State of the Union January 2009

The Issues: The Economy

Megan McArdle and Ryan Avent compare recessions and depressions, revisit the housing bubble and the banking crisis, consider the future of the 401(k), and ponder whether Obama can prevent a repeat of the 1930s

RYAN AVENT: Ok! The economy: what is the deal?

MEGAN MCARDLE: That's a great question, Ryan. And if either of us REALLY knew the answer to that, we'd be keeping very quiet and getting rich
So, let's start with the big one
Are we in a recession or a depression?

RYAN AVENT: That's the question, isn't it?
Well, I suppose there are technical definitions for depression out there
I believe a popular one is a 10% drop in GDP in one year, which would suggest we are not

MEGAN MCARDLE: Part of the problem is that, as far as I know there isn't an agreed on distinction

RYAN AVENT: It's kind of, like, worse than recession

MEGAN MCARDLE: Other than the old saw that it's a recession when your neighbor loses his job, and a depression when you lose yours

RYAN AVENT: In that case, maybe we are so far, then, still in recession territory


It is clear that this is something more than a garden variety recession, though
How much more remains to be seen

MEGAN MCARDLE: I'm leaning towards the D word
The depth is bad, but what I'm worried about is the length.
I feel like, postwar, we basically understood how we got into the recessions and how to get out again, through a combination of fiscal and monetary changes

RYAN AVENT: That's an interesting point, but I wonder to what extent the knowledge is colored by hindsight

I think in 1980, for example it was very clear what happened


MEGAN MCARDLE: Paul Volcker shot interest rates up to 20%--

RYAN AVENT: Volcker happened

MEGAN MCARDLE: ...and when they came down again, the recession eased
Simple fluctuations in aggregate demand driven by tighter money

RYAN AVENT: And then that became the model for recent recessions

MEGAN MCARDLE: This is not such a fluctuation
Even in 1974-5 you had a clear cause in the oil shocks
It wasn't necessarily comforting, but at least it was comprehensible

RYAN AVENT: But do we think that the current downturn hearkens back to some earlier brand of recession or is a new phenomenon entirely?

MEGAN MCARDLE: My current theory, which is fairly unsatisfactory, is that every sixty years or so, in a developed economy with a decently stable financial system, a number of factors collide to produce a perfect storm that causes problems in the financial system, and a very prolonged economic readjustment

RYAN AVENT: I think that's sensible

MEGAN MCARDLE: In hindsight, we can tell a comprehensible story about what happened . . .
but that doesn't really give us the "why."
Investment banks have collapsed before in the midst of bubbly markets in new, high leverage debt instruments.
Drexel Burnham leaps immediately to mind
But the whole financial system retrenches without collapsing.

RYAN AVENT: Well, one key, I think, is that every Tom, Dick, and Harry was borrowing to speculate, essentially, in the housing market
Which reminds us of the stock market pre-Depression

MEGAN MCARDLE: Actually, believe it or not, the number of people in the stock market wasn't that large.
Certainly not anything like the numbers who were speculating in housing in 2006

RYAN AVENT: Are you telling me the speculating bellhop is apocryphal?

MEGAN MCARDLE: Not exactly

RYAN AVENT: Because that would be disappointing

But most people on Main Street wouldn't have been trading stock.
Certainly nothing like the numbers who were involved in the housing market.
The stock market's primary effect was on business investment and the banking system, and of course, the lifestyles of some rich people
Unfortunately, that was bad enough
But that's the same sort of mystery
You can tell a plausible story about how the stock market touched off the Great Depression
But it only REALLY works if you already know the Great Depression was going to happen

RYAN AVENT: But that story would include massive bank failures

MEGAN MCARDLE: There wasn't any particular reason, in an era dominated by debt finance--

RYAN AVENT: And really bad monetary policy

MEGAN MCARDLE: ...that industrial demand should have fallen as spectacularly as it did.
I find even the Milton Friedman thesis curiously unsatisfying these days
If you read him, or Bernanke, or any of the other greats, what you start to notice is these really fairly big holes that are glossed over.
Friedman, for example, notes that "It's not entirely clear why the second banking crisis happened" (I paraphrase from memory)
And then marches briskly onto the next thing


MEGAN MCARDLE: Bernanke says much the same thing about the secular collapse in consumer demand in 1930
Well, two years ago, I would have happily nodded along
Indeed, I did
Suddenly, I'm rereading and saying, "Wait a minute! These are pretty much the crucial questions we need to answer!"
Are we going to have a banking crisis?
Is consumer demand going to collapse without reason?
And it turns out we NEVER knew those answers
We just thought we did
Or I thought we did, anyway
Perhaps you were more skeptical

I'm not sure that it's necessary to wrap things up in one or a few neat packages, though

MEGAN MCARDLE: Which is lucky, because I'm not sure it's possible

RYAN AVENT: No. There are a lot of stories that aren't mutually exclusive that contribute to the the Depression and this environment

MEGAN MCARDLE: I think that's a big point
The last seventy years of economics have been, if I might take a little journalistic license, the search for the Unified Field Theory of depressions.
Maybe there isn't one
Maybe you just get them when too many things go wrong at once

RYAN AVENT: It's all about the economic ether


RYAN AVENT: I mean, I think that's about right

MEGAN MCARDLE: That leads us to the next Big Question, though
Can Obama get us out of it?

RYAN AVENT: In a complex system with lots of feedbacks, if too much goes wrong you get a bad situation

MEGAN MCARDLE: Will stimulus work?

RYAN AVENT: Man, I hope so


RYAN AVENT: I have been on the yes side of this debate

MEGAN MCARDLE: What do you think of his stimulus package?

RYAN AVENT: I think it's pretty good
It's hard to know what the final thing will look like
I'm not as concerned about the initial size
I think that the next round of economic statistics may well tell us whether more is needed, and create the political environment to deliver more
If we do think this thing will continue for three years or so, then we can tailor our solutions appropriately
But it's also difficult to know how things will work out without real improvements in the financial system
And the real thunder and lightning in Obama's early days may come on that score, rather than on stimulus
Citi will become the National Bank of Obama, or some such thing
What do you think of the stimulus?
Libertarian opinion has not been particularly kind on this regard

MEGAN MCARDLE: I'm kinder to the notion of stimulus, in theory, than most libertarians
Here are my questions
1) Do we know that stimulus really does much in these situations? Most of the argument that it does rests on a couple of data points. And all those data points really indicate, in the most positive possible spin, is that stimulus works for a year and then stops working as soon as the spending stops
2) How much of the belief that stimulus "works" comes from measurement error? If you hire people to dig holes and fill them up, measured GDP increases. But actual welfare would probably have been higher if those hole-diggers and hole-fillers had been on the dole, consuming leisure
3) Where will the money come from? We certainly don't have excess savings, as Keynesian theory would seem to demand. And the foreigners who have been lending us money may need it to perform their own domestic stimulus
4) How fast can these "shovel ready" projects actually be put in? Most of the projects we really want, like high speed rail, require skilled workers, like crane operators, who aren't necessarily underemployed right now, not illegal laborers who are good with a shovel and a hammer

RYAN AVENT: Those are good questions.

MEGAN MCARDLE: 5) When does the U.S. start running into sovereign debt problems? If WWII is our model, then fiscal stimulus requires levels of spending I don't think we can borrow
6) How is the U.S. going to roll over this gargantuan quantity of short-term debt at absurdly low interest rates if the economy does recover?
I think that's it

RYAN AVENT: On 1), I think it's worth taking action simply to prevent a bad situation from becoming really bad. We do have an indication that there is some positive multiplier there, and given the probable duration of the recession and our infrastructure needs, there's a good argument for a large, sustained stimulus.
If we have things that are worth doing, we should do them, and of course the longer the time-frame, the better the projects will be.
At present we can borrow very cheaply
Which is good. And while foreign central banks are likely to stop lending to us on the scale of recent years, they'll continue to have some demand for Treasuries.
And suddenly -- too suddenly really -- we're saving again. Private saving may well finance the 2009 deficit.

MEGAN MCARDLE: Right now, my impression is that much of that saving is paying down debt

RYAN AVENT: But there is a question about how long we can sustain this kind of borrowing, I'm just not sure that the alternative—not borrowing—is anything we want to confront.

MEGAN MCARDLE: Which is just cash sitting on balance sheets
I'm not particularly worried about this year's deficit
I'm more worried that, in libertarian parlance, "There is nothing as long lived as a 'temporary' government program"
If we do bad things because we *can*, we'll be stuck with them for a long time
You and I probably disagree on this
But I don't think it desireable to have another jump of 1000 or 2000 basis points in the government share of GDP

RYAN AVENT: I don't know, I mean, there are long-run budget issues.
The question is, how hard is it going to be to address them?

MEGAN MCARDLE: Well, we've known for at least ten years that we were facing a major Medicare crisis

RYAN AVENT: That's the big one.

MEGAN MCARDLE: So far the legislative response has been—massive new spending

RYAN AVENT: Politicians have a tough time saying no

MEGAN MCARDLE: They have a harder time saying no when they are cutting an existing benefit -- in part, for the fair reason that people come to depend on those benefits
It may not be fair that some guy in Iowa gets paid not to grow corn on his acreage, but as of now, that's an integral part of his fiscal strategy

RYAN AVENT: But health spending is going to rise in any case. If the rise takes place on the government balance sheet, but it's a smaller total rise, then perhaps we're not in such bad shape.

MEGAN MCARDLE: And if you cut the benefit, you not only take away a big part of his income, but sharply reduce the value of his major asset, the farmland
Similarly, we don't know what market alternatives might have arisen to Medicare
But now there aren't any, which means if you cut it at all, you devastate either seniors or doctors, or both

RYAN AVENT: No, but we can see what other countries are doing, and how much they're spending, with what effects

MEGAN MCARDLE: As I say though, it's much easier to not spend the money in the first place then to stop spending it
Doctors in other countries make much less than here, as do other health care workers down the chain
It's one thing to restrain someone's salary, it's another to tell him that he now can't pay his mortgage
And seniors are used to a lot of treatment
In other countries, they aren't used to being able to, say, see a doctor once a week if it strikes their fancy
They never could, so they don't miss it

RYAN AVENT: Well, let's step back a moment
Greg Mankiw has written several times in criticism of Rahm's statement that the crisis presents an opportunity (paraphrasing)
He suggests that this points to a Democratic desire to permanently increase the size of government
But just as possibly, it could be that the crisis will provide the opportunity to make some of these hard decisions


RYAN AVENT: Is that Obama's plan?
I don't know

MEGAN MCARDLE: But I will say that I don't think it's apocryphal that the Democrats view this as a historic opportunity to spend more, permanently
We just had a big article on it -- and Josh Green is not exactly a wild-eyed conservative.

RYAN AVENT: Spend more, or differently?

More programs
They're not looking for opportunities to cut spending
They view it as an opportunity to pass their wish list under the guise of stimulus
And the belief that small-government conservatism has been discredited

RYAN AVENT: This view is not unique to our representatives
I believe it's popular in the electorate
Which is how they all got there

But the electorate is not, by and large, under the impression that a failure of financial regulation directly translates into universal healthcare.
Our representatives seem to be

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