Elliott Parker: Why is this recession different?
November 19, 2011
If you think this recession has been going on too long, you are not imagining things.
Economists define recessions as the period of actual decline in real economic activity, which we generally measure with Gross Domestic Product. The recession, which began in early 2008, was officially over by the middle of 2009. Adjusting for price inflation and population, real per-capita GDP fell by 6.4 percent. Normally, it would have grown by about 1.5 percent per year.
That doesn’t sound so bad, considering how most of us thought we were looking into the deep abyss in the Fall of 2008.
But even though real per-capita GDP has grown by 3.2 percent since the middle of 2009, we still are 8 percent below where we would have been without the housing and banking crisis that Wall Street helped create. Adding it up, we have lost almost $4 trillion in income so far. As our annual GDP is $15 trillion, you can see we are talking about a lot of money. Since forecasters expect that a robust recovery is still several years away, this loss will only keep rising.
Normally, recessions last less than a year, and the recovery takes another year or so. Why is this recession different?
Let me let you in on a poorly-kept secret: This was a depression. Some economists prefer to call it a “balance sheet” recession, so we don’t frighten the children (or consumers, or investors, or voters), and so people don’t think we are comparing this to the Whopper of the early 1930s, when government did everything wrong in response.
People assume a depression is just a word for a bad recession, but those who study the history of recessions know it as a downturn caused by a financial crisis. Why is that so different?
In a financial crisis, banks and other financial institutions become extremely concerned about the poor quality of the debt they hold, and are afraid to take on any more risk. As a result, they collect reserves to offset their bad debt instead of lending it out. Firms with weak demand that can’t get loans don’t buy investment goods, and don’t hire.
Unlike in recessions caused by tightening monetary policy, recessions like this tend to push interest rates towards zero. Price deflation is also a danger, since falling prices make debt harder to repay, and encourage banks to hold cash and bonds instead of making loans like they are supposed to do. Unless stopped, deflation creates more deflation, causing a downward spiral.
Consumers lose a substantial share of their wealth, which permanently depresses consumption. Because our financial crisis involved housing, the biggest asset most people own, homeowners are substantially poorer than they were five years ago. Firms that depend on previous consumer spending habits struggle to survive.
Governments tends to become the borrower of last resort in such cases, as investors flee other assets and look for somebody relatively safe to hold their money. As the Euromess is now demonstrating, however, even governments may not be safe bets.
When the recession is short-term, state and local governments with falling tax collections, increased spending needs, and balanced budget requirements can raid rainy-day funds and other balances. But if the recovery doesn’t come soon enough, financial distress forces these governments to cut spending or raise taxes at exactly the wrong time. Though the private sector was hit first by the recession, the contraction of the public sector substantially slows down the recovery.
In normal times, when the economy is near full employment and markets are working well, an increase in government demand only crowds out private demand. Firms sell more to the government and less to private investors or consumers. If government borrows to pay for its spending, this bids up interest rates, reducing borrowing by the private sector. If those borrowed funds come from abroad, then exports fall instead, since every dollar we borrow from a foreigner is a dollar not spent on our goods. The multiplier in normal times is near zero, so that an extra dollar spent by government has very little net effect.
In a typical recession, there is slack in the economy and crowding out is not total, so the multiplier is likely to be positive but still not very big. But fiscal policy often requires a legislative decision, and implementation takes time; by the time government acts, the economy is well on its way to recovery. The private sector can generally create enough growth on its own, if government doesn’t make things worse.
In a depression, however, other tools stop working, and the economy’s normal recuperative powers are weak. Fiscal policy becomes the only tool left, even though it has limited effectiveness. In essence, government spending can serve as a parachute, slowing the economy’s decline, not a rocket to return us to full employment. The recession won’t be as deep as it would have been, but the damage is still substantial and recovery still takes years.
International evidence shows that recessions caused by financial crises are deeper and longer. Even seven years later, economies are 10 percent below where they should have been, on average. Fiscal intervention can reduce the severity, but can’t make it all better.
Why don’t most people understand this difference? We have simply forgotten our past. Those who lived through the Great Depression will never forget it, and know that this one now hardly compares. But prior to that big one, depressions occurred with some regularity, and they tended to last twice as long, and be twice as deep, as other recessions.
The institutions and rules we created after the big one, to prevent it from happening again, led us to eventually believe that depressions were only a scary tale our grandparents told us so we would be more cautious. We eventually came to believe we didn’t need no stinkin’ rules anymore, as the bandit in The Treasure of the Sierra Madre might have said.
Now most of us still don’t know what hit us.
• Professor Elliott Parker is chairman of the Economics Department at the University of Nevada, Reno.