Understanding the Lesser Depression

**J. Bradford DeLong, U. C. Berkeley, August 2011

(1) Background

1.2 What Happened: A First Cut

Economists' Wrong Explanations

Economists have a number of theories of why the downturn that started the Lesser Depression was so large and why the recovery from it has been so slow—indeed, to date nonexistent. Some of these theories, those put forward by economists whom Rüdiger Dornbusch would classify as “plumbers”, are simply wrong. We can dispose of them quickly.

A Great Forgetting?: A first group, headed by Arizona State University’s Edward Prescott, has argued for decades that business cycles are the result of—and are socially optimal responses to—uncertainty and stochastic variation in the rate of technological change.

It is certainly the case that good news about technology can produce a boom, with rapidly growing output and employment and productivity above trend: recall the second half of the 1990s. And it is certainly the case that bad news about resource availability can produce a downturn: that was certainly part of 1973-1975 and 1979-1982, and perhaps the larger part of 1973-1975.

But technology does not regress: we do not forget how to make and do things, and thus Prescott’s attempt to attribute a sharp downturn in employment and production to some change in economically-applicable technology—to a “great forgetting”—seems doomed to failure. Indeed, in our Lesser Depression the argument seems to go the wrong way: it is not that the productivity of American workers today is lower than in the past or lower than expected back in 2006, it is rather higher.

A Great Vacation?: A second group, of which the most vocal member is the University of Chicago’s Casey Mulligan, claims that downturns come when workers lose their taste for employment, and that you can tell that this is so by looking at the “Douglas formula” relating movements in labor productivity relative to trend to movements in employment relative to trend.

Indeed, as of the second quarter of 2011 labor productivity was 5% above its 2003-2007 trend, which Mulligan claims reflects a decline in desired work hours by American workers of 15%—much more than the decline in work hours actually seen in the Lesser Depression. According to Mulligan’s theory, the entire fall in the employment-to-population ratio is simply the result of American workers’ sudden desire to work less: to take a great vacation—itself induced, he claims, by the fact that if you have no job the Obama Administration will pressure your lender to reduce the principal amount you owe on your mortgage. 
The big problem with Mulligan’s story is that people did not quit their jobs in unusual numbers in 2008 and 2009: instead, they were fired.

Firings went up, quits went down, and more important new hires went down as firms that would otherwise have expanded found that they did not have the customers to justify expanding employment. Mulligan never asked the very first reality-check question: does my theory of why fewer people are at work today fit with the process of how the decline in employment actually took place? The answer is that it does not.

Most important of all, however, is the question of how the unemployed feel about their status. In Mulligan’s theory they are happy not to have jobs: they could get jobs at the prevailing wage that others are getting, and have decided not to. But few of America’s unemployed today are at all happy with their situation.

A Great Europeanization?: A third group, headed by the University of Chicago’s Robert Lucas believes that the failure of the employment-to-population ratio to recover to normal levels is due to fear of the policies of President Barack Obama. Lucas believes that “[o]ur economy has got a remarkable ability to return to its long term growth trend... quick[ly]: two or three, four years...” But things were not back to normal by 2009, or 2010, or 2011. Lucas’s conclusion? This: 

Liquidity is no longer the problem.... Yet business investment remains very low.... [T]he problem is government is doing too much.... Likelihood of much higher taxes, focused on the “rich”. Medical legislation that promises large increase in role of government. Financial legislation that assigns vast, poorly-defined responsibilities to Fed, others. Are these conditions that foster a revival in business investment, consumer spending?

But the answer appears to be “yes, it is”.

Business spending on equipment and software has recovered very well from its downturn, and is in no wise dragging the economy down by doing worse than average. It is other components of spending—housing construction, government employment, consumer spending by middle-class households now far underwater with their home mortgages—that has failed to recover. The claim that business fear of Obama’s policies is at the root of slow recovery does not seem to pass its first consistency checks with the data.

Paul Krugman observes that much of Lucas’s confidence in his Obama-centric explanation comes from yet another failure of Lucas to mark his beliefs to reality. Obama’s policies have attempted (so far without any notable success) to move the structure and function of the American government closer to those seen in more social democratic western Europe. And it is an item of conservative faith that in western European countries red tape strangles employment and enterprise. A case for such an argument could have been made from the mid-1980s—but not before—until the end of the 1990s—but not since.

Government Guarantees: Yet a fourth group believes that excessively-generous government loan guarantees induced too many working-class households who could not afford to carry mortgages to buy houses and thus too many American construction workers to build too many houses. Since the market system cannot easily deploy the construction workers elsewhere—they are, when not engaged in building houses, zero marginal product workers—we are doomed to suffer depression until the overhang of excess houses constructed during the 2000s housing bubble is worked off.

The problem here is once again a failure to mark the theory to market. During the boom of the 2000s America built perhaps five million houses above trend and financed them with mortgages on which perhaps $100,000 per mortgage will never be paid back. That is a total economic loss to investors in the housing sector due to overconstruction of $500 billion dollars. But the world economy had, in 2007, $80 trillion total of financial wealth. How can a $500 billion loss bring an $80 trillion wealth economy into a depression? That question is never answered.

Moreover, the claim that we have to wait until the overhang of bad capital investment produced by the housing bubble is worked-off would lead us to predict that the U.S. economy would by now be in a healthy boom, because the overhang of housing construction has been worked off. As Figure 11 shows, the housing boom that led to above-trend housing construction has been followed by a housing bust of below-trend housing construction: we now have perhaps one million fewer houses than a simple extrapolation of pre-bubble trends would predict. When people become tired of living in their sisters’ or their in-laws’ basements and resume normal housing purchase patterns we will find that we have not an overhang but a shortage of housing investment.

I believe that all four of these theories illustrate one of the great vices of economics—what Joseph Schumpeter in called “the Ricardian vice”.8 People have started from what they take to be obvious principles of human psychology and markets—that people seeking their own welfare trading in markets will create an efficient system of production in the case of the “great forgetting” and the “great vacation” explanations, that high taxes and tight regulations can impoverish an economy in the “great Europeanization” explanation, and that government guarantees in finance induce “heads we win—tails the government behaves” behavior by lenders—and reasoned to what they take to be logical conclusions without ever doing the elementary sanity or reality checks. The fact that this goldsmith-like reasoning can go so awry in the hands of those who are not very skillful at it or not terribly grounded in reality was the reason that Rüdiger Dornbusch scorned those economists whom he called “plumbers”.

You need to be aware that these theories are out there. And you need to be able to rebut them. But once you are aware of them and do know how to rebut them, do not let them trouble you further.

Let us turn, instead, to attempts to understand the origins and persistence of our Lesser Depression that have promise.