Is this really a replay of the Great Depression?
Professor Garett Jones
Garett Jones: So far, it looks like a junior version of it — a bubble collapses, and that cripples the balance sheets of otherwise healthy firms and banks. Anybody in this economy who borrowed a lot of money based on the belief that home prices would never fall is in a lot of trouble. Of course, nobody thinks the economy is going to decline by 25 percent as it did during the Depression. Part of what made the Great Depression “great” was the failure of the Federal Reserve to respond aggressively: it let the money supply fall by a third. This time, the Fed has been incredibly responsive: monetary supply grew 10 percent over the past year. Money growth takes a year or two to help the economy, but help is already on the way.
Menzie Chinn: I think the problems of recapitalizing and repairing the financial system are more intractable than during the Great Depression and early 1990s credit crunch. Furthermore, there is a synchronized aspect in the global downturn which adds extra headwinds. That’s why, in terms of output loss and duration, this recession will easily rival that of the 1980-82 recessions.
What do you like and dislike about the stimulus package?
Professor Menzie Chinn
Chinn: What’s good is that it exists, and that there are some transfers of resources to states. Given how strapped the states are for funds, they will spend a big chunk of it, although there could have been a bigger bang for the buck had we given them more. What’s not so good is that compared to earlier versions, the bill President Obama signed relies more on tax cuts and tax rebates and less on spending. But it’s not clear this is an effective way to stimulate the economy, since given the level of uncertainty, middle- and upper-income people will save a lot of their tax cuts, so you don’t get as big a “multiplier effect.” [Editor’s note: The great 20th century economist John Maynard Keynes argued that each dollar the government injects into the economy creates multiple dollars’ worth of output. To simplify: Uncle Sam pays $100 to a biofuels engineer, who spends part of it at a car dealership, who then spends part of that sum on new carpets for his showroom, and so on.]
Jones: What’s good is the direct aid to people who are suffering ― food stamps, unemployment insurance, maybe the Cobra subsidies. What’s not so good are the poorly targeted spending programs: the infrastructure spending and the green spending. Few of the people hired for these jobs will be pulled out of long-term unemployment; they’ll mostly be moving from the private sector to some government contractor.
If the bill had focused on hiring West Coast construction workers and East Coast bankers, then they would’ve found a lot of unemployed people to hire. But Congress didn’t do that. Instead, they’re spending more on low unemployment sectors like science, education, and health care. It’s almost like they designed it to crowd out the private sector.
Chinn: If the economy were at or near full employment, you could make that argument. But I suspect that for the next 18 months, there is going to be a lot of underutilized resources. The likelihood of crowding out is small.
Is there a risk that the stimulus plan replicates Japan’s mistakes of the 1990s?
Jones: Yes, there is. Just like in Japan, the stimulus spending takes our eye off the main issue — the crippled banks. Good Keynesianism helps the private sector heal itself through money growth, temporary tax incentives, and automatic, depoliticized spending like unemployment insurance. But in Japan, bad Keynesianism simply shifted hundreds of thousands of workers into the government-funded construction industry.
Chinn: There’s a benefit to having people working on infrastructure that arguably could have a high social rate of return. I’m thinking of things like the national parks lodges built during the Depression. That might not have been efficient spending, but we are glad to have them 80 years later.
I also think there is a problem with the analogy. Japan did two things in the 1990s. One was a massive stimulus that increased the national debt, and a lot of it was not very efficient. The other was that they failed to take care of their financial system in decisive fashion. The technocrats knew what the solution was, but the politicians were not willing to inject sufficient taxpayer money into the system. For the U.S., the big danger I see is that we don’t bite the bullet and fix the system — including letting some banks go under — and make sure it’s well regulated afterward.
What are the chances we will do the right thing?
Chinn: I’d say better than 50-50.
Jones: I’d have hoped for better than 50-50 out of the best and the brightest. So far, the U.S. technocrats have followed the same policy as the Japanese: they’re keeping the zombie banks alive with government support. There’s no need for that. The biggest banks have $1 trillion in long-term debt sitting on their balance sheets, debt that could be effortlessly converted into stock with the pounding of a bankruptcy judge’s gavel. That debt-to-equity “cram down” would give the big banks thick layers of equity that would restore trust and reinvigorate lending. President Obama’s technocrats haven’t yet been willing to do that. Here’s hoping they change their minds.
Chinn: Well, let’s be frank. The problems left over from the past eight years of incredibly bad economic management are weighting the odds against us. So my better than 50-50 assessment is testament to the high regard I have for the technocrats in the Obama administration.
Some argue that stimulating the economy when employment is falling is not something the private or public sector can do effectively. What do you think?
Jones: Again, Japan is a great example. One of the big insights of modern unemployment research is that hiring workers or searching for a job is a lot like dating: it just takes a long time to find a good match. If we have stadium-style mass weddings, yes, we’ll raise the number of married couples, but we’ll probably create a lot of bad matches. The same is true in the job market, whether it’s the government or the private sector that’s doing the hiring.
If our goal is just to have an excuse to send checks to people who are suffering, then maybe the government needs to create a lot of these “mass weddings.” But if our goal is to get some actual value out of the new workers, it’ll take a long time to ramp up. And during all that ramp-up time, we could’ve been helping the private sector heal itself through bank restructuring.
Chinn: As I see it, any spending is going to help. Also, it’s not clear to me that the stimulus plan will have the spending come in too late. Around 70 percent of the spending will occur within the next 18 months. Given that most forecasters are projecting a long recession, the fiscal stimulus will still be timely.
Jones: It’s just not true that any spending is going to help. If $1 of government spending only creates $1 of extra output, then that spending needs to be genuinely valuable — especially when we consider that future generations will be paying for this spending with wealth-destroying taxes. Now if $1 of government spending creates $2 or $3 of extra output during a recession, then Menzie’s absolutely right: that would set off a virtuous cycle of consumer spending. But the best historical evidence doesn’t support these big multiplier effects.
Are we all Keynesians now?
Chinn: No, but there are a lot more than there were a year ago, including among academic economists.
Jones: When the financial crisis hit, many academic economists panicked, and they retreated to the most primitive, freshman-level Keynesianism imaginable. I’m hoping that over the next year our profession recovers from that panic and remembers the better side of Keynesianism.
Keynes recognized two big facts: that market economies can twist themselves into short-run knots, and that the mechanisms for untying them are clunky and cumbersome. He spent his later years trying to find ways for government to help the private sector untie those knots without just creating new, tighter ones. Keynes concluded that public works programs were a bad kind of stimulus: they usually come too late, after the economy would’ve fixed itself anyway, and it encouraged politicians to manipulate things. A Keynesianism that helps the private sector heal itself is a Keynesianism we should all embrace.
Chinn: The private sector can heal itself eventually. But it may take a very long time to work its way through, and I doubt that modern societies can bear that long a wait.
