford a higher national debt.  What we can’t afford is a depression. Also, beware of the protectionists.  They tend to become more vocal during hard times.  They will argue that we should protect American jobs at the expense of foreign jobs.  The problem with that argument is twofold:  If we don’t buy imports, then foreigners can’t buy our exports; and there’s nothing preventing other countries from protecting their domestic jobs from our export competing products.  Everybody loses in a trade war.  That was one of the most significant lessons of the Great Depression.

Another common ideological argument against deficit spending on the part of the government is that it crowds out the private sector.  Pretty soon, the argument goes on, there is no private sector – only a public sector.  Everyone will become dependant on the government for his or her economic well-being from health care to education to employment.  While this argument may have merit in the long run, it doesn’t do anything for us in the short run.  Right now, capitalism’s private sectors are shrinking.  They are the problem, not the solution.

There is one caveat we should proffer regarding a contemporary deficit spending stimulus package for the United States.  Historically, the U.S. government has deficit spent and run up the national debt when it was able to manage it with rapid economic growth in its future.  After WWII, for example, the U.S. economy grew more rapidly than the debt and the debt/GDP ratio fell precipitously to 33% by 1980.  This time it won’t be as easy for the U.S. economy to recover so rapidly.  That’s because it faces much more competition from other countries around the world unlike the post WWII experience where it was competing with war torn nations.  Increasing productivity in the U.S. relative to other countries is problematic.  While that might make the rising debt more difficult to manage, it is not a strong enough argument to nullify the efficacy of the stimulus package that we need next year.

Return to Home Page     Return to World Economics News

The Global Economics Game   (C) 2000-2004-2012 Ronald W. Schuelke   All Rights Reserved