Legal Commentary

Unemployment and Depression--Posner

By Richard Posner

I am not bold enough to make forecasts about economic recovery, given the unusual economic situation that the country is in. The recovery may be fast or slow, shallow or steep, continuous or interrupted--and if fast and steep may set the stage for inflation and other economic troubles. So I am neither an optimist nor a pessimist.

I am uncomfortable with the way in which modern economists discuss economic downturns. Before the 1930s depression, economic busts were called--"depressions." As far as one can judge from the incomplete nineteenth-century economic statistics, that depression was of unprecedented severity, and hence came to be called the "Great Depression." Which is fine. But thereafter, for reasons I can't fathom, economic busts, instead of being called "depressions" (though of course not "Great Depressions," because they were much less severe), came to be called "recessions." The current downturn, because it is the worst since the Great Depression, is now being called the "Great Recession." I find this lexical nitpicking distracting and unhelpful. Why not just say, we're in a depression, severe by postwar standards but mild compared to the Great Depression?

I also question the convention that says that a depression (or recession, if one insists on retaining that word) ends when GDP growth resumes. Actually, that is not the official (National Bureau of Economic Research) position; its business-cycle committee looks at other factors as well, such as employment. It would be a nonsensical convention applied to the Great Depression; it would imply that the Great Depression ended in March 1933, when output and employment began to rise from their respective one-third and one-quarter decline from 1929.

I would prefer to say that a depression ends either when economic output returns to its pre-depression level or, better, when it returns to the GDP trendline of average annual growth, which is about 3 percent in real terms. So this depression has not ended.

This depression was never likely to be as severe as the Great Depression. One reason is the automatic stabilizers, such as unemployment benefits and other social-welfare programs, and progressive income tax. Another reason is changes in the composition of the workforce. Manufacturing and construction, two of the industries most likely to respond to a fall in demand by laying off workers, account for a much lower percentage of the U.S. workforce today than in the 1930s; and services (which had a low unemployment rate even in the Great Depression) account for a much higher percentage. In addition, there is federal deposit insurance, and a clearer understanding that in a depression the government should try to increase the money supply, and indeed should try to create at least a mild inflation. The Roosevelt Administration did both things as soon as it took office and they probably were responsible for the rapid improvement in the economy that began soon after his inauguration, though it was later interrupted by the economic dive in 1937 and 1938--what has been called the "second depression."

Nevertheless this depression resembles the Great Depression in one respect that makes forecasting particularly chancy--it has been accompanied and made worse by a financial crisis. The normal depression comes about either from something that happens in the nonfinancial economy, such as a big increase in productivity which causes unemployment, or by the action of a nation's central bank in raising interest rates to stop or head off inflation. In both cases, as shown in research by Christina Romer and others, the depression can be effetively treated by the central bank's reducing interest rates, which stimulates economic activity by increasing lending.

But we are in a depression in which interest rates are very low. Indeed, the Federal Reserve is maintaining the federal funds rate at just a shade over zero percent and has been for many months. There are other interest rates, and the effect of the federal funds rates on them is complex, but nevertheless there is nothing further the Fed can do, or at least that it wants to do (because it's beginning to worry about a future inflation), to lower interest rates, though credit remains very tight because the banks remain undercapitalized and demand for loans is weak because people and many businesses are overindebted.

It's because monetary policy, though in combination with bailouts it has saved the banking industry from bankruptcy, cannot do anything to stimulate economic activity that we have the $787 billion stimulus program and other programs, such as the federal subsidies that are keeping GM and Chrysler in business. These programs may be responsible for the recent improvement in the economy, at least in part, though there is no good evidence.

The consumer price index is lower than it was a year ago, which means we're in a deflation. It's a mild deflation, but any deflation increases the burden of debt, which in turn reduces personal consumption expenditures and investment. The unemployment rate is high and rising, and the underemployment rate, 16.8 percent in August, is very high. Housing prices remain very low, which increases indebtedness because a house is the principal asset of most people, and mortgage debt obviously does not fall when the value of the mortgaged property falls. The fall in housing prices, by wiping out the housing equity of milliions of people, exacerbates unemployment by making it more difficult for the unemployed to seek jobs in different parts of the country--they can't afford the down payment on a house if their existing house is worth less than the unpaid balance of their mortgage.

Another factor retarding recovery is the reluctance of older workers to retire, because their retirement savings are impaired. Employers are reluctant to lay them off for fear of being accused of age discrimination, which is illegal. With fewer workers exiting the work force, there is less room for the thousands of people who each day are looking for a job.

There are factors pushing in the opposite direction--toward a rapid recovery. As manufacturers work off their inventories, production restarts; as people's incomes fall, they divert more income to consumption and less to savings; when their incomes fall really far, they start spending their existing savings; and as durables wear out, the demand for durables increases. (It's the fact that the purchase of durable goods is postponable that leads to such drastic falls in manufacturing in a depression, compared to services.) And as economic conditions improve in other countries, U.S. exports will rise, which will stimulate U.S. output.

I don't know how these factors balance out, and I suspect no one knows. After the economists and the businessmen alike were caught by surprise by the housing and credit bubbles and ensuing financial crisis, all macroeconomic forecasts should be treated with a measure of skepticism.

Full post as published by Becker-Posner Blog on September 09, 2009 (boomark / email).