Lessons of the Recession

Raghuram Rajan's book, FAULT LINES, is one of the best books I have read concerning the causes of the Great Recession. He now has an article in FOREIGN AFFAIRS that brings it forward. He goes over some ground covered in his book, arguing that the United States and other developed nations distorted markets for a couple of decades by making credit very accessible.  People's spending increased even as incomes didn't increase as much.  The bursting of the housing bubble induced households to deleverage, which was necessary.  For some of the European countries, it was government spending more than household spending that took place in the 15 years prior to the crash.  In neither case, Rajan argues, is the answer to increase government deficit spending.  We need to address the longer term problems.
Rajan's arguments run counter to the view that this is not the time to take the long view. We need to stimulate in order to get growth going. Once growth is back, then we can address the longer-term problems. Rajan argues against this on the grounds that the prosperity we had was not sustainable.  Further, the history of public policy has been to ignore the problems when we have prosperity.
He writes, "Fiscal austerity is not painless and will probably subtract from growth in the short run. It would be far better to phase reforms in over time, yet is is preceisely because governments did not act in good times that they are forced to do so, and quickly, in bad times. Indeed, there is a case to be made for doing what is ncessary quickly and across the board so that everyone feels that the pain is shared, rather than spreading it over time and risking dissipating the political will."
The whole piece is worth reading.

Economic Discontent as Noted by Michael Boskin

An op-ed piece in today's Wall Street Journal is of interest about the slowness of the recovery, but I think also fails in an important way. Michael Boskin argues that the recovery promised by the Obama administration has fallen short. It is hard to disagree with that. He then compares the GDP growth rate in the 4 quarters and 12 quarters after the trough of some past recessions--1975 and 1983. The growth rates were much higher in the previous two recessions than in this recession.

My concern is that not all recessions are alike and that the cause of a recession may be important in determining the pace of recovery. Both the 1975 and 1983 recessions were related to supply side issues such as rising oil prices, and a recent past of high inflation. The Fed tried to reduce inflation by raising interest rates. In the case of 1975, the Fed soon quit raising interest rates because of the recession while in the early 80s, the Fed held firm. Once inflation was reduced substantially and people recognized it, the economy was in a good position to grow rapidly.

The current recession has a different source. Fed policy was not tight; in fact it was probably too loose. Debt was the big problem. Consumers were spending beyond their means and running up debt. When housing collapsed and many households realized their wealth was not as great as they had thought, they reduced spending and worked on increasing savings and reducing debt. It takes time to do this and we cannot expect consumers to return to their old spending patterns in a short period of time. Further, as noted in Reinhart and Rogoff's book, This Time is Different, recessions that begin with financial crises tend to last longer. That is, the cause of the recession matters.

HUD Saved Us from a Depression

An article in today's New York Times concerns the Federal Housing Administration. FHA provides insurance for homebuyers who don't meet traditional criteria for conventional loans. In othe words, the FHA is part of the government support and encouragement of homeownership. During the subprime craze, many buyers bypassed the FHA, but in the last year or so the FHA has backed a lot of mortgages. Their reserves are low--0.53 percent of the total porfolio, and some think that the FHA will need a bailout before too long. Yet, they also had faced pressure from Congress to open their doors to a broader group of applicants, i.e., applicants with lower down payments and poorer credit ratings. Brian Montgomery, a former head of the FHA, said that even if a bailout is needed, people should still feel gratitude. The article ends with a quote form Mr. Montgomery, "They should be going over to the H.U.D. building and frankly thanking the career staff for saving them from a depression."

So, government subsidization and pressure on lenders to encourage broader homeownership led to the run up in housing prices. When the housing bubble burst, we entered a severe recession. The FHA has continued to prop up housing markets, evidently saving us from a depression. But the collapse in prices that followed the run-up in prices is due, to a considerable extent, to government policy. Does that make sense?

Is the Recession Over?

The Bureau of Economic Analysis issued a statement today reporting that GDP increased in the third quarter. Normally, that would mean the recession is over. Obviously, the pain is not over yet, and we are no where near a level of output that we had before the recession began. Another concern is that the third quarter may be something of an anomoly because auto sales surged with the "cash for clunkers" program. Real personal consumption expenditures rose 3.4 percent while durable goods increases 22.3 percent.

The figures are preliminary and may be adjusted when more data become available in late November.

Posner, the Keynesian

Richard Posner, one of the denizens of the law-and-economics movement, as well as a federal judge, wrote a book on the economic recession, A Failure of Capitalism. He also has a blog through the Atlantic magazine on the "depression," the term he prefers. Now he has an article in the New Republic on how he became a Keynesian. In addition, he weighs in on economists lack of understanding of the macroeconomy, although he is not as mean-spirited as Krugman. He said he was baffled by the economists' disarray and decided to read Keynes' General Theory himself. What he offers is a principles-level account of Keynes' ideas.
When Posner says that, "There is no professional consensus on the details of what should be done to arrest the downturn," he is correct. But he seems to imply there should be a consensus. But macroeconomics is complex because the macroeconomy is complex. Polls of economists have consistently found economists to be more of one mind on micro issues than macro issues. But, even in micro issues, there can be substantial disagreements. To take Posner's area, law and economics, there is not a consensus on whether capital punishment deters murder. There are philosophical differences, theoretical differences, and empirical differences among people who have examined the issue. This does not imply that we should give up on law and economics or that we should go back to economic analysis of law that predates Coase or Posner's early work.
If you check out his blog, you can see that Posner is also experiencing the rabid rage of Krugman and Brad DeLong because he criticized a speech Christina Romer gave. As a lawyer and judge, he seems thick-skinned enough to deal with the criticism.

Lehman Brothers Anniversary

It has been a year since Lehman Brothers went bankrupt after the government refused to bail them out as it had with Bear Stearns. There has been a spate of articles and essays on the events that have occurred in the last year. Several interesting columns appeared recently in the Financial Times. Niall Ferguson wrote on why a Lehman deal would not have prevented the financial crisis and the recession. In fact, he argues, it took the collapse of Lehman Brothers and the credit freeze to get Congress to act and pass a huge, across-the-board bail out. Martin Wolf wrote on the wrong lessons from Lehman's fall. Wolf argues that we cannot allow the too-big-to fail doctrine continue, and that an ambitious overhaul of the financial system is in order. John Kay writes that changes are needed in what assets are required to stand behind deposits at banks.

The essay I like best is buy William White, "Some Fires are Best Left to Burn Out." He raises the question of whether the constant effort at preventing any and all recessions from occurring or from continuing increases the ultimate cost of a later severe recession. He uses an analogy from fighting forest fires. Fires thin out undergrowth and rejuvenate the forest. If all forest fires are prevented or immediately put out, it leads to a larger more dangerous forest fire later. The focus tends to be on the short term and causes problems in the long term.

White's point is important. It is common to hear laments in the financial press about businesses being too concerned about the profits of the next quarter. This short-term emphasis comes at the expense of long-term planning and profitability. But the same tendency exists in the public sector. Every recession that has taken place since I have been a professional economist has been seen as requiring immediate action to stop and get the economy growing again. This has been true of recessions that turned out to be relatively short or mild. The Obama administration argued that the end was near and the stimulus package was needed to prevent a depression. Never mind the huge deficits; we have to fix things now! I am not arguing for or against the stimulus package at this point. I am just noting the similarity between the private and public sectors. But what if firms that focus on the next quarter end up reducing their long-term viability? And what if the government's efforts to forestall or prevent any economic downturn ensure that there will be eventually a severe downturn? White says, "Just as good forest management implies cutting away underbrush and selective tree-felling, we need to resist the credit-driven expansions that fuel asset bubbles and unsustainable spending patterns."

(Note: I did not link the opinion pieces from the Financial Times since a subscription is required to upload the articles.)

Letter on Krugman's Essay

The letter to the editor of the Sunday magazine of the New York Times that my colleague, Marty LaBarge, and I wrote in response to Paul Krugman's essay, "How Did Economists Get It So Wrong?" will be published in Sunday's magazine, and is available on-line here. A comparison with my earlier post below shows that the editors shortened it by a sentence.

How Did Economists Get It So Wrong?

Paul Krugman had an essay in Sunday's New York Times magazine. He argued that modern macroeconomics was unable to see the crisis coming and that a new macroeconomics would have to start with Keynes. My colleague, Marty LaBarge, and I submitted the following letter to the editor of the magazine:

Paul Krugman offers a critique of modern macroeconomics in his essay, "How Did Economists Get It So Wrong?" He cites a concern for mathematical elegance over truth and reliance on efficient marekt theory as reasons for economists missing the instability in markets. But similar arguments could be made about the Keynesianism that Krugman advocates. In its heyday, Keynesianism included elegant mathematical models that demonstrated marekts are inherently unstable, and had its own version of an efficiency theory, only it was government that was efficient; a wise and good government could "fine-tune" the economy through appropriate fiscal policy, ignoring how real-world governments actually operated. While financial markets do fall short of perfection, the progression of the "perfect storm" of events that generated the worst recession since the Great Depression--the global saving glut, low interest rates, securitization, and government policy supporting homeownership--cannot be blamed on "extraordinary delusions and the madness of crowds."

Krugman pays no attention to the approximately twenty-year period of good macroeconomic performance known as the "Great Moderation." He also ignores "bubbles" that didn't lead to recessions. Something is at work besides irrational financial markets. The market system works well most of the time. Perhaps a key factor affecting whether a shock to the system or even 'irrational exuberance" leads to a serious recession is the level of buffer stocks held by households and firms. When savings exist and debt levels are not inordinately high, the economy adjusts to a shock. But when debt levels are high and savings low, the bursting of bubbles in houses and equities can turn into a severe recession. The crucial question now is whether taking on huge levels of government debt is the best way back to sustainable growth.

We don't know if the letter will be published or not.

The Great Depression Redux

There is an update of a column that appeared in April in Vox by two economic historians--Barry Eichengreen and Kevin O'Rourke. You can get it here. The date the start of the current recession later than the NBER did, and compare a number of variables with the same time period during the Great Depression. It is sobering.

Repurcussions of the Recession on State and Local Government

The economic recession impacts people in many ways. There are direct effects if one is laid off, owns a business that is seeing declining sales, and so on. The federal government sees a reduction in tax revenues and an increase in some expenditures automatically. These are called automatic stablizers and are in place to cool things down when the economy is booming and to stimulate the economy when output is falling. The federal government doesn't have a binding budget constraint so changes in income and expenditures don't have to match.
Things are different for most state and local governments. They usually have mandated balanced budget requirements, at least for operating expenses. State and local governments tend to rely on the sales tax as an important source of income. But, when consumers are not buying so much because of reduced incomes, sales tax revenues fall, leading to cuts in programs. The Wall Street Journal has an article today, in which it discusses the sharp drop in sales tax revenues impacting many states and local governments.

"Worst since the Great Depression"

In a speech before the Brookings Institution on March 9, 2009, Christina Romer said that she has been uttering the words, "worst since the Great Depression" far too often. She is not alone. The words have been uttered by many politicians, economists, financial analysts, and just about everyone. The economy is down and seems to be sinking lower. Whatever measure we might use--unemployment, foreclosures, consumer confidence--we see a gloomy picture.

How are we doing on crisis management? In my view, not well. First, the economists. Keynesianism dominated the profession in the decades following World War II. Many economists believed we could fine tune the economy and select the level of unemployment that was associated with full employment by accepting a certain level of inflation. The stagflation of the 1970s destroyed that rosy view. Work by macroeconomists, both at theoretical and empirical levels, led to a rejection of the view that the answer to a recession was to increase government spending. The short-run multiplier associated with government spending was not that large, and the long-run effects tended to be nil or negative. In the current crisis, many prominent economists are arguing strenuously for massive increases in government spending. Let's return to the macroeconomics of the 1950s and 1960s and ignore everything we have learned since the 1970s. Since this is the "worst since the Great Depression," let's revert to depression-era thinking.

Second, the politicians. There has been a lot of talk about needing bipartisan solutions and approaches to government. Both parties have failed at crisis management. The crisis began as a credit crisis and a solution to the banking and financial sectors is needed. But the "fixes" for the financial sector have been inadequate and inconsistent. For all the talk of bold action, there has not been outlined a bold, consistent procedure to deal with the balance-sheet problems of banks. The stimulus plan includes many items that cannot be considered stimulative but actually represent the pent-up demand for programs favored by Democrats. Let's add autos to the mix, but also tell the auto makers how they should run their firms. Certainly a senator or representative knows more about making and selling cars than people who have worked in the industry for decades. It is easier and more fun to tell people how to run their businesses, or to fulminate over executive compensation, or to pass spending bills than to think seriously and hard about how to recapitalize banks and restore confidence in the financial sector.

Third, the public. You and me. We want quick answers. We want a riskless future and only good times. We want to be able to spend and buy any gadget that interests us without worrying about saving for the future. After all, rising home prices and equity prices should take care of our retirement. Oh, along with social security, medicare and senior discounts. We want it all!

Economics recognizes that we cannot have it all. There are opportunity costs to decisions and choices made. Choices have consequences, often unintended. Just because this is the "worst ______________ (fill in with your preferred term) since the Great Depression" does not mean that the choices we make will not have costs or consequences. Let's come out of the recession with more reasonable spending and saving decisions, and with an awareness that we cannot eliminate risk. We cannot have it all.