Or why Ed Lazear should have heeded R&R a bit more.
From “Credit: A Starring Role in the Downturn,” by Òscar Jordà, based on an examination of 14 advanced economies over 140 years:
We are unlikely to learn how the United States will recover from the Great Recession by examining other post-World War II downturns. In the United States, the past six decades have completely lacked another financial event like the one experienced from 2007 to 2009. …
Professor Jorda’s reasoning:
Is the intensity of credit creation in the expansion phase systematically related to the severity of the subsequent recession? And is there a difference between how credit behaves in an ordinary recession versus how it performs in a recession associated with a financial crisis? The answers to both questions appear to be yes, and therein lie the lessons that can inform the economic outlook.
Broadly speaking, in a financial crisis, a large fraction of banking system capital becomes depleted. However, directly measuring such an effect can be difficult. An alternative is to look at the responses to capital depletion. Laeven and Valencia (2010) argue that, in a financial crisis, the banking system experiences significant financial distress that compels banking authorities to intervene. Examples of such intervention include liquidity support, guarantees on bank liabilities, asset purchases, nationalizations, restructuring, deposit freezes, and bank holidays. All these occurred after Lehman Brothers failed. Some were implemented even earlier, with the sale of Bear Stearns.
Jordà, Schularick, and Taylor (2011) find that, regardless of the genesis of the recession, more leverage results in deeper recessions and slower recoveries. Moreover, in financial crises, leverage is associated with a steeper and more persistent decline in consumption as households try to repair their balance sheets. Since consumption constitutes more than two-thirds of GDP, it is not surprising that losses in output follow a similar pattern.
I’m not exactly sure what point you are trying to make with the Lazear reference, but did you happen to note Figures 1 & 2, which according to the author show that “these figures display how much more severe and prolonged the falls in employment and investment have been in the most recent recession and recovery, eclipsing anything else observed in the United States during the post-World War II period.”
Does that mean you are now backtracking on your peculiar attempts to show the current recovery is not unusually bad? As a side note, I am disappointed (but not that surprised) to see you reprint one of the most widely used economic non sequiturs regarding the financial crisis:
“in financial crises, leverage is associated with a steeper and more persistent decline in consumption as households try to repair their balance sheets. Since consumption constitutes more than two-thirds of GDP, it is not surprising that losses in output follow a similar pattern.”
I have yet to hear a suitable explanation of this statement. In what economic model do recessions follow because agents allocate more resources to paying down debt versus consumption?
The point Chinn makes seems clear and telling. Lazear explicitly compared the 2008 recession to the 1981-2 recession. Now Jorda points out that you can’t do that. It’s comparing apples with oranges.
The problem is not one of quantity, but quality: the estructure and governing dynamics of a balance-sheet recession like the 1929 or 2008 recessions differ radically from the structure and governing dynamics of a central-bank-generated recession produced by the Fed stomping on the brake pedal with high interest rates. Krugman and DeLong and many other Keynesians have pointed this out repeatedly. DeLong made this point by citing a paper by Reinhart and Rogoff just 12 days ago.
Jeff: The title of Lazear’s article is “The Worst Economic Recovery in History”, not “The Worst Economic Recovery in US Post-WWII History”. But if it makes you happy to be leader of the “Lazear is right, and we should condition on size of downturn but not on financial crises” club, then by all means.
Actually, the comparison is not apples to apples, but fruit salad to fruit salad.
2008 was a financial crisis; 1979 was not.
However, both 1979 and 2008 were major oil shocks. In that sense, the periods are quite comparable, in fact, the two most comparable oil shocks in the entire record.
We are now living the mid-year 1980 to mid-year 1981 period. That ended in another recession. It also created, within four years, 25% excess production capacity in the oil supply, and that in turn under-pinned the Great Moderation.
There is no Great Moderation this time. The post-1979 period continues indefinitely. As I have stated before, I think the total oil supply peaks out late this year; an equity analyst friend of mine (a very good analyst, I might add) pegs the peak at Q2 2013.
In any event, we are going to be supply-constrained for transportation fuels until CNG-powered vehicles become widespread. GM, Ford and Chrysler just introduced a line of bi-fuel pick-ups. The transition has begun.
Jordà wrote:
…is there a difference between how credit behaves in an ordinary recession versus how it performs in a recession associated with a financial crisis?
Hmmm? And just what is an ordinary recession? Sounds like the myth of the magical automatic business cycle to me.
Laeven and Valencia (2010) argue that, in a financial crisis, the banking system experiences significant financial distress that compels banking authorities to intervene. Examples of such intervention include liquidity support, guarantees on bank liabilities, asset purchases, nationalizations, restructuring, deposit freezes, and bank holidays.
And it never occured to them that the very solutions that their crisis “compels” is what caused the problem and prolonged the problem. The late Jude Wanniski used to say that it was not the bad economics of the demand side economists that caused the problems but their policy reactions when their theories failed.
Steven Kopits wrote: “In any event, we are going to be supply-constrained for transportation fuels until CNG-powered vehicles become widespread. GM, Ford and Chrysler just introduced a line of bi-fuel pick-ups. The transition has begun.”
There’s a glut of natural gas in the US right now, but is it sufficient to meet all the demands that are planned for it: CNG-fueled vehicles; replacement of significant amounts of coal-fired generation in the Eastern Interconnect in response to the CSAPR; exports of LNG.
Jeff In what economic model do recessions follow because agents allocate more resources to paying down debt versus consumption?
In what economic model do recessions not follow when when aggregate demand contracts because paying down debt increases savings above planned investment?
Let’s jump into Mr. Peabody’s “Way Back Machine” and go back to a time of IS/LM curves and people like David Laidler worrying about money demand functions. During the 1981/82 recession no one believed the LM curve was flat. Quite the contrary. During late 2008/early 2009 no one believed the LM curve wasn’t flat. Except today we would call it an MP curve, but it’s just as flat. Thirty years ago the Fed had a lot of room to manuever. Today, not so much. The recessions of the early 80s were planned responses to an overheated economy rocked by “real” supply shocks. The Fed’s job was to hold down aggregate demand. The Great Recession was an unplanned response to credit markets freezing up. These are financial shocks, not “real” side shocks.
The question you should be asking is how to classify the 2001 recession.
Slug asked:
In what economic model do recessions not follow when when aggregate demand contracts because paying down debt increases savings above planned investment?
All but Keynesian mercantilism. Capital based economic models understand the function of savings. Demand theory models – significantly Luddite – essentially ignore the importance of capital.
Steve Kopits claimed: Actually, the comparison is not apples to apples, but fruit salad to fruit salad.
Sorry, that’s just not correct. Both 1929 and 2008 were balance sheet recessions in which credit is not a secondary actor but the prime mover in the downturn. In such an economy-wide credit crunch, central banks rapidly hit the zero bound and fiscal policy becomes unable to have much effect.
Steve goes on to claim: 2008 was a financial crisis; 1979 was not. However, both 1979 and 2008 were major oil shocks. In that sense, the periods are quite comparable, in fact, the two most comparable oil shocks in the entire record.
No, once again, sorry, but you have cheery-picked one minute factor which is negligible in comparison to the other driving forces in the 2008 financial collapse. The main driving forces were the tremendous buildup of a housing bubble larger than anything else on record in American history, and the simultaneous buildup of literally unmeasurable amounts of volatile junk-quality debt in the shadow banking system worldwide. No one really knows how big the bubble in CDAs and CDOs and other derivatives in the shadow banking system was circa 2007, but estimates I’ve seen place it around 90 trillion dollars. That’s more money than all the economies on earth.
Not even remotely comparable to the 1981-2 recession, which was caused by Volcker in the central bank raising the prime rate to historic levels.
Steve goes on to pile absurdity upon ludicrousness by asserting: We are now living the mid-year 1980 to mid-year 1981 period. That ended in another recession.
No, utterly wrong. This recession has not been caused by sky-high prime rates, but by the massive collapse of multiple speculative bubbles which generated so much debt that the entire world economy is now trapped in Keynes’ “paradox of thrift.” I.e., while it’s beneficial to each individual to stop spending and pay down debt, it’s fatal to the economy as a whole, since it destroys aggregate demand.
Steve doesn’t get it, just as Lazear doesn’t get it, and just as the Eurocrats in Brussels don’t seem to get it. This time really is different compared to all other postwar recessions. Because this time it’s not just a matter of lowering interest rates to the point where businesses will increase investment again and consumers will start purchasing again. Businesses and consumers can’t start purchasing again until they deleverage their Brobdingagian colossal crushing debt, and that’s going to take quite a few years.
And incidentally, when Steve or someone else starts ridiculing me for claiming “this time it really is different,” bear in mind that the San Francisco Fed is saying exactly the same thing.
I quote from the Federal Reserve Bank of San Francisco economic letter of 16 April 2012:
“From the Great Depression until the fall of Lehman Brothers, the United States did not experience any large-scale systemic banking crises. Modern macroeconomic models generally omitted banks and finance. But that did not seem to be a problem as long as the financial sector remained reasonably stable. In the waning years of the 20th century, there was ample support for such models. In the United States, output grew 4% annually, inflation ran about 2%, and unemployment was around 4%.
“The Great Recession upended this paradigm. Attention has focused once again on leverage and excess credit—the `Achilles’ heel of capitalism,’ in the words of James Tobin’s (1989) review of Hyman Minsky’s book Stabilizing the Unstable Economy. Of course, this was not the first such rude awakening. Economic history is replete with financial crises that force economists to relearn the role that credit plays in their genesis and aftermath. This Economic Letter reaches back 140 years, examining the experiences of 14 advanced countries, to document the enduring influence of credit in the economic fortunes of nations. Credit is critical to correctly understanding current economic events. The Great Recession broke the mold cast in the typical post-World War II downturn. The recovery appears to be following a different model as well.”
Source: Federal Reserve Bank of San Fransisco Economic Letter of 16 April 2012, “Credit: A Starring Role in the Downturn.”
The problem, it seems to me, is more fundamental than implied by the term “financial crisis.” It is the overhang of the excessive private debt incurred in a heyday of overarching expectations. The only way to cure the problem quickly is to have the debt renounced. That essentially requires destroying the financial sector that sits atop the pile and must take the first tranche of losses. The alternative is to suffer through a protracted period of deficient demand.
But the notion that we haven’t had a like experience in 60 years is apt in my view, and completely negates the value of econometric analysis of the situation based on the within-country post-war experience.