The Economy: The End of the Beginning…

… but probably not the beginning of the end! It is interesting to see the speed at which sentiment seemingly switches. Last October and in late February and early March of this year, people seemed desperate, believing a new Great Depression was inevitable. The past few months have seen renewed optimism with many suggesting that the economy could recover by the end of the year – which in turn has led many to worry that a pickup in economic growth will lead to massive inflation. All three views are probably wrong.

Not a Great Depression

As expected, the crisis spread from Wall Street to Main Street, but this is not a Great Depression. Between 1929 and 1933, the US economy shrank by a quarter. Real estate prices fell by 50% in 2 years. Retail banks failed. Unemployment reached 25%. Many queued around the block for soup and bread. In New York many who lost their residence found refuge in Central Park.

The unemployment rate is currently 9.5% and the banks that have been most affected by the crisis are the commercial banks rather than the retail banks. Most importantly, the Fed has learned from past mistakes. Overly tight monetary policy turned the downturn into the Great Depression during the 1930s. Ben Bernanke is a scholar of the period and will not let it happen again. The global rate cuts that have been orchestrated by the major global central banks and the sheer size of the fiscal stimuli show policymakers understand the gravity of the situation and are trying to provide appropriate liquidity. I am confident the combined might of all the world’s central banks and governments will prevent the crisis from becoming catastrophic.

While outright deflation might be avoided, the economic headwinds and imbalances remain strong suggesting a slow multi-year recovery

During the early 2000s the Fed and the Treasury did many crisis simulations to see how they would respond to a Japan-like deleveraging and banking crisis. They always responded rapidly and efficiently – lowering interest rates, nationalizing banks, separating good assets from bad, etc. Interestingly enough, when faced with an actual crisis, while often knowing exactly what needs to be done, they have not shown the political will to do quite enough to solve the crisis. Granted, the Treasury and the Fed responded much faster than the Japanese policymakers who took two years to start significantly lowering interest rates and increasing government spending. However, with regards to the banking crisis, the solutions proposed have been haphazard and incomplete. The solution we have opted for, seemingly for fear of political retribution, is to hope that the banks can earn their way out of the problem. The issue with this solution is that, like in Japan, it creates zombie banks which need to retain all of their earnings and does not provide the economy with the credit it needs to function.

Moreover, the solution to the crisis that the administration seems to be hoping for is that people start borrowing again to spend on housing, cars, and consumer goods, and it is therefore pushing policies to promote the buying of cars and houses. The issue here is that this is like offering a heroin addict one last hit before sending him to rehab. You don’t solve a problem of excess leverage but piling on more leverage! That is also true at the country level. The overall level of indebtedness does not change based on whether the debt sits on the balance sheets of individuals, companies, or governments.

The underlying problem of excess leverage can only be solved with increased saving by consumers, greater profits for companies, less spending by governments, and higher tax revenues – ideally driven by productivity growth. As expensive as they were, the large bank bailouts were unavoidable as businesses and consumers need credit to function. The economy cannot operate without an effective banking system, but it’s unclear that we need such a large fiscal stimulus.

The stimulus seems to be motivated by the fact that as a society we no longer seem willing to suffer from short-term pains for longer-term gains. The massive stimulus will ease the short-term pain, but the automatic stabilizers built into such high levels of government debt relative to GDP will probably prevent any real recovery for 5-10 years as they did in Japan over the last 20 years. When growth picks up interest rates will increase as people start fearing inflation. Combined with increased taxes as the government needs to get its fiscal house in order, the crowding out of private investment which is the true long-term driver of growth, and a slew of anti-growth policies, growth will probably be limited to 1-1.5% a year in the recovery. The economy will no longer technically be in a recession, but it won’t feel like recovery, either. In other words, we bought great depression insurance and recession sweeteners at the cost of prolonged economic stagnation!

Inflation is not a short-term concern

It’s interesting to note that if Japanese policymakers had to do it again, they probably would not redo the massive fiscal easing which ultimately left them with little other than a huge pile of debt and an economic speed limit brought about by the aforementioned automatic stabilizers. Given those stabilizers, inflation is unlikely to be a worry in the short term.

Moreover, while the amount of money in circulation has increased significantly, the velocity of money has shrunk dramatically. It is unlikely to recover as the solution we elected for the banking crisis is to hope banks can earn their way out of trouble. With this multiyear solution, banks don’t originate many new loans as they retain their profits to shore up their balance sheets.

Politically, it’s also unclear that the United States can inflate its way out of debt. An angry middle class will probably demand that Congress tighten its purse strings. There was little popular support for the bank bailouts, especially as the crisis was presented as caused by Wall Street. Taxpayers are in no mood to be told that some of what ails the economy is due to their own irresponsibility (see Whodunit?), and that much more of their money is needed both to minimize the pain and to pay for the entitlement promises made to the retiring baby boom generations.

Moreover, China, America’s largest foreign creditor, will strive to protect its dollar assets. As long as China believes that America will eschew an inflationary solution, it will remain in China’s interest to buy the US debt that must fund America’s coming shortfall in tax revenues and the entitlement commitments that stretch for decades. But if America credibly indicates that it will pursue a genuinely inflationary monetary policy, the prospect of massive capital losses on its dollar reserves may cause China to preempt that action. Given how much America now needs China, it is not clear that America could pursue an outright inflationary policy if China acts to prevent it.


We have avoided a Great Depression, but the ill-advised solutions we are implementing to deal with the crisis are setting us up for at least 5-10 years of economic stagnation.

  • Fabrice –

    I like this article a lot, think it’s smart, nuanced, and succinct. Also think it’s entirely “directionally correct” in its conclusions on the most likely scenario.

    A few thoughts in the spirit of provoking conversation among friends / thought partners:

    1. At the margin, I have less confidence Bernanke et al will be able to avoid the pain of a deflationary spiral, for 3 reasons:
    — 1/2 to 2/3 of mortgage foreclosure pain still to come; we are likely going to find ourselves in a node where 1 in 6 (!) mortgage holders default. The government has demonstrated itself to be clueless on how to deal with this so far. Note this is a solvency problem not liquidity.
    — “Pushing on a string”: As Richard Koo argues in his kick-ass book The Holy Grail of Macroeconomics, balance sheet recessions like this are marked by scarred borrowers being scared to borrow. Re: pumping up bank reserves doesn’t really help because households and business are too focused on de-levereging to take out loans
    — Death of securitization as we know it translates into a massive increase in the cost of capital. I.e., even to the extent people/businesses want to borrow the real (not nominal) cost of borrowing has experienced a step function increase due to change in credit creation mechanisms

    2. At the margin, am also skeptical that — if Bernanke et al keep printing enough money through QE to effectively combat deflation — they will successfully be able to avoid inflation on the other end. This has to do with a general belief I have that academics like Bernanke (and Summers) have insufficient respect for the law of unintended consequences and too much belief in their ability to control outcomes. The world doesn’t behave like the model.

    You could summarize these nitpicks in a sentence as: At the margin, I think there is still a higher probability for “extreme outcomes” than your post implies.

  • I have taken to reading Micheal Shedlocks blog for economics as often as I refer to the drudge report to see what is driving the news cycle.

    All you have to do is google MISH

    What you will see there is that he is predicting the same thing as this article but end of the year is out for when recovery begins.

  • Hi Fabrice,

    quite interesting but as always in this kind of review of the facts we miss as a conclusion a solution.

    I mean looking what is wrong is one thing but fixing the problem another one

    And let’s keep it simple, what would you advise to your readers ?

    a) take vacation
    b) take a loan to pay for your vacation
    c) ? let us know

  • Claude,

    I think fgrinda mentions a solution- productivity growth: “The underlying problem of excess leverage can only be solved with increased saving by consumers, greater profits for companies, less spending by governments, and higher tax revenues – ideally driven by productivity growth.”

    The recent article “A Long Way To Go” in the Economist (written in much the same spirit as “The End of the Beginning…”) suggests that recovery will depend on America’s ability to shift from nurturing consumption to export-driven growth. American consumers need to reduce their debt, no matter how painful it may be.

    So, I would venture the answer to your question would be:

    c) Don’t take a loan for a vacation, rather save up for one. Or put your savings towards the promotion of American tourism to attract foreign tourists.

    Hawaii anyone?!!!!… Sipping Mai Tais on the beach is an appealing interlude to a hot, rainy summer in NYC.