A Failure of Capitalism (VII): Are We at a Turning Point?

by Richard A. Posner

I am going to discuss forecasts of economic recovery, but first let me remind readers that I am blogging on Andrew Sullivan's website only for this week. Next week I will resume my AtlanticCorrespondents blog, "A Failure of Capitalism," http://correspondents.theatlantic.com/richard_posner/.

There is enormous speculation in the media, fed by statements by government officials, with regard to the question whether the current economic downturn has reached, or will soon reach, its bottom and start upward. I believe this speculation, and the data and opinions on which it is based, are of little value, probably too little to guide individual or business decisions. People got tired of reading about economic gloom and doom, so the media were happy to play up indications that the worst was over.

The problem, which is related to the discussion of uncertainty in my last blog entry in this series, is the inherent instability of a capitalist economy.

(This is a fact, not a criticism.) The average growth of the U.S. economy has long been about 3 percent a year, but the actual growth from year to year oscillates around that trend line in an irregular, unpredictable fashion. This oscillation is the "business cycle," but the word "cycle" is misleading in this context because it suggests a smooth, wave-like motion, like a pendulum; and the real motion is anything but.

One reason, perhaps a main reason, for the oscillation (rather than steady growth) is feedback effects. There is an analogy to climate, another unstable system. Carbon dioxide in the atmosphere raises surface temperatures by trapping heat radiated from the earth; the higher temperatures, among their other effects, melt the Alaskan and Siberian permafrost, releasing methane, another "greenhouse gas," which leads to a further increase in surface temperatures. Also, the warmer the atmosphere, the more water vapor it holds, hence the more cloud cover there is, and clouds by blocking sunlight can reduce surface temperatures. Similarly, we know how an asset-price bubble can expand and then burst, and in bursting can trigger a recession, which can feed on itself: demand falls, so output falls, so unemployment rises, so incomes fall, so there is hoarding and a further reduction in demand, so output declines further and unemployment rises further. Eventually, as inventories shrink and durables wear out and hoarding produces a savings glut, the downward spiral stops and then reverses. In either direction, feedback effects amplify the effect of what initially may be a small change in economic behavior.

Because of the inherent instability of the economy, as of the climate, it is not possible to spot with any confidence a bottom or turning point in a recession or depression until recovery is well under way and one can look back and see the bottom through the rear-view mirror as it were. As long as unemployment is increasing, as it seems still to be doing, there is a danger that the downward spiral will continue--that a further increase in unemployment will cause a further reduction in spending and investment by reducing incomes and increasing the propensity to save rather than spend by those whose incomes have fallen or who fear becoming unemployed or, if they are unemployed already, fear that it will take a long time for them to find another job.

The government's enormous expenditures on containing the downward movement of the economy have undoubtedly had some effect; the analysis of fear in my last blog entry suggests that a returning sense of business and consumer confidence can have an independent positive effect on recovery from a depression; and sheer passage of time is beneficial--inventories shrink, durables wear out, and eventually safe (and therefore unproductive) savings stop increasing (the savings glut). But whether these developments have merely slowed the economic decline, rather than bringing it to the verge, at least, of a full stop, remains to be seen. The recent rise in stock prices has encouraged many to think that the depression is actually over, which is surely premature. The Dow Jones Industrial Average was 7,900 at the beginning of February, when the nation was in a state verging on panic about the economy, and it has risen only modestly since, to 8,400 today, and thus remains far below its peak of 14,000 in October of 2007. The housing market remains in very bad shape, and large losses in commercial real estate loans, other business loans, and credit card debt loom. Defaults and bankruptcies, business and personal, are at a high level. General Motors may declare bankruptcy soon, with unpredictable consequences. Other shoes may drop.

Even assuming that the worst is over, one cannot know how fast, or along what path, the economy will recover, reaching the trend line so rudely interrupted by the economic downturn that began at the end of 2007 and accelerated dramatically beginning last fall. The sharp drop in the market value of people's savings, concentrated as those savings are in houses and common stock, the continuing economic distress in major trading partners of the United States, and the ballooning budget deficits and money supply, may prevent a full recovery for a number--an unknown number--of years.

I make no predictions. The burden of my argument is that the instability of the economy makes predictions about the recovery from a depression perilous.