The Shape of the Downturn
Jo Walton Reviews Vernor Vinge’s "A Fire Upon the Deep"

Four Years After the Wake-Up Call

About four years ago exactly, we learned that we were in trouble. We had a housing boom driven by unrealistic expectations of house prices and mortgage costs that had created a housing overhang of overbuilding. Moreover, bankers who ought to have known better and had promised management and shareholders that they were originating-and-distributing securities that rested on a fundamental base of subprime mortgages had held onto such securities instead. The daily gyrations of the usually-placid Federal Funds market starting in late 2007 told us all that banks were really worried that other banks had jumped the shark and turned themselves insolvent.

FRED Graph  St Louis Fed 7

The Fed Funds Market since Last June

Four years ago nearly all mainstream economists would have said that, even though the situation appeared serious, by now the economy would be back to normal. Some of us would have said that within a couple of years the housing capital overhang would have been worked off--and it has--and so there would no longer be any real cause of recession. Some of us would have said that within a couple of years people would have adjusted their price expectations to the lower level consistent with the nominal shock of the flight to quality, and there would be no price-expectations reason for recession. Some of us would have said nominal shocks can disturb the labor market matching process, but not for long: that conditional on the absence of a current negative shock the unemployment rate jumps 40% of the way back to it's natural rate value in a year.

Very few of us thought that it would be long and nasty: Paul Krugman, Nouriel Roubini, and Raghuram Rajan are the only three names regularly on my must-read radar screen that come to mind--and none of them specifically feared that a subprime mortgage crisis would have catastrophic consequences. UPDATE: Dean Baker was warning very early that the housing crash was (a) inevitable and (b) would be log and nasty.

And as it turned out to be long and nasty, recent economic theories of macroeconomics have fallen like tropical rain forests. The--already implausible--claims that downturns had real causes? Fallen. The claim that downturns lasted only as long as workers misperceived their real wage? Fallen. The claim that the labor market cleared in a small number of years? Fallen. Those of us who believed that the long run came soon, that the cause of downturns was transitory price-level misperceptions, or that downturns had real causes need now to be looking for new jobs, or at least new theories.

And we are left with the live macroeconomic theories being those of the 1960s, at the latest. This is embarrassing for those of us who want to belong to a profession that is a progressive science, rather than an analogue of medieval barbering.

So what would the economic theories of the 1960s and before tell us to do?

  • Milton Friedman: monetary expansion, and more monetary expansion--quantitative easing as deep and as broad as necessary to get nominal GDP back to its trend.

  • John Maynard Keynes (or at least one of the moods of Keynes): have the government borrow and buy stuff, and keep buying stuff until real economic activity is back to some normal trend value.

  • Jacob Viner: Why choose? Do both! Print lots of money and have the government use it to buy stuff and hire people.

The odd thing is that none of those three recommended policies--all of which are sponsored by economists with the purest of purebred pedigrees--have been followed. We simply have not expanded government purchases as a share of potential GDP in this downturn:

FRED Graph  St Louis Fed 4

And while the Federal Reserve has taken the monetary base to previously-unimaginable levels--up from $900 billion to $1.7 trillion in late 2008, up to $2 trillion in let 209, and up to $2.7 trillion in early 2011--it has never adopted Milton Friedman's recommended policy that it start buying bonds for cash and keep buying bonds for cash until nominal spending is on the path that the Federal Reserve wants it to be on:

FRED Graph  St Louis Fed 5

And so right now nominal GDP is $15 trillion/year when it ought to be $16.7 trillion/year:

FRED Graph  St Louis Fed 6

It is not as though anybody is happy with 9% plus unemployment, is it?