The Developing Economic Situation: February 2-May 1, 2009

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My book A Failure of Capitalism: The Crisis of '08 and the Descent into Depression was completed on February 2 of this year. That was the day I sent the edited manuscript back to the publisher (Harvard University Press) to be put into page proofs. After February 2, I could not make any substantive changes. Of course February 2 was not the end of the economic crisis, or of the government's response, or of my education in depression economics; and so my intention (announced in the book's preface) was and is to update the book by means of this blog, weekly (but more frequently at first), and to invite and respond to readers' comments, until the crisis is over or (more likely) I run out of things to say.

In this first entry, I summarize economic developments since February 2; in my second, which I will post tomorrow, I will summarize the political developments--the government's remedial efforts--since February 2. My tentative menu of subsequent entries is (1) adding some depth to my discussion of certain economic issues, and suggesting some additional readings; (2) discussing current plans and proposals for changing the regulation of banking and finance; (3) revisiting the issue of who is to blame for the crisis, (4) responding to critics, and (5) discussing the role of law and law schools in helping the economy to recover. After that--we'll see.

So--the economic update. Much has happened in the three months since February 2, though nothing--I emphasize--to alter the basic analysis and conclusions in my book. I begin with some economic data. The unemployment rate, 7.2 percent in December 2008 (the latest unemployment rate available when I finished the book), had risen by March to 8.5 percent, and the underemployment rate (which includes not only the officially unemployed, but also people who have given up looking for a job or who are involuntarily working part time) had risen from 13.5 percent to 16.2 percent. The Dow Jones Industrial Average, which though it contains only 30 stocks is a very good barometer of change because its stocks are all heavily traded, has risen since February 2 from $7,800 (rounded to the nearest hundred dollars) to $8,200. This change, an increase of about 5 percent, has little predictive significance--such is the complexity of the economic and psychological forces that influence stock prices in the short run. But it is a positive sign because so much of people's savings nowadays consists of direct or indirect ownership of common stocks. Any increase in the market value of those savings is likely to make people feel a little richer and therefore a little less hesitant about spending money; and it is a dearth of spending that is the immediate cause of the fall in output and employment that is at the heart of the economic crisis. But because this is so, the fact that personal consumption expenditures fell in March (by 0.2 percent from February), because personal incomes fell (by  0.3 percent) and the rate of personal savings increased (from 4 percent to 4.2 percent--compared to well under 1 percent a year ago), is a negative sign. This is not the time for frugality--from a social, though not an individual, standpoint.

The Gross Domestic Product (the market value of all goods and services sold in the economy) fell in the first quarter of 2009 at an annual rate of 6.1 percent, which is just two-tenths of a percent less than the fall in the last quarter of 2008 and more than 8 percent below the GDP trend line (that is, below where GDP would be in a year of normal economic growth). Bank credit continues to be constricted. Indeed, bank lending has fallen since the bank bailouts began last fall--a fall that has fueled populist rage against "Wall Street." And total excess bank reserves (that is, cash or its equivalent that banks are not required by the regulatory authorities to keep rather than lend or invest) have risen from $2 billion in 2007 to $725 billion in March of this year. That is, banks are continuing to hoard cash, partly because they are undercapitalized, but more, I think, because (1) lending into a depression is risky and (2) the demand for loans has declined because of the overindebtedness of consumers (whose savings are concentrated in volatile assets, namely houses and stocks, the value of which has plunged).

So the economy is continuing to decline. But there is evidence that the rate of the decline has slowed--inventories, for example, have declined, which brings closer the day when manufacturers will have to produce more goods in order to satisfy even weak demand.

If we think of the depression and recovery as forming the bottom half of a circle, then as one moves down the left side of the circle the rate of decline falls, reaching zero when we are at the bottom of the half circle. But it is merely a guess that the current depression plus recovery can be approximated by a half circle. An alternative possibility is that the continued fall in employment (for almost no one thinks that unemployment has peaked yet) will continue or even accelerate a downward spiral, as more and more people lose jobs and therefore suffer a fall in income and as the still-employed become increasingly anxious that they will lose their jobs, causing them to curtail spending. And that curtailment in turn would accelerate the decline in output and precipitate additional layoffs, reducing still further the propensity of consumers to consume and so leading to a further round of layoffs.

The most ominous depression phenomenon--significant deflation--cannot be ruled out, although it is less likely than it seemed to be in the last quarter of 2008. In that quarter, the Consumer Price Index fell by almost 3.5 percent. The index was slightly positive in the first two months of this year, slightly negative in the third--and slightly below what it was a year ago. It could continue to fall, if a continued fall in demand causes sellers to keep reducing their prices. Moreover, as long as the index is below the rate of inflation, even if it is not negative, the economy is hurt; people or firms that a year ago borrowed money for a year at 7 percent interest, when inflation was expected to be about 4 percent, were paying a real rate of interest of only 3 percent; with inflation currently at zero (actually slightly below), their real rate of interest is 7 percent--more than twice what they reckoned on.

Another notable development since February is the dramatic increase in the amount of money that the government is committed, or intending to, borrow or create or pledge as a guarantee, as by expanding deposit insurance, all in an effort to speed recovery from the depression. That amount was $7.2 trillion at the beginning of February; it is $12.8 trillion now. No doubt most of this money will be recovered (or, in the case of the guarantees, never spent because the default guaranteed against does not occur). When the Federal Reserve pumps money into the economy, for example by buying credit card debt, the debt, being short term, is paid off in a short amount of time and the payment reduces the Fed's liabilities by the amount of the cash that it spent to buy the debt.

But whether and when the government will recover the vast amounts of capital that it has contributed to the banks, the tens of billions in mortgage relief and in loans to the Detroit automakers, the hundreds of billions in Keynesian deficit spending--and all this on top of the "normal" budget deficit, which is huge and will be much greater this year and possibly for several years to come because of the drop in federal tax revenues caused by the depression--is anyone's guess. As emphasized in my book, it is the unprecedented scope and cost of the government's recovery measures that mark the current economic crisis as a depression, and no mere recession; for the costs and hence gravity of an economic crisis include not only the loss of output and employment during the acute phase of the crisis but also the costs incurred in trying to put the economy on the road to recovery. I will discuss some of the costs tomorrow, when I update the reader on the recovery measures taken by the government, or proposed, since February 2.

I do not know when the bottom of the depression will be reached, or what output and employment will be at the bottom, or how long it will take after the bottom is reached for the economy to rejoin the GDP trend line. We seem nearer to the bottom than we were in February 2, when no bottom could be glimpsed. But that is all that responsibly can be said; any attempt at prediction on my part would be bootless speculation. 

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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.
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