How Depressions End

I think some people, both people on the right and people with views well to my left, have taken my recent optimism about the near-term economic outlook to be a kind of apologia for the Obama administration’s economic recovery initiatives. On the contrary, what I see taking place this winter and spring is something like what Paul Krugman called your great-great-grandfather’s recession back in a 2009 column. Obviously this depends a bit on how old you are, but say you’re my age—thirty. In that case, your father’s recession is caused by a deliberate Federal Reserve campaign to curtail aggregate demand to reduce inflation. You grandfather’s recession is the Great Depression, caused by a bungling of policy in 1929 ameliorated by expansionary monetary policy from 1933-36 and ended by the massive stimulus program otherwise known as World War II. But your great-great-grandfather’s recessions, were basically just not met with a policy response. Industrial activity would decline, people would try to move back to the farm (the Unemployment Insurance of the 19th century), the inflow of immigrants would decline, and the funk would last an unpleasantly long time. But not forever. So by the same token, once action was taken to halt the downward spiral of collapse it starts to become inevitable that sooner or later you’ll start catching up.

Back to Krugman on February 19 2009:

Consider housing starts, which have fallen to their lowest level in 50 years. That’s bad news for the near term. It means that spending on construction will fall even more. But it also means that the supply of houses is lagging behind population growth, which will eventually prompt a housing revival.

Or consider the plunge in auto sales. Again, that’s bad news for the near term. But at current sales rates, as the finance blog Calculated Risk points out, it would take about 27 years to replace the existing stock of vehicles. Most cars will be junked long before that, either because they’ve worn out or because they’ve become obsolete, so we’re building up a pent-up demand for cars.

The same story can be told for durable goods and assets throughout the economy: given time, the current slump will end itself, the way slumps did in the 19th century. As I said, this may be your great-great-grandfather’s recession. But recovery may be a long time coming.

That’s Tyler Cowen’s option number two, where “marginal rates of return rise with depreciation” which brings the natural rate of interest up, which means that unless the Fed commits new policy errors its objective stance switches from being contractionary to expansionary and we get a recovery. Now of course maybe we will have new policy errors. I don’t discount that possibility. Policy errors happen. But the point is that absent additional policy errors, economic slack produced by a nominal shock doesn’t last forever. Stuff gets old and people want to replace it.