When Will This Recession End?

One of the most frequent questions people are asking me is when and how will this crisis end? Unfortunately there is no clear answer,so perhaps we should go back in time and look at our policy options in the context of past recessions.

First: the usual way we get out of a recession is through monetary policy. The Federal Reserve Board lowers interest rates to a point that enough people and businesses are encouraged to borrow. The loans they take out provide stimulus once the proceeds are spent, and the economy starts to revive. As more people and businesses see that things are returning to normal they too start spending again, and the revival becomes self-sustaining, so the Fed stops lowering interest rates.

The recession of 1981/82 is a classic example of this kind of recovery. Actually it is even more interesting since that recession was brought about by the Federal Reserve Board raising rates in order to eliminate inflationary expectations. So that downturn was ‘engineered’ by the Fed – it was Paul Volcker’s great triumph – and is not necessarily a good example for us to use now. Plus back then there was plenty of room to lower rates aggressively. Now, with the Fed Funds rate close to zero, we have precious little room for further rate cuts. So monetary policy is a non factor at the moment.

Second: since we appear to restricted to fiscal policy we need go further back for examples, to the Great Depression. After a few false starts the huge public works programs and general government spending of the mid and late 1930’s managed to replace the lost private demand sufficiently to get the economy rolling again. Unfortunately the biggest of those spending programs was the military build up during World War II! I doubt that we are about to copy that solution, so the recently signed stimulus package is the closest we have to a 1930’s style program. As I have argued before I don’t think it is enough to revive the economy. It was too small to plug the demand gap between ‘potential’ and actual demand completely, so unless there is a follow up package soon, all we can hope is that the current plan stops the rot rather than starts the recovery.

Third: that leaves us with a search for a third solution. For examples of that we need to go even further back in time. If neither monetary nor fiscal policy is up to the task the economy is left to its own devices and we have to look for the seeds of recovery within the current set up. Think of it this way: the problem we have is a huge gap in demand. The economy is faltering because people and businesses are simply buying much less than the resources of the economy can produce. The result is that there is huge ‘spare’ capacity in the form of idle factories and unemployed, or underemployed, workers. Closing that gap ‘naturally’, without stimulus, can only come from a recovery in spending. Looking around we can identify where that spending will come from. The demand for cars is way below our capacity to make them. At some point our current stock of cars will wear out, break down, or just get obsolete so we will start to replace them. Demand will go back up. The same can be said for housing: the current rate of construction is allowing the inventory of unsold homes to shrink slowly. There will come a time when that shrinkage has gone too far and a shortage emerges. Then construction will restart. Most aspects of the economy where the items being bought are large ticket items, which is where the demand gap is largest right now, are susceptible to this process. So we know with certainty that sometime in the future demand will recover. The issue is when?

If we reach back far enough we can find historical examples of such self-starting recoveries. They were the norm back in the 1800’s before economic theory had shown us the way to intervene and shorten downturns. The most often cited example is the great recession of 1873, which lasted five years after which there was a short strong recovery followed by another downturn. It was almost a decade before growth was steady again.

So, in the absence of more determined action by the government, and given that we cannot export our way out of this mess because everyone else is in the same crisis we are, we can say with some degree of confidence that we are in for a few years of high unemployment and very weak growth – if any. The recently revealed minutes of the Fed’s internal discussions on policy indicate that many of their analysts think the recession and subsequent period of weakness will last for several years. They talk of unemployment remaining high well into 2011, with only a slow improvement after that. It looks as if they think the stimulus package will blunt to recession and therefore shorten it somewhat, but is not enough to jump start anything. That means a prolonged and uncertain time before will see strong growth. Remember that this recession started in late 2007, so five years would mean a 2012 or even 2013 recovery. A lot of damage will be done before then.

Which is why we need more action.

We know how to fix this. We simply need the political will to go ahead.

Addendum:

This topic is now all the rage. I dug out this entry from the blog Think Progress this morning: Recession Discussion . The chart shows the recessions during the late 1800’s. I am surprised both by the frequency of downturns and some of their severity. Much of 20th Century economic theorizing has been devoted to constructing policies to avoid the boom-bust pattern so evident in the late 1800’s. In fact the furious pro and con Keynesian debates that consumed so much energy were entirely about that issue. So I am very surprised, and a little distressed, to see the Wall Street Journal print this Op-Ed piece: Don’t Believe The Stimulus Scaremongers . This guy is actually arguing that we should go back to the nineteeenth century and just allow the economy to self correct whenever it hits a downturn. That would be the libertarian or ‘Gilded Age’ Republican position I suppose. No government intervention at all. That’s like saying we should allow smallpox to ‘run its course’, it too will ‘self correct’.

But we have found a cure. Why not use it?