Sunday :: Jan 4, 2009

A Matter of Sematics

by Mary

Paul Krugman is worried that the economic situation is liable to get much, much worse because the politicians are not taking the need for a substantial stimulus package seriously enough and he warns that what could follow is a depression.

This ties right into a couple of other pieces I read today: one from the Economist which defined the difference between a recession and a depression and another via Calculated Risk where Janet Yellin notes the situation we are in is not a garden-variety recession and stronger measures are needed to avoid a depression.

The Economist writes that one way to look at the difference between recessions and depressions is to look at what triggered the problem. Standard recessions are caused by tightening monetary policy for managing inflationary incidents (such as the situation the US faced when Volker raised interest rates to snuff out the double digit stagflation) and "a depression is the result of a bursting asset and credit bubble, a contraction in credit, and a decline in the general price level."

Another important implication of this distinction between a recession and a depression is that they call for different policy responses. A recession triggered by tight monetary policy can be cured by lower interest rates, but fiscal policy tends to be less effective because of the lags involved.

By contrast, in a depression caused by falling asset prices, a credit crunch and deflation, conventional monetary policy is much less potent than fiscal policy.

As Paul Krugman writes, the current proposed conservative solutions won't work:

Milton Friedman, in particular, persuaded many economists that the Federal Reserve could have stopped the Depression in its tracks simply by providing banks with more liquidity, which would have prevented a sharp fall in the money supply. Ben Bernanke, the Federal Reserve chairman, famously apologized to Friedman on his institution’s behalf: “You’re right. We did it. We’re very sorry. But thanks to you, we won’t do it again.”

It turns out, however, that preventing depressions isn’t that easy after all. Under Mr. Bernanke’s leadership, the Fed has been supplying liquidity like an engine crew trying to put out a five-alarm fire, and the money supply has been rising rapidly. Yet credit remains scarce, and the economy is still in free fall.

Friedman’s claim that monetary policy could have prevented the Great Depression was an attempt to refute the analysis of John Maynard Keynes, who argued that monetary policy is ineffective under depression conditions and that fiscal policy — large-scale deficit spending by the government — is needed to fight mass unemployment. The failure of monetary policy in the current crisis shows that Keynes had it right the first time. And Keynesian thinking lies behind Mr. Obama’s plans to rescue the economy.

Janet Yellin provided this perspective:

I agree with [Martin Feldstein] that the current downturn is likely to be far longer and deeper than the "garden-variety" recession in which GDP bounces back quickly. As Marty points out, a defining characteristic of this downturn is its cause. Typically, recessions occur when monetary policy is tightened to subdue the inflationary pressures that emerge during a boom. This time, the cause was the eruption of a severe financial crisis. Cross-country evidence suggests that, following such an event, GDP remains subdued for an extended period. And consistent with this evidence, many forecasters expect this to be one of the longest and deepest recessions since the Great Depression. Indeed, the crisis is ongoing. ...If ever, in my professional career, there was a time for active, discretionary fiscal stimulus, it is now. Although our economy is resilient and has bounced back quickly from downturns in the past, the financial and economic firestorm we face today poses a serious risk of an extended period of stagnation—a very grim outcome. Such stagnation would intensify financial market strains, exacerbating the problems that triggered the downturn. It's worth pulling out all the stops to ensure those outcomes don't occur.

Yet, despite signs that our economy is heading over the cliff, conservatives are adamant that we should not be helping the people most affected by the catastrophic financial crisis. No matter what you read or hear about the crisis, those most affected are not the investors losing money and it is not Wall Street companies going under; those most affected are the huge numbers of Americans that are losing their livelihoods, their homes, and their dreams for the future. The worst part of this crisis is what it does to those people who have no resources to feed their families, pay for housing, attend school, nor pay for health care. They are the ones who pay for the insane policies and blatant greed that made a few wealthy beyond their wildest dreams. But according to conservative ideology, those most affected must not expect help because it would make them weak.

Yet, this is as it always has been. After all, conservatives have a track record of devising policy which lets people starve rather than letting government spend a penny on helping them.

Hopefully, Obama does not succumb to the free market ideologue thinking that is bound to march the country straight over the cliff.

Mary :: 9:15 PM :: Comments (3) :: Digg It!