Friday, November 20, 2009

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The US is in a depression. It is rather a mild depression, as depressions go, but if I may use the terms “recession” and “depression” in accordance with their verbal roots, although US economic activity is no longer receding, it is still depressed. (It is depressed by any standard, I think, but particularly, my own criterion would be, in comparison with what we know the US economy is capable of producing.) And it will remain so, even in the best case, “for a considerable period of time.” You don’t go from a doubling of the unemployment rate, back to normal business activity, without experiencing a great deal of melancholia along the way.

Most observers blame the economic collapse on the humungous housing and credit boom, which went bust in a particularly unpleasant manner. But what would have happened if the boom had never taken place? That very boom, even with war spending as an additional stimulus, and with households that were willing to consume their entire income, was, it seems to me, barely enough to forestall depression. Despite having such considerable help, the financial boom did not produce an economic boom. It barely created enough demand to bring US economic activity up to its potential for a year or so.

The bigger they come, the harder they fall, and this one was huge – but not huge enough, not strong enough, even in its days of glory, to fully hoist the boulder by which we are now being crushed. Blame this decade’s financial excess for the acuteness of the recession, but don’t blame it for the existence of a depression. It’s not clear exactly what it is, but we are dealing with some sort of “long wavelength” economic phenomenon whose underpinnings were a pre-existing condition. Today, one or two powerful shots of temporary fiscal stimulus may help chase away the worst of the blue devils, but they won’t be sufficient to restore health.

As I see it, there are only two ways the US can end this depression. One is by deliberately, intentionally, publicly, and resolutely engineering a moderately high inflation rate (in the future) by promising to use whatever monetary policy is necessary to achieve a mercilessly escalating series of price level targets once that policy finally acquires traction. That approach would force people (and businesses) to abandon “safe” investments and start building something that will allow them to take advantage of the inflation by selling the products at higher prices than they cost to create.

The other way is to risk (but probably not create) a very high inflation rate (again, in the future, not in the present) by means of massive deficit spending sustained to the point of recklessness. This deficit spending could take the form either of increased government purchases, which stimulate economic activity directly, or of “helicopter drop” tax cuts financed by creating money, which, if done on a sufficiently large scale, will eventually make people (and/or businesses) feel wealthy enough to start spending more.

Neither of these things is going to happen. Not in the current political climate, and not in any political climate that I can imagine over the next decade. I conclude that, when this depression ends, it will not be the US that ends it. This depression will end when the rest of the world (considered collectively) decides that it wants more than it is able or willing to produce, and when it approaches the US, bearing its accumulated IOU’s, offering to retire them at a substantial discount (a discount enforced by the foreign exchange market, not by renegotiating the instruments themselves), and asking the US to produce the remainder of what it wants.

Or else this depression will just continue. Eventually, some day, America’s capital stock will have deteriorated to the point where it cannot even supply the depressed level of demand that it will still be experiencing. (I mean demand “depressed” relative to what the US would have been capable of producing if growth had somehow proceeded normally, making efficient use of available resources. I’m optimistic that the US will experience growth over the next decade, just not enough growth. In my lexicon, if, for example, growth of demand were just sufficient to absorb labor force and productivity growth while leaving 10.2 percent of the labor force unemployed and 17.5 percent of the broadly defined labor force either unemployed or under-employed, as they are today, that would definitely still qualify as a continuing depression, though, by the way, it wouldn’t necessarily leave investors feeling depressed.) And once our capital stock does deteriorate sufficiently – in the future, but not in the foreseeable future – we will have to start building something again.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.


David Pearson said...

The rest of the world could very well decide to cash in its dollars for goods. This points to one of the fundamental problems with the economy the Fed has created.

Ordinarily, the adjustment in trade imbalances would lead to an adjustment out of the "depression" as our exports surge. This economy is not ordinary. It is predicated on ultra-low interest rates -- the effect of a decade of Fed "experimentation" with deflation-fighting.

What happens to an economy based on low rates when foreigners trade IOU's for goods? The negative force of higher interest rates swamps the positive force of higher exports. Of course, that could lead to a situation where further dollar devaluation merely leads to higher interest rates.

Andy Harless said...

David: "The negative force of higher interest rates swamps the positive force of higher exports."

That depends on how the Fed and the Treasury react. The Fed will likely keep short-term interest rates low (unless the inflationary impact of the dollar's decline is unexpectedly large). In that case, the effect on interest rates depends on the supply and demand for longer-term Treasury securities (unless you think it will also affect risk spreads, but it's not clear which direction that effect would be). So the question is: what does the Treasury's supply curve look like? Right now, the Treasury is (misguidedly, in my opinion) trying to take advantage of low rates by doing a significant fraction of its financing long term. If rates start to rise, that incentive will start to disappear, and the Treasury might well start doing more short-term financing, thus limiting the yield curve impact.

But it's also not clear to me why rates would rise in the first place. The time for US creditors abroad to worry about a weak dollar is before the dollar collapses, not after. The cheaper the dollar gets, the less subsequent depreciation risk there is, and the more chance there is of subsequent appreciation. When foreign investors become unwilling to accept low yields on US bonds, the result would be a drop in the dollar, which should be sufficiently large to allow them to anticipate subsequent appreciation. There's no need for US interest rates to change unless domestic investors lose confidence in US bonds. But that would be a good thing, because they would have to shift their wealth into more productive assets.

Richard H. Serlin said...

"It’s not clear exactly what it is, but we are dealing with some sort of “long wavelength” economic phenomenon whose underpinnings were a pre-existing condition."

What do you mean by this? Can you cite some theory, papers, or other readings that explain this?

Andy Harless said...

Richard, I just mean that, whatever is going on, it is something that started long before the recent recession and is likely to continue long after. I use the phrase "long wavelength" to mean something that takes place over a longer period of time than the usual business cycle.

Richard H. Serlin said...

Thank you Andy,

With regard to your pessimism, "Neither of these things is going to happen. Not in the current political climate, and not in any political climate that I can imagine over the next decade." Here is an idea for achieving strong action even in spite of the political mess: The use of reconciliation for a stimulus. How is this possible?

A stimulus can be done through reconciliation, and therefore need only 50 votes and the VP to break the tie, if it's deficit neutral. But how can it be deficit neutral and still be a stimulus?

The answer is that it must be deficit neutral over a period of 5 years. So, put in the spending now, and the tax increases, on the very wealthy, on pollution, to pay for it 3 or more years later. If the recession is not over by then, roll it over, that is do another one of these stimuli at that time.

It's not that unlikely that you can find 50 Democrats in their caucus of 60 that will support a very large stimulus, especially one that is deficit negative over 5 years. And I love the idea of making the stimulus as much as possible high return investments like infrastructure, alternative energy, education, which grow GDP long term and therefore decrease the government debt as a percentage of GDP.

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