How Recessions End

Recessions eventually end without government intervention, but it is likely to take a lot longer to happen.  Before Keynes, most classical economists thought that recessions were natural, inevitable, and even a good thing.  After a decade of the Great Depression in his cushy Harvard job, Austrian-educated economist Joseph Schumpeter said in 1939:

Commonly, prosperity is associated with social well-being, and recession with a falling standard of life. In our picture they are not, and there is even an implication to the contrary.  

In other words, Schumpeter thought that recessions may be associated with social well-being and economic expansions with a falling standard of living!  He explained that this is because:

…Times of innovation…are times of effort and sacrifice, of work for the future, while the harvest comes after.…The harvest is gathered under recessive symptoms and with more anxiety than rejoicing.…[During] recession…much dead wood disappears.  BC, 142-143.

So recessions are good because they are like a harvest festival when productive people can enjoy thanksgiving for their leisure as they enjoy their past “effort and sacrifice” and unproductive (people? capital? businesses?) are “dead wood” that must be pruned at during recession!  That is a really bad metaphor.  Similarly, Hayek thought that a fiscal or monetary stimulus could only make a recession worse and that they must end of their own accord without any effort to ameliorate them.   

How Recessions End:

1. Government monetary or fiscal stimulus makes markets clear.
2. Increase in ROI of new capital increases investment. 
1. Depreciation of old capital stock increases ROI of new capital:
• Keynes explained that capital decays and becomes obsolete over time until it becomes scarce enough to make replacement highly profitable. 
• Consumer durables also depreciate.  The US automobile fleet is older than ever and the number of housing units per capita has not been this low in many years. 
2. Technological advances increase ROI of new capital.  
3. Bankruptcy, savings, and refinancing repair balance sheets.  Liquidity constrained consumers and businesses feel free to borrow and spend again. 
4. Prices eventually get flexible in the long run and markets clear.  E.g.: real wages and housing prices drop reducing unemployment and increasing housing sales.  Nominal housing prices rise again and construction begins. 

As Krugman says, without positive government monetary or fiscal stimulus (#1 above), the adjustment, can go on for a long, long, long, long time.  

So let’s look at the NBER business cycle data. What we see is that some of those prewar slumps were really, really long: the Panic of 1873 was followed by a recession that lasted 5 1/2 years.

The NBER data shows that recessions have been getting shorter and less frequent, so something has been helping and better monetary policy (and automatic fiscal stabilizers) are probably part of the reason. 

BUSINESS CYCLE DATES		DURATION IN MONTHS
		Contraction	Expansion
		Peak to Trough	Previous trough to this peak
1854-1919 (16 cycles ‘Free’ Market) 1919-1945 (6 cycles Fed Era) 1945-2009 (11 cycles Keynesian Era)		22 18 11	27 35 59

The Crisis We Should Have Had and Still Might

An interesting question is why didn't we have the economic crisis that most economists thought we would have when the housing bubble popped.  One reason is that savings does not equal investment.  The crisis was supposed to be a credit crunch when developing countries decided to stop saving their money and loaning it to us.  However, that never happened and foreigners kept trying to loan money to the US.  Secondly, the real estate and financial bubble was only partly related to the foreign inflows and its popping is completely unrelated.  Moneybox:  

...Some people sat around looking at the US economy from 2002-2006 and thought all was well. But many people looked at it and could see clearly that all was not well. That we were on an unsustainable path and that we were primed for a crash. The main feature of the unsustainable path was huge inflows of foreign capital into AAA-rated American financial instruments, including US gvoernment debt, mortgage-backed securities, etc. These unsustainable flows were distorting employment patterns and sustaining unsustainable living standards. Americans were maintaining broad-based consumption growth only through excessive household indebtedness and underpayment of taxes relative to the quantity of services being received. Someday soon, the capital flows would come to an end and we'd have a version of a classic developing economy sudden stop of "hot money," except it would be happening to a rich industrialized nation. The value of the dollar would crash, restraining inflation would require high interest rates, and the US economy would feature a period of painful restructuring.

There was no particular reason to believe that this crisis would lead to a prolonged period of mass unemployment since the dollar crash would facilitate exports (including tourism) and import-competing industries, but it would very possibly create a stubbord residual of long-term unemployed people. What's more, it would be a prolonged crisis in American living standards.
...But this is not the crisis we're having. Interest rates are low. Headlines tell us that "U.S. Factories Could Suffer From Dollar’s Appeal". I'm inclined to think that we will, at some future point, face the crisis we should have had and it will need to be addressed in complicated ways. But the crisis we're having is, for all its horror and scale, a pretty banal monetary crunch—the natural rate of interest is below zero, nomimal rates can't go below zero, and the Fed won't act to push real rates lower. Fixing that wouldn't fix "all our problems" any more than ending the Great Depression solved all the problems of the America of its time (Jim Crow, anyone?) but it would solve the problem and it doesn't require us to fix the other stuff first.

Accounting Identities

Krugman says that certain accounting identities are laws that are true, but then he gives laughably incomplete examples that are nowhere near true.  The incompleteness of the first is obvious because he immediately contradicts it with his second "identity".
(1)  Savings = Investment       (S=I)

Which he immediately contradicts with his second law:
(2)  Savings-Investment = NetExports      (S-I=NX)

In reality, both "identities" are woefully incomplete.  The true identity is:
(3)  Savings-Investment = NetExports + liquidity changes      (S-I=NX-l)

The last term (l) is the increase in the money supply due to a decreasing gap between savings and lending.  If I increase my savings by putting cash in my mattress, that increase in savings is subtracted from the money supply and has no impact upon investment.  Similarly, if the bank that has my savings  increases its reserves without lending it out, then there is a decrease in investment without any change in savings.  Or if the bank stops lending to businesses and buys government bonds instead, then there is no impact on investment because government spending is irrationally immune to reductions in the interest rate.  Increased spending on government bonds just increases their prices (which lowers their interest rates) and this absorbs liquidity because the supply of government bonds is perfectly inelastic with respect to the interest rate. 

The perfectly inelastic supply of bonds means that greater expenditures are spent buying exactly the same quantity of bonds and this reduces the liquidity of the economy by the area of the rectangle between the dotted lines at P1 and P2. 

Krugman notes that the first identity, (S=I), is often misinterpreted to come up with Say’s Law and/or the Treasury view.  The second identity, (S-I=NX), is often misinterpreted to come up with the doctrine of immaculate transfer.  But these misinterpretations happen because our identities are incorrect.  The Say's Law/Treasury view would be impossible if we used a true identity that does not leave out important leakages, and the doctrine of immaculate transfer would be much less likely to arise because changes in liquidity have obvious impacts upon exchange rates. 

Occam's Razor should not be a reason to sacrifice the additional complexity at the altar of simplicity.  An equation with four variables is still much simpler than most of the equations used in economics or even the rest of science.  The quintessential beautiful equation, E=MC², may appear to have only three variables, but it also has an exponent and the speed of light is really the product of two variables (time and distance), so it isn't really any simpler than S-I=NX-l.  And it is better to start with the complete equation and cross off variables in special cases rather than start with the special cases.  In a closed economy, NX=0 and in a perfect economy l=0, and then you get S=I, but this is often passed off as the basic way that the economy works when it is always and everywhere a completely unrealistic simplification.  Why make the unrealistic simplification the base case rather than use the realistic equation as the base case?

The l adds in the Wicksellian concept that S≠I and that whenever there is suddenly a big increase in the gap between S and I, the real interest rate is out of whack and that causes a recession.  That is a pretty important concept.  It is the link between old-fashioned (non-monetary) Keynesianism and Monetarism. It is the link between Y=C+I+G+NX and MV=PY.  

Now what about MV=PY?  Is something important left out of that too?  The actual measurements of these variables seem to contradict the equation.  Is it measurement error or are we leaving an important variable out of the "identity" again?  Y=C+I+G+NX seems to match its measurements pretty well.

RBC at the Fed

RBC theory says that monetary policy only affects inflation and has no effect on unemployment and growth.  This matters because if monetary policy only affects inflation, then there is no special role for monetary policy during a recession except that people generally like inflation to be low and stable. That is probably why Richmond Federal Reserve President Jeffrey Lacker doesn't seem to understand that his job at the Fed is to fight unemployment during recessions by boosting growth.  Yglesias quotes Lacker:

“The Fed doesn't control growth. We can interfere with it. We can impede it,’’ Lacker said. “But in general the growth rate the economy can crank out is determined by technology, people's preferences, resource endowments, other policies and the like. Our job is to keep inflation low and stable.”

"Lacker ought to check the Fed's own FAQ page:"

The Congress established two key objectives for monetary policy--maximum employment and stable prices--in the Federal Reserve Act. These objectives are sometimes referred to as the Federal Reserve's dual mandate. The dual mandate is the long-run goal for monetary policy, and the Congress also established the Federal Reserve as an independent agency to help ensure that this monetary policy goal can be achieved.

Not low and stable, but stable and consistent with maxmimum employment. Different! ...If you have unemployed workers and idle capital goods then you're cranking out less than you could because monetary policy is too tight. Conversely, if you try to push total economy-wide spending above the economy's capacity to produce goods and services then money is too loose and you'll get inflation. The way Lacker describes it, there's no state of the world that would constitute money being excessively tight.

If the Fed truly didn't have any impact on growth and unemployment (which are tightly linked by Okun's law), then what have they been doing at all of those meetings??  It would be extremely easy to do monetary policy if inflation really were the only concern.  Inflation is almost never troublesome during a recession.  And RBC theory also says that inflation does not have any impact on growth and unemployment, so the real question is why does Lacker even care about inflation???

Interest Rate Equilibriates Savings and Investment: Wicksel

Moneybox:

Swedish economist Knut ...Wicksell argued that there is a “natural rate of interest,” at which desired savings is balanced by desired investment and the economy suffers from neither inflation nor massive excess capacity. A recession occurs when the natural rate of interest falls below the actual interest rate. Instead of savings being channeled into investment and driving the economy forward, firms and households start merely hoarding and the economy stalls, leaving workers and equipment idle.

Wicksell’s work leaves open the question of why the natural rate of interest might rise or fall, so it doesn’t make for much of a causal theory of recessions. But under normal circumstances central bankers can cure recessions by cutting interest rates to bring them closer to the natural rate. This brings saving and investment back into equilibrium and ensures that resources are put to good use.

Unfortunately, the financial crisis we’ve been suffering through pushed the natural rate very low—below zero. The Fed can’t set the nominal interest below zero, and has steadfastly refused to engage in the variety of “unorthodox” measures that would push real rates lower...

The Fed knows it could do more, but it would probably only do more if the economy hurt the profits at Wall Street Banks.  The Fed simply does not care enough about unemployment to try to use its "unorthodox" tools.  We need unorthodox tools because of the liquidity trap.  President Bush's chief economist, Greg Mankiw estimates that we needed unorthodox monetary policy:

I wrote a paper on monetary policy in the 1990s .... I estimated the following simple [Taylor rule] formula for setting the federal funds rate:

Federal funds rate = 8.5 + 1.4 (Core inflation - Unemployment).

Here "core inflation" is the CPI inflation rate over the previous 12 months excluding food and energy, and "unemployment" is the seasonally-adjusted unemployment rate. The parameters in this formula were chosen to offer the best fit for data from the 1990s....
Eddy Elfenbein has recently replotted this equation.  Here it is:

The interest rate recommended by the equation is the blue line, and the actual rate from the Fed is the red line.

Not surprisingly, the rule recommended a deeply negative federal funds rate during the recent severe recession.  Of course, that is impossible, which is why the Fed took various extraordinary steps to get the economy going.  But note that the rule is now moving back toward zero.  As Eddy points out, "At the current inflation rate, the unemployment rate needs to drop to 8.3% from the current 8.5% for the model to signal positive rates. We’re getting close."

I won't go on record to predict that we are only 0.2 percentage points of unemployment away from rapid growth, because the sort of "Taylor rule" ideal (the blue line) that Mankiw estimated is always changing and it is easier to plot in hindsight, but I agree that we are getting closer to the tipping point where faster recovery is likely. 

Unemployment and New College Grads

 CS Monitor:

According to a recent piece in the New York Times, about half of the class of 2010 still hadn’t found a job almost a year later. (By contrast, 90 percent of the classes of 2006 and 2007 already had jobs a year later). ...Economists and social observers now talk about a lost mini-generation, fearing these recent grads will never catch up financially because the lower your starting salary, the smaller your earning potential over time.

 CNBC:

It's official: The housing crisis that began in 2006 and has recently entered a double dip is now worse than the Great Depression.

Prices have fallen some 33 percent since the market began its collapse, greater than the 31 percent fall that began in the late 1920s and culminated in the early 1930s, according to Case-Shiller data.