In the 12 years of the Great Depression – between thestock-market crash of 1929 and America’s mobilization for World War II –production in the United States averaged roughly 15% below the pre-depressiontrend, implying a total output shortfall equal to 1.8 years of GDP. Today, evenif US production returns to its stable-inflation output potential by 2017 – a huge“if” – the US will have incurred an output shortfall equivalent to 60% of ayear’s GDP.
In fact, the losses from what I have been calling the“Lesser Depression” will almost certainly not be over in 2017. There is nomoral equivalent of war on the horizon to pull the US into a mighty boom anderase the shadow cast by the downturn; and when I take present values andproject the US economy’s lower-trend growth into the future, I cannot reckonthe present value of the additional loss at less than a further 100% of ayear’s output today – for a total cost of 1.6 years of GDP. The damage is thusalmost equal to that of the Great Depression – and equally painful, even thoughAmerica’s real GDP today is 12 times higher than it was in 1929.
When I talk to my friends in the Obama administration, theydefend themselves and the long-term macroeconomic outcome in the US by pointingout that the rest of the developed world is doing far worse. They are correct.Europe wishes desperately that it had America’s problems.
Nevertheless, my conclusion is that I should stop callingthe current episode the Lesser Depression. Yes, its shape is different fromthat of the Great Depression; but, so far at least, there is no reason to rankit any lower in the hierarchy of macroeconomic disasters.
The US bond market agrees with me. Since 1975, the nominalannual premium on the 30-year Treasury bill has averaged 2.2%: in other words,over its lifespan, the 30-year nominal T-bill yields are 2.2 percentage pointsmore than the expected average of future short-term nominal T-bill rates. Thecurrent 30-year T-bill yields 3.2% annually, which means that, unless the marginalbond buyer today is unusually averse to holding 30-year Treasuries, she anticipates thatshort-term nominal T-bill rates will average 1% per year over the nextgeneration.
The US Federal Reserve keeps the short-term nominal T-billrate near 1% only when the economy is depressed, capacity is slack, labor isidle, and the principal risk is deflation rather than upward pressure onprices. Since WWII, the US unemployment rate has averaged 8% when theshort-term nominal T-bill rate is 2% or lower.
That is the future that the bond market sees for America: aslack and depressed economy, if not for the next generation, at least for mostof it.
Barring a wholesale revolution in thinking and personnel atthe Fed and in the US Congress, activist policies will not rescue America. Onceupon a time, policymakers understood that the government should tweak asset supplies toensure sufficient supplies of liquid assets, safe assets, and savings vehicles.That way, the economy as a whole would not come under pressure to deleverageand thus push production below potential output. But this basic principle ofmacroeconomic management has simply gone out the window.
A majority of the Fed’s governors believes that aggressivemonetary expansion has reached, if not exceeded, the bounds of prudence. Amajority in the US Congress is taking its cues from “Theodoric of York,Medieval Barber” (a stapleof the US comedy show Saturday Night Live in the 1970’s). It believes that whatAmerica’s infirmeconomy needs is another good bleeding in the form of more rigorous austerity.
As Oscar Wilde’s Lady Bracknell says in The Importance of Being Earnest:“To lose one parent…may be regarded as a misfortune. To lose both looks likecarelessness.” It was America’s misfortune to undergo one disaster of the GreatDepression’s scale; to undergo two does indeed look like carelessness.
What, then, should economists who seek to improve the worlddo, if we can no longer realistically expect to nudge policy in the right direction?
At a similar point in the Great Depression, John MaynardKeynes turned away from focusing on influencing policy. Instead, he attemptedto reconstruct macroeconomic thought by writing his General Theory of Employment, Interest, and Money,so that the next time a crisis erupted, economists would think about theeconomy in a different and more productive way than they had between 1929 and1933.
This week, the economist and frequent US official LawrenceSummers, in a lecture at the London School of Economics, called for anotherreconstruction of macroeconomic thought – and of the institutions andorientation of central banking. That is a Keynesian ambition, but can it beaccomplished? A latter-day Keynes is nowhere to be found, and no BrettonWoods-style global consensus to reform central banking is on the horizon.