A Bursting Bubble Doesn’t Mean Engine Trouble

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David Brady's picture

A Bursting Bubble Doesn’t Mean Engine Trouble

At the start of the Great Depression, John Maynard Keynes wrote, “The world has been slow to realize that we are living this year in the shadow of one of the greatest economic catastrophes of modern history.” People soon began to doubt future growth prospects. But Keynes said they should not be pessimistic, “For the resources of nature and men’s devices are just as fertile and productive as they were.” Keynes explained that the economy was suffering from “magneto trouble.” The problem was not with the economic engine, which was still as strong as before, but instead a technical problem of weak global aggregate demand, which Keynes compared to a car’s magneto, or electrical system. Rather than an expensive new engine, the car simply needed a relatively cheap new battery to run again.12 Today, the world is trying to recover from the greatest economic catastrophe since the Great Depression. The recovery has stalled, just as it did throughout the 1930s. Nevertheless, global growth dynamics have not changed from before the crisis, and if the correct policies are taken to boost demand, the world economy will recover and growth will return to pre-recession levels.

Recessions typically are not as devastating as the one today, but this was not a normal recession. It resulted from a financial crisis, and recoveries that follow financial crises historically are weaker because they result in problems, like excessive household debt, which force people to dramatically reduce their spending. And after a severe financial crisis, the natural interest rate falls well below zero. This makes conventional monetary policy insufficient for promoting recovery. Thus, other policies, such as fiscal stimulus and unconventional monetary policy, must be used to restore full employment. Nevertheless, policymakers are reluctant to aggressively use these policies, which are why recoveries from severe financial crises have been weak. Moreover, this has been the only financial crisis during the postwar era that has affected the entire globe, which makes it difficult for countries to export their way to recovery. Therefore, one should not compare this recovery to those of other postwar severe financial crises such as Norway in 1987, Sweden in 1991, or Japan in 1992.3

Instead, it is more useful to compare it to the recovery of the Great Depression, whose causes and the global nature are very similar to today’s crisis. In both, a bursting housing bubble in the United States led to financial turmoil around the world. This turmoil dramatically reduced spending and caused a major shortfall in aggregate demand. Moreover, the Great Depression lasted for nearly ten years. For those who lived through it, it seemed as if it would never end. But after the correct policies finally went into effect, it did end. In the United States, this was not until World War II, when the military buildup provided the fiscal stimulus that the United States needed to boost aggregate demand and promote recovery. Moreover, abandoning the gold standard helped end the Great Depression. The gold standard caused a deflationary shock, and leaving it allowed countries to depreciate their currencies to regain competitiveness and boost output.4

So Keynes was right, and the world did recover from the Great Depression. But today many economists think that “this time is different.” For instance, many influential people say that growth dynamics have changed, and there is no quick solution because the problems are too deep and structural. For example, economist Jeffrey Sachs argues that “we need new economic strategies to overhaul broken systems” in the form of long-term structural reform. Sachs believes that unemployment is high because people lack the skills to compete in the new global economy.5 To be sure, scholars argued the same thing in 1939 in The American Economic Review. But two years later, after the United States began its military buildup for the war and thereby increased aggregate demand, employment rose twenty percent.6 Certainly there are structural issues today, such as health care costs, climate change, and inequality, which need to be addressed. Nevertheless, aggregate demand shortfall caused by the financial crisis, and not structural problems, accounts for high unemployment and the large output gap in economic growth. As Keynes noted, while the car is not in totally perfect condition, fixing its magneto, rather than replacing its engine, is all that is needed to get it moving again.

Today, policymakers are not heeding the lessons of the Great Depression; they are repeating the same mistakes. This is the most obvious in the focus on debt, austerity, and price stability. In Europe, the 2012 IMF World Outlook report indicates that the austerity policies are responsible for deepening the recession.7 Also, the euro is serving the function that the gold standard served during the Great Depression. Countries at the core of the eurozone, such as Germany, are near full employment, whereas the periphery countries, such as Spain, are deeply depressed. Because it shares a common currency, however, Spain cannot depreciate its currency to regain competitiveness. Currently, European leaders are favoring internal devaluation to promote recovery. This is ineffective because it is difficult to cut wages, and deflation in Spain would only worsen the debt problem. Just as European countries abandoned the gold standard during the Great Depression, Europe’s current leaders must do something similar. Since abandoning the euro is not a good option, they must change their strategy to close the structural imbalance between the eurozone’s core and periphery. Aggressive expansionary monetary policy from the ECB would increase aggregate demand in Europe, which would increase output and employment in Spain and other struggling countries. This would however lead to higher inflation in Germany. Germany and the ECB are currently unwilling to accept that, but for Europe to recover and the euro to survive, they must accept modestly higher inflation of around four percent.8

In the United States, meanwhile, the economy has remained depressed due to weak aggregate demand as households undergo deleveraging to pay down debts.9 Too much focus on the deficit instead of jobs has kept the United States as well as other countries like the United Kingdom from implementing sufficient economic stimulus to strengthen demand. Politicians and pundits have instead fixated on reducing the deficit and paying down national debt. Nevertheless, recovering from the global financial crisis should take priority. Therefore, these countries could take advantage of the record low interest rates that allow them to borrow money, basically for free, and end their self-defeating austerity. Since interest rates are at the zero bound, increases in government spending have a significant effect on raising GDP.10

During the Great Depression, preparing for World War II forced the U.S. government to quit obsessing over the deficit and to do just this. Nevertheless, a wasteful and destructive war does not have to be the only reason for stimulus, especially as this money could be spent on productive projects. The stimulus is needed in the United States to provide aid to state and local governments to rehire teachers who have been laid off. Also, the United States needs investments in infrastructure and other long-term investments for growth. In addition to the stimulus, debt relief could help struggling homeowners to refinance their underwater mortgages and promote a housing recovery. As the United States and European economies recover, this will allow emerging markets to increase their exports and end their slumps, restoring growth across the globe.

In conclusion, the recovery has stalled, but growth dynamics have not changed from before the global financial crisis. The same situation occurred throughout the 1930s, but once the correct policies finally went into place, the global economy recovered. There is no reason why this time needs to be different. When a car will not start, the problem is usually not the engine. Replacing the battery may be all that is needed. The global economic growth engine is still as strong as before.

References: 
  1. John Maynard Keynes, “The Great Slump of 1930” http://www.gutenberg.ca/ebooks/keynes-slump/keynes-slump-00-h.html
  2. Paul Krugman, End This Depression Now! W.W. Norton & Company, Inc. 2012. p. 22.
  3. Carmen M. Reinhart and Kenneth Rogoff, This Time is Different: Eight Centuries Of Financial Folly. Princeton University Press. 2011. pp. 230-248.
  4. Miguel Almunia, A. Bénétrix, B. Eichengreen, K.H. O’Rourke, and G. Rua, “From Great Depression to Great Credit Crisis: similarities, differences and lessons.” Economic Policy, 25: 219–265. doi: 10.1111/j.1468-0327.2010.00242.x. April 2010. http://onlinelibrary.wiley.com/doi/10.1111/j.1468-0327.2010.00242.x/full
  5. Jeffrey Sachs, “Move America’s Economic Debate Out of Its Time Warp.” Ft.com July 12, 2012, http://blogs.ft.com/the-a-list/2012/07/12/move-americas-economic-debate-...
  6. Paul Krugman, “A Structural Blast from the Past.” The Conscience of a Liberal. NYTimes.com. May 9, 2012, http://krugman.blogs.nytimes.com/2012/05/09/a-structural-blast-from-the-...
  7. IMF. “World Economic Outlook 2012.” Coping with High Debt and Sluggish Growth. International Monetary Fund. October 2012, http://www.imf.org/external/pubs/ft/weo/2012/02/index.htm
  8. Paul Krugman, “Internal Devaluation, Inflation, and the Euro (Wonkish).” The Conscience of a Liberal. NYTimes.com. July 29, 2012, http://krugman.blogs.nytimes.com/2012/07/29/internal-devaluation-inflati...
  9. Atif Mian and Amir Sufi, “What Explains High Unemployment? The Aggregate Demand Channel.” November 2011, economics.mit.edu/files/777
  10. Almunia et al.
  11. Almunia, Miguel, Bénétrix, A., Eichengreen, B., O’Rourke, K. H. and Rua, G. “From Great Depression to Great Credit Crisis: similarities, differences and lessons.” Economic Policy, 25: 219–265. doi: 10.1111/j.1468-0327.2010.00242.x. April 2010.http://onlinelibrary.wiley.com/doi/10.1111/j.1468-0327.2010.00242.x/full
  12. IMF. “World Economic Outlook 2012.” Coping with High Debt and Sluggish Growth.International Monetary Fund. October 2012.http://www.imf.org/external/pubs/ft/weo/2012/02/index.htm
  13. Keynes, John Maynard.“The Great Slump of 1930.”http://www.gutenberg.ca/ebooks/keynes-slump/keynes-slump-00-h.html
  14. Krugman, Paul. “Internal Devaluation, Inflation, and the Euro (Wonkish).” The Conscience of a Liberal. NYTimes.com. July 29, 2012.http://krugman.blogs.nytimes.com/2012/07/29/internal-devaluation-inflati...
  15. Krugman, Paul. End This Depression Now! W.W. Norton & Company, Inc. 2012.
  16. Krugman, Paul. “A Structural Blast from the Past.” The Conscience of a Liberal. NYTimes.com. May 9, 2012. http://krugman.blogs.nytimes.com/2012/05/09/a-structural-blast-from-the-...
  17. Mian, Atif and Amir Sufi. “What Explains High Unemployment? The Aggregate Demand Channel.” November 2011. economics.mit.edu/files/7771
  18. Reinhart, Carmen M. and Kenneth Rogoff. This Time is Different: Eight Centuries f Financial Folly. Princeton University Press. 2011.
  19. Sachs, Jeffrey. “Move America’s Economic Debate Out of Its Time Warp.” Ft.comJuly 12, 2012.http://blogs.ft.com/the-a-list/2012/07/12/move-americas-economic-debate-...