No, I Really Do Not Think That We Were Doomed to the Lesser Depression Plus the Greater Stagnation: I Think Paul Krugman Gets One Wrong Here…: Monday Focus: March 24, 2014

I read Paul Krugman, and I want to sharply dissent:

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Paul Krugman: Did Inflation Phobia Cause the Great Recession?: “Even avoiding the financial panic almost surely wouldn’t have meant avoiding a prolonged economic slump.

How do we know this? Well, what we actually know is that the panic was in fact fairly short-lived, ending in the spring of 2009. It doesn’t really matter which measure of financial stress you use…. Yet the economy didn’t come roaring back, and in fact still hasn’t. Why? Because the housing bust and the overhang of household debt are huge drags on demand, even if there isn’t a panic in the financial market…

Let me start with a graph that has become one of the principal lenses through which I view what has happened since 2005: my graph of four key components of total spending–real spending on exports, real spending by government purchasing goods and services, real spending by businesses purchasing equipment (and software), and real spending by construction firms building houses–all plotted as deviations from their business-cycle peak shares of potential real GDP:

FRED Graph St Louis Fed 14

What this graph tells me is this:

Back in 2005, the U.S. economy had enormous structural imbalances: exports were very low, especially relative to imports (global imbalances, remember?), and housing construction was very high (the housing bubble and the subprime boom, remember?). Clearly the 2005 pattern of sectoral activity could not go on indefinitely: at some point it would stop. And, when it stopped, the question was–as Larry Summers used to say back when he was Treasury Secretary–whether it would stop by rebalancing up to full employment, with the deficit sectors growing in activity as the surplus sectors shrank, of by balancing down into depression.

And at the start of 2005, the rebalancing began. China and other export-surplus countries began allowing a more-rapid appreciation of their currencies. The American housing bubble reached its full inflation and began to deflate, and the volume of housing construction began to decline shortly thereafter. Housing investment was certain to fall as investors became aware of the risks involved in funding subprime and home equity in a declining house price environment and pulled back, and consumption spending was likely to fall as homeowners watched their housing equity shrink. The question was: would this send the economy into recession, or would something else take up the slack?

Preview of No I Really Do Not Think That We Were Doomed to the Lesser Depression Plus the Greater Stagnation

And for the first two-and-a-half years of rebalancing–from mid-2005 to the start of 2008–the answer was: rebalancing up. While housing (and consumption) spending fell, exports rose, and the unemployment rate stayed roughly constant. Money from the sale of exports to the U.S. that would in 2005 have gone into the housing market flows instead into purchasing U.S. exports. Growing demand for U.S. exports pulls workers out of other occupations into export industries. The vacancies thereby opened are filled by workers pulled in from other industries, creating other vacancies. And so when workers in housing construction are laid off because of shrinking housing investment, there are places for them to go–they do not substantially boost unemployment. Thus from 2005 to the start of 2008 the U.S. macroeconomy is in a phase of classical adjustment: sectors whose value has dropped shrink; sectors whose (relative) value has risen grow; recession and unemployment are neither desirable nor necessary pieces of structural adjustment.(1)

But then as 2008 arrives the macroeconomy changes its phase. People in aggregate now feel overleveraged, illiquid, short of genuine reserves. The easiest way to build up your reserves of safe assets, liquid assets, and collateralizable savings vehicles is to spend less out of your income. But because your spending is somebody else’s income, when everyone tries to cut their spending relative to incomes total incomes fall. How far does it fall? Until incomes have fallen far enough so that, even though they would (at full employment) like to build up their holdings of money-like assets, they don’t feel they can afford to. And there the economy sticks, in a state of deficient demand and high unemployment.

That is the story of 2008-9: a financial crisis that greatly increased desired holdings of safe, liquid, collateralizable assets, and a consequent collapse of spending and rise in unemployment.

Preview of No I Really Do Not Think That We Were Doomed to the Lesser Depression Plus the Greater Stagnation

OK. So what is supposed to happen next? If an excess demand (at full employment) for money-like assets causes a general glut of commodities and a depression, it is an excess supply (at unemployment) of money-like assets that induces a rise in spending, and a recovery and thereafter a boom. What is there at a trough to induce a subsequent return to normalcy? Five things:

  • Psychology, as whatever social transmission mechanisms caused the mass panic ebb…
  • Rising real balances, as deflation takes hold and reduces the price level relative to baseline…
  • Rising marginal product of capital, as depreciation reduces the actual and technological change increases the optimal capital stock…
  • Balance-sheet repair, as debt amortization takes hold–offset, however, to the extent that deflation takes hold and magnifies the real value of debts…
  • Government policy–expanding the money supply and thus lowering (safe) interest rates, banking and regulatory policy to lower risk premia, and fiscal policy to simply buy stuff…

All five of these can break that version of Say’s Law in which lack of production and supply creates its own lack of demand, create an excess supply of money and thus an excess demand relative to current production for currently-produced goods and services, and push planned expenditure above projected income.

Why haven’t they done so? Why have we simply been growing at trend since the fall of 2009 rather than recovering to potential? Why haven’t the stagnation of housing and the collapse of government purchases been associated with a redirection of spending flows to cause a boom in other sectors?

Preview of No I Really Do Not Think That We Were Doomed to the Lesser Depression Plus the Greater Stagnation

As Jean-Baptiste Say wrote to Thomas Robert Malthus back in 1819:

I shall not attempt, Sir, to add… in pointing out the just and ingenious observations in your book; the undertaking would be too laborious…. [And] I should be sorry to annoy either you or the public with dull and unprofitable disputes. But, I regret to say, that I find in your doctrines some fundamental principles which… would occasion a retrograde movement in a science of which your extensive information and great talents are so well calculated to assist the progress….

What is the cause of the general glut of all the markets in the world, to which merchandize is incessantly carried to be sold at a loss?… Since the time of Adam Smith, political economists have agreed that we do not in reality buy the objects we consume, with the money or circulating coin which we pay for them. We must in the first place have bought this money itself by the sale of productions of our own. To the proprietor of the mines whence this money is obtained, it is a production with which he purchases such commodities as he may have occasion for…. From these premises I had drawn a conclusion… “that if certain goods remain unsold, it is because other goods are not produced; and that it is production alone which opens markets to produce.”…

[W]henever there is a glut, a superabundance, [an excess supply] of several sorts of merchandize, it is because other articles [in excess demand] are not produced in sufficient quantities… if those who produce the latter could provide more… the former would then find the vent which they required…

And as Thomas Robert Malthus wrote back:

We hear of glutted markets, falling prices, and cotton goods selling at Kamschatka lower than the costs of production. It may be said, perhaps, that the cotton trade happens to be glutted; and it is a tenet of the new doctrine on profits and demand, that if one trade be overstocked with capital, it is a certain sign that some other trade is understocked. But where, I would ask, is there any considerable trade that is confessedly under-stocked, and where high profits have been long pleading in vain for additional capital? The [Napoleonic] war has now been at an end above four years; and though the removal of capital generally occasions some partial loss, yet it is seldom long in taking place, if it be tempted to remove by great demand and high profits…

And while I will not say that Say’s Law is true in theory, I will say that the panoply of economic policy provides plenty of weapons to make it true in practice…

I cannot say that I have a complete answer. But I would point to 2005-8 as evidence that we are not doomed: that the economy could have, and can still, rebalance itself at (what we used to think of as) full employment…