|The Shadow of Depression
by J. Bradford DeLong
J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau for Economic Research. He was Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates.
BERKELEY – Four times in the past century, a large chunk of the
industrial world has fallen into deep and long depressions
characterized by persistent high unemployment: the United States in
the 1930’s, industrialized Western Europe in the 1930’s, Western
Europe again in the 1980’s, and Japan in the 1990’s. Two of these
downturns – Western Europe in the 1980’s and Japan in the 1990’s –
cast a long and dark shadow on future economic performance.
In both cases, if either Europe or Japan returned – or, indeed, ever
returns – to something like the pre-downturn trend of economic growth,
it took (or will take) decades. In a third case, Europe at the end of
the 1930’s, we do not know what would have happened had Europe not
become a battlefield following Nazi Germany’s invasion of Poland.
In only one instance was the long-run growth trend left undisturbed:
US production and employment after World War II were not significantly
affected by the macroeconomic impact of the Great Depression. Of
course, in the absence of mobilization for WWII, it is possible and
even likely that the Great Depression would have cast a shadow on
post-1940 US economic growth. That is certainly how things looked,
with high levels of structural unemployment and a below-trend capital
stock, at the end of the 1930’s, before mobilization and the European
and Pacific wars began in earnest.
In the US, we can already see signs that the downturn that started in
2008 is casting its shadow on the future. Reputable forecasters – both
private and public – have been revising down their estimates of
America’s potential long-run GDP.
For example, labor-force participation, which usually stops falling
and starts rising after the business-cycle trough, has been steadily
declining over the past two and a half years. At least some monetary
policymakers believe that recent reductions in the US unemployment
rate, which have largely resulted from falling labor-force
participation, are just as valid a reason for shifting to more austere
policies as reductions in unemployment that reflect increases in
employment. And much the same processes and responses are at work –
with even greater strength – in Europe.
Most important, however, has been what looks, from today’s
perspective, like a permanent collapse in the risk-bearing capacity of
the private marketplace, and a permanent and large increase in the
perceived riskiness of financial assets worldwide – and of the
businesses whose cash flows underpin them. Given aging populations in
industrial countries, large commitments from governments to
social-insurance systems, and no clear plans for balancing government
budgets in the long run, we would expect to see inflation and risk
premiums – perhaps not substantial, but clearly visible – priced into
even the largest and richest economies’ treasury debt.
Sometime over the next generation, the price levels of the US, Japan,
and Germany might rise substantially after some government
short-sightedly attempts to finance some of its social-welfare
spending by printing money. The price levels are unlikely to go down.
Yet the desire to hold assets that avoid the medium-term risks
associated with the business cycle has overwhelmed this long-run
fundamental risk factor.
But the risk that the world’s investors currently are trying to avoid
by rushing into US, Japanese, and German sovereign debt is not a
“fundamental” risk. There are no psychological preferences,
natural-resource constraints, or technological factors that make
investing in private enterprises riskier than it was five years ago.
Rather, the risk stems from governments’ refusal, when push comes to
shove, to match aggregate demand to aggregate supply in order to
prevent mass unemployment.
Managing aggregate demand is governments’ job. While Say’s law – the
view that supply creates its own demand – is false in theory, it is
true enough in practice that entrepreneurs and enterprises can and do
depend on it.
If the government falls down on the job, John Maynard Keynes wrote 76
years ago, and “demand is deficient…the individual enterpriser...is
operating with the odds loaded against him. The game of hazard which
he plays is furnished with many zeros,” which represent “the increment
[by which] the world’s wealth has fallen short of...savings,” owing to
“the losses of those whose courage and initiative have not been
supplemented by exceptional skill or unusual good fortune. But if
effective demand is adequate, average skill and average good fortune
will be enough.”
For 62 years, from 1945-2007, with some sharp but temporary and
regionalized interruptions, entrepreneurs and enterprisers could bet
that the demand would be there if they created the supply. This played
a significant role in setting the stage for the two fastest
generations of global economic growth the world has ever seen. Now the
stage has been emptied.