How Low Can We Go?

The Financial media and economics blogosphere is full of wonky goodness this week  with all kinds of forecasts of the economy.  The big question is how bad will it get?  The secondary questions deal with economic forecast assumptions built into the Obama Budget.  Are they overly rosy or realistic?  I’ll save the wonkiest battle for last even though it is the most interesting.   It is between Mankiw and Krugman (with me agreeing with Mankiw for a change on a technicality) but it’s based on some pretty high level math so let’s start with the the least technical shot across the bow of  the good ship Hopey Changey.

Robert Barro has the most blunt assessment of the big question in this week’s WSJ.  His opinion piece just asks the question out right.  What Are the Odds of U.S. Depression? Barro is a member of what you could possibly call the elite team of economists in the country.  His credentials and CV are impeccable.  His record of academic publishing is unassailable.  He teaches at Harvard.  He also tends to be a voice from the right.   However, he’s presenting research in this opinion piece so this isn’t based on dogma, but some high level number krunching.   He’s actually put the probability of a ‘great’ depression at 20%.

The bottom line is that there is ample reason to worry about slipping into a depression. There is a roughly one-in-five chance that U.S. GDP and consumption will fall by 10% or more, something not seen since the early 1930s.

Our research classifies just two such U.S. events since 1870: the Great Depression from 1929 to 1933, with a macroeconomic decline by 25%, and the post-World War I years from 1917 to 1921, with a fall by 16%. We also assembled long-term data on GDP, consumption and stock-market returns for 33 other countries, sometimes going back as far as 1870. Our conjecture was that depressions would be closely connected to stock-market crashes (at least in the sense that a crash would signal a substantially increased chance of a depression).

I’d really suggest you buck up and actually read his story line about his data because it is very interesting.  He basically looks back at periods when there were severe stock market crashes (like now) and looks at trends.  His database is not restricted to US history but includes severe recessions and depressions from 34 different countries.

His assessment of forecasts is based on looking at the Fed scenarios.  He tips his conservative bent at the end of this quote by basically saying none of the policies we’ve seen to date are going to do much.  I highlighted his proposed time line.  He does think we’re going into a situation that will be worse than the 1980s recession but most likely not as bad as the Great Depression of the 1930s.

In this relatively favorable scenario, we may follow the path recently sketched by Federal Reserve Chairman Ben Bernanke, with the economy recovering by 2010. On the other hand, the 59 nonwar depressions in our sample have an average duration of nearly four years, which, if we have one here, means that it is likely recovery would not be substantial until 2012.

Given our situation, it is right that radical government policies should be considered if they promise to lower the probability and likely size of a depression. However, many governmental actions — including several pursued by Franklin Roosevelt during the Great Depression — can make things worse.

I wish I could be confident that the array of U.S. policies already in place and those likely forthcoming will be helpful. But I think it more likely that the economy will eventually recover despite these policies, rather than because of them.

Another really interesting viewpoint on the policy choices and approaches used by the Obama Team is outlined by Richardo Caballero at VOX today. Caballero argues that the macroeconomy will not recover unless the problems with the banking system and the finance industry are solved.  He considers solving the systemic problems essential to any scenario and argues that the Obama team is using a  “deal mentality” which is further crippling the economy.  Caballero is at MIT which is where the wonkiest of the wonkiest economists reside.  He sees the contagion in the markets right now and says there is no end in sight until the we deal with the source.  (Note: After two days of relative calm in the markets, we’re crashing again.  Usually, the financial sector is a stabilizing force in markets, in this current market, they are  leading the contagion. We’ve also heard from GM auditors that the company is at that point where it should be shut down. I’m assuming our government leaders are still asleep after the big party at the White House last night.  Has POTUS taken up the Fiddle?)

The Obama team’s strong words are followed by policies focused on getting a ‘deal’ for taxpayers. Here one of the world’s leading macroeconomists argues that squeezing current stakeholders for political appearance is short-sighted and self-defeating. Until the systemic panic is alleviated, the crisis will continue. This requires the investment of massive political capital right now; we are running out of time.

We are dealing with a massive problem of uncertainty and fear. There are, for sure, important real problems to solve, especially in our main financial institutions, but these are problems that are hard enough to solve in normal circumstances, and they are insurmountable unless panic is put to rest. No matter how many inefficient contortions, liquidations, and conversions individual financial institutions may do, until the problem of systemic panic is resolved, it is only a matter of time until the next crisis blows up in our faces. Those that think that solving the problems of one bank, by nationalizing it or otherwise, will restore confidence, fall into an extreme fallacy of composition. What may be the right solution for an isolated case, is not, or may even backfire, for a systemic problem.

We are running out of time and there is no end in sight unless massive political capital is put at risk now. We have a superb team of economists and technicians, but their voices all seem to have been lost. I recall Larry Summers rightly claiming that if markets over-react, the government has to over-react even more. Secretary Geithner, even in his much criticized first announcement, sounded to me like a man of principles, the right principles. We must stabilize the financial system, regardless of cost, was the message delivered with clenched teeth. However, Geithner’s and Summer’s actions do not match their own strong rhetoric. It is not that they don’t draw lines in the sand when faced with political pressures, but rather, they seem to be spending much of their energy tackling political hurdles rather than facing head-on the financial crisis.

I’m going to let Mark Thomas of Economist’s View succinctly explain this ‘model’ to you.

There is a marginal cost and a marginal benefit associated with the use of an additional unit of political capital, so another way to state this is that there is a market failure of some sort causing a distortion in either the perceived costs of the perceived benefits of using a unit of political capital on this problem. What is the market failure? One possibility is information. If people see the costs of these programs (the trillions they hear about every day), but do not see the benefits as directly (e.g. how much worse things could have been had we taken no action at all), that is, the benefits are underestimated for some reason, then politicians will not be willing to spend additional political capital getting these programs through. The key – and something economists could do a better job of helping with – is to convince people it will be worth it to spend the money, to explain how the policies help them on net even if they have to hold their noses when they look at some parts of what is being done, and to convince them that there is no better way to proceed. If “the return from reversing the downward spiral will be enormous,” then people need to be convinced of that, and if they are, the political problems will take care of themselves. Politicians could just do it, assume they know best and put the policies in place no matter what the public thinks, but practically that’s not likely to happen and the political hurdles – the belief that the benefits won’t be large enough to cover the costs – must be overcome before the policies can be enacted.

Okay, here comes the wonkiest of the wonks. Krugman and Mankiw have been having a back and forth for some time.  Mankiw has been an advisor to the last few Republican regimes and was widely thought, at one point, to be a candidate for Fed Chair.  Krugman, of course, is the wonky champion of the Keynesian school of thought.  Knowing and Making explains their current debate pretty well given that it is over the mathematical basis of the assumptions of the basic behavior of the time series underlying forecasts.  Oops, let me make that somewhat more intuitive.

If you look at how an economic time series behaves over time, you’ll notice patterns.  Some of these series will get hit by some kind of shock but will return to what we call a ‘trend stationary position’.  In other words, if you push a rocking chair hard , the rocking chair will rock wildly for a while but the rocking chair will not move any where.   It will just rock harder than usual.  In other cases, if you push the rocking chair, it will rock wildly and move to another location.  So you just don’t get the wild back and forth, you get a displacement of the rocking chair. (That series is NOT trend stationary).    So, the chair’s rocking represents the wild gyrations say of the stock market, but since the chair didn’t move from it’s original position, it will eventually go back to it’s same nice rocking pattern in it’s same nice place.  Okay, given that, here’s a quote.

The Obama administration projects that when the recession ends, growth will be faster than the long-term average, as the economy catches up with its permanent trend. This is called the trend-stationary assumption – Paul Krugman supports it and Greg Mankiw disagrees, citing an alternative hypothesis called unit-root.

The unit root hypothesis or assumption is that the chair not only swings violently but it moves positions when you give it a good shove.  So, what does this mean for economic forecasts?  If you go to the site, you’ll see a bunch of graphs that show you the various assumptions and their results.  You’ll also see that the rosy Obama scenario brings the economy back to capacity and things will return to normal.  Blog author Leigh Caldwell hopes for the Krugman assumption but believes Mankiw is probably more right here.

I would love to think that it does, but I don’t really believe it. In some models, capacity growth comes from growth in the economy’s stock of investment; in which case it seems unlikely to be growing right now, with net corporate borrowing falling and investment low. In others, it comes from innovation and knowledge spillovers; and if innovation is reduced in the recession then it won’t continue.

His bottom line then is this:

Krugman’s assertion that capacity keeps on rising might be correct – but that probably depends on one of the following conditions:

• The recession is short enough not to significantly affect innovation and investment
• Growth depends on factors that are not (negatively) affected by recessions
• Underlying capacity growth will accelerate beyond trend as the recession ends

The first we can yet hope for, but it’s looking less likely every month.

The second depends on your model. There is a literature of growth theory on which I am not an expert, but most of the modern work aims to model endogenous growth, arising from factors like intellectual property investment that arise within the economic system. That given, it seems likely that these would be affected by a recession. But you could argue that the effect of a 7% recession is only a 7% reduction in intellectual investment; thus capacity growth falls only from 2.5% to 2.33%, hardly a crippling fall. On the other hand, this type of investment might be proportional to corporate profits instead of revenue, in which case a recession has a disproportionate impact on it.

(Incidentally, one of the main exponents of new growth theory is Paul Romer, who is not married or related to Christina Romer, who as head of the CEA produced the administration’s trend-stationary growth forecasts.)

The third assumes that capacity can grow at well over trend for a few years in a row; but my own feeling is that this growth is asymmetric. It can certainly fall below trend but it’s harder for it to rise above. But I am hesitant to write off this option completely without evidence.

Unfortunately, I have to go with this analysis instead of the Krugman/Romer assumptions.  It may be however, because I teach out of the Romer book and was taught with the Romer view which represents the New Growth Theory.  Paul’s thing is microeconomics and trade theory.  His macroeconomics schooling was before this so he may be less inclined to have the bias I have to Paul ROMER (not Christine).

So, after reading through these and quite a few other discussions, I have to say I’ve thrown my hat in with the glass is half empty crowd. (Although, I’m really drinking that liquid down fast everytime the market closes it mayb e less than half empty by now.)  I think we’ve only just begun and we’re going to see more historical lows in the relevant variables than highs.  The next shock to the market will happen on March 11.  That’s when February’s unemployment data is coming on.  It’s expected to be historically bleak–perhaps worse than the great depression losses–so I can still see why the markets are depressed.  I am too.