Diagnosing (economic) depression

With all the rhetoric (and blog posts) about a potential economic depression, The Economist offers a means to diagnose the differences between a recession, a depression and a Great Depression. From the story:

THE word “depression” is popping up more often than at any time in the past 60 years, but what exactly does it mean? The popular rule of thumb for a recession is two consecutive quarters of falling GDP. America’s National Bureau of Economic Research has officially declared a recession based on a more rigorous analysis of a range of economic indicators. But there is no widely accepted definition of depression. So how severe does this current slump have to get before it warrants the “D” word?

A search on the internet suggests two principal criteria for distinguishing a depression from a recession: a decline in real GDP that exceeds 10%, or one that lasts more than three years. America’s Great Depression qualifies on both counts, with GDP falling by around 30% between 1929 and 1933. Output also fell by 13% during 1937 and 1938. The Great Depression was America’s deepest economic slump (excluding those related to wars), but at 43 months it was not the longest: that dubious honour goes to the one in 1873-79, which lasted 65 months...

Before the 1930s all economic downturns were commonly called depressions. The term “recession” was coined later to avoid stirring up nasty memories. Even before the Great Depression, downturns were typically much deeper and longer than they are today (see right-hand chart). One reason why recessions have become milder is higher government spending. In recessions governments, unlike firms, do not slash spending and jobs, so they help to stabilise the economy; and income taxes automatically fall and unemployment benefits rise, helping to support incomes. Another reason is that in the late 19th and early 20th centuries, when countries were on the gold standard, the money supply usually shrank during recessions, exacerbating the downturn. Waves of bank failures also often made things worse.

But a recent analysis by Saul Eslake, chief economist at ANZ bank, concludes that the difference between a recession and a depression is more than simply one of size or duration. The cause of the downturn also matters. A standard recession usually follows a period of tight monetary policy, but a depression is the result of a bursting asset and credit bubble, a contraction in credit, and a decline in the general price level. In the Great Depression average prices in America fell by one-quarter, and nominal GDP ended up shrinking by almost half. America’s worst recessions before the second world war were all associated with financial panics and falling prices: in both 1893-94 and 1907-08 real GDP declined by almost 10%; in 1919-21, it fell by 13%...

Where does that leave us today? America’s GDP may have fallen by an annualised 6% in the fourth quarter of 2008, but most economists dismiss the likelihood of a 1930s-style depression or a repeat of Japan in the 1990s, because policymakers are unlikely to repeat the mistakes of the past. In the Great Depression, the Fed let hundreds of banks fail and the money supply shrink by one-third, while the government tried to balance its budget by cutting spending and raising taxes. America’s monetary and fiscal easing this time has been more aggressive than Japan’s in the 1990s.

However, these reassurances come from many of the same economists who said that a nationwide fall in American house prices was impossible and that financial innovation had made the financial system more resilient. Hopefully, they will be right this time. But this crisis was caused by the largest asset-price and credit bubble in history—even bigger than that in Japan in the late 1980s or America in the late 1920s. Policymakers will not make the same mistakes as in the 1930s, but they may make new ones.

Click here for full story.

Worst financial crisis since the 1930s?

Although it's unlikely that we'd see the same type of market unraveling that led to the Great Depression, the degree of the crisis is leading many to claim that it's the worst since the 1930s. Although the U.S. now has policies in place to avoid another Depression, the road ahead is still uncharted. From a Wall Street Journal article:

The financial crisis that began 13 months ago has entered a new, far more serious phase.

Lingering hopes that the damage could be contained to a handful of financial institutions that made bad bets on mortgages have evaporated. New fault lines are emerging beyond the original problem -- troubled subprime mortgages -- in areas like credit-default swaps, the credit insurance contracts sold by American International Group Inc. and others. There's also a growing sense of wariness about the health of trading partners...

The consequences for companies and chief executives who tarry -- hoping for better times in which to raise capital, sell assets or acknowledge losses -- are now clear and brutal, as falling share prices and fearful lenders send troubled companies into ever-deeper holes...

Each episode seems to bring government intervention that is more extensive and expensive than the previous one, and carries greater risk of unintended consequences.

Expectations for a quick end to the crisis are fading fast. "I think it's going to last a lot longer than perhaps we would have anticipated," Anne Mulcahy, chief executive of Xerox Corp., said Wednesday.

"This has been the worst financial crisis since the Great Depression. There is no question about it," said Mark Gertler, a New York University economist who worked with fellow academic Ben Bernanke, now the Federal Reserve chairman, to explain how financial turmoil can infect the overall economy. "But at the same time we have the policy mechanisms in place fighting it, which is something we didn't have during the Great Depression."...

The U.S. financial system resembles a patient in intensive care. The body is trying to fight off a disease that is spreading, and as it does so, the body convulses, settles for a time and then convulses again. The illness seems to be overwhelming the self-healing tendencies of markets. The doctors in charge are resorting to ever-more invasive treatment, and are now experimenting with remedies that have never before been applied...

Fed and Treasury officials have identified the disease. It's called deleveraging, or the unwinding of debt. During the credit boom, financial institutions and American households took on too much debt. Between 2002 and 2006, household borrowing grew at an average annual rate of 11%, far outpacing overall economic growth. Borrowing by financial institutions grew by a 10% annualized rate. Now many of those borrowers can't pay back the loans, a problem that is exacerbated by the collapse in housing prices. They need to reduce their dependence on borrowed money, a painful and drawn-out process that can choke off credit and economic growth.

At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets...

Deleveraging started with securities tied to subprime mortgages, where defaults started rising rapidly in 2006. But the deleveraging process has now spread well beyond, to commercial real estate and auto loans to the short-term commitments on which investment banks rely to fund themselves. In the first quarter, financial-sector borrowing slowed to a 5.1% growth rate, about half of the average from 2002 to 2007. Household borrowing has slowed even more, to a 3.5% pace...

Hedge funds could be among the next problem areas. Many rely on borrowed money to amplify their returns. With banks under pressure, many hedge funds are less able to borrow this money now, pressuring returns. Meanwhile, there are growing indications that fewer investors are shifting into hedge funds while others are pulling out. Fund investors are dealing with their own problems: Many have taken out loans to make their investments and are finding it more difficult now to borrow.

That all makes it likely that more hedge funds will shutter in the months ahead, forcing them to sell their investments, further weighing on the market...

This crisis is complicated by innovative financial instruments that Wall Street created and distributed. They're making it harder for officials and Wall Street executives to know where the next set of risks is hiding and also contributing to the crisis's spreading impact...

The latest trouble spot is an area called credit-default swaps, which are private contracts that let firms trade bets on whether a borrower is going to default. When a default occurs, one party pays off the other. The value of the swaps rise and fall as the market reassesses the risk that a company won't be able to honor its obligations. Firms use these instruments both as insurance -- to hedge their exposures to risk -- and to wager on the health of other companies. There are now credit-default swaps on more than $62 trillion in debt, up from about $144 billion a decade ago...

Few financial crises have been sorted out in modern times without massive government intervention. Increasingly, officials are coming to the conclusion that even more might be needed. A big problem: The Fed can and has provided short-term money to sound, but struggling, institutions that are out of favor. It can, and has, reduced the interest rates it influences to attempt to reduce borrowing costs through the economy and encourage investment and spending.

But it is ill-equipped to provide the capital that financial institutions now desperately need to shore up their finances and expand lending...

One pleasant mystery is why the crisis hasn't hit the economy harder -- at least so far. "This financial crisis hasn't yet translated into fewer...companies starting up, less research and development, less marketing," Ivan Seidenberg, chief executive of Verizon Communications, said Wednesday. "We haven't seen that yet. I'm sure every company is keeping their eyes on it."

At 6.1%, the unemployment rate remains well below the peak of 7.8% in 1992, amid the S&L crisis.

In part, that's because government has reacted aggressively. The Fed's classic mistake that led to the Great Depression was that it tightened monetary policy when it should have eased. Mr. Bernanke didn't repeat that error. And Congress moved more swiftly to approve fiscal stimulus than most Washington veterans thought possible...

But the risk remains that Wall Street's woes will spread to Main Street, as credit tightens for consumers and business. Already, U.S. auto makers have been forced to tighten the terms on their leasing programs, or abandon writing leases themselves altogether, because of problems in their finance units. Goldman Sachs economists' optimistic scenario is a couple years of mild recession or painfully slow economy growth.

Economists debate depth of downturn

A v-shaped recession? U-shaped? How bad will it be? Will it turn into a depression? At this point, a depression is unlikely, at least according to a group of economists contacted for a story in the New York Times (via Patrick.net):

Even if the economy continues to deteriorate, economists generally agree that the United States is not heading for another Great Depression. Not only are the conditions far less dire, eight economists said in interviews, but the government is playing a heightened role in trying to cushion the impact of the housing downturn, losses at financial institutions and rising unemployment.

“The government is larger now and it acts as an anchor,” said Richard Parker, senior fellow at the Shorenstein Center at Harvard. “During the Great Depression, the government had neither the means nor the capability to serve as a backstop.”

But the economists — who range from academics to policy researchers, liberals to conservatives — disagreed about just how bad this economic slowdown, led by the worst housing slump since the Depression, could be...

Most of the economists who were interviewed blamed Alan Greenspan, the chairman of the Federal Reserve from 1987 to 2006, for his unwillingness to clamp down on either the technology stock bubble or the run-up in housing prices.

“The Fed isn’t the whole story, but it’s a big part of it,” said Gerald P. O’Driscoll Jr., who was vice president of the Federal Reserve Bank of Dallas from 1982 to 1994 and is now a senior fellow at the Cato Institute, a libertarian research organization in Washington. “It allowed these absolutely insane bubbles to happen. The lesson is, you can’t let these bubbles continue unabated with no policy making.”

But the economists said others were to blame, too: investors, banks and rating agencies, as well as the current chairman of the Federal Reserve, Ben S. Bernanke, and the Clinton and Bush administrations...

The economy’s woes might have been preventable, the economists all agreed, if the actors involved had made more realistic assumptions about the future. And about the laws of gravity.

“People are way too willing to extrapolate from history,” said Jan Hatzius, chief domestic economist at Goldman Sachs. “If it’s 2005, you can’t look at a 40-year run of data and say, ‘It must be a law of nature that housing prices never fall.’ ”...

All the economists agreed that regulators should have been looking more closely at Fannie and Freddie.

“Everybody turned a blind eye,” Mr. O’Driscoll of the Cato Institute said. “The Fed deliberately and consciously refused to regulate the mortgage industry like it was supposed to have done. I’m not a big fan of government regulation, but sometimes the government can do something to help — and in those cases, it has to.”

Ah, the power of 20/20 hindsight.

Why another Great Depression is unlikely

With the housing bubble blogosphere abuzz lately with posts and comments predicting another Great Depression, L.A. Times writer Michael A. Hiltzik provides an excellent overview of how things are different this time around:

Dysfunctional capital markets, frantic central banks, stressed-out consumers, fear and uncertainty -- all are alarming echoes of the global economic cataclysm of the 1930s.

Which raises the inevitable question: Could another Great Depression be lurking over the horizon?...

On the surface, there are disquieting parallels between economic conditions in the early 1930s and those of today. There is the popping of enormous asset bubbles -- stocks then, housing now.

And, as in the Great Depression, the financial system is in disarray. It was symbolized back then by the failure of thousands of banks, mostly small, local outfits -- 2,300 in 1931 alone.The parallel today is the crippling ofonetime giantssuch as Bear Stearns Cos., Countrywide Financial Corp. and Ameriquest Mortgage Co.

Many economists believe that the U.S. will find it almost impossible to avert a recession, if one has not started already. Housing remains mired in a deep slump,with some analysts projecting that Southern California home values could plunge 40% from their peaks last year.The Commerce Department reported this week that new residential building permits nationwide plummeted 36.5% in February from a year earlier.

Then, like now, stock prices were highly volatile. The S&P 500 index, which fell more than 56% from 1928 through 1940, nevertheless recorded four up years in that span, including a 46.5% gain in 1933....

BUT

But there are vast differences between the 1930s and today. U.S. unemployment reached 25% during the Depression; last month it was reported at 4.8%. The international industrial economy was a shambles in the '30s. Today it is coming off a global boom....

Economists and historians say the most important difference between today's economic environment and the old days is the government's role.

"There's a perception now that you don't stand around at the central bank and whack people with a ruler for making bad decisions," said Robert Brusca, chief economist at New York-based Fact and Opinion Economics. "Instead, you do something."

Nothing demonstrates that as vividly as the Fed's orchestration of the takeover of Bear Stearns by JPMorgan Chase & Co. over the weekend. The deal staved off a possible Bear bankruptcy, which the central bank feared might traumatize financial systems worldwide.

The resolution drew a stark contrast with the Fed's role in the 1930 collapse of the Bank of the United States, a New York institution largely serving Jewish immigrants. The failure was then the largest in U.S. history, and the Fed's inability to arrange a rescue by Wall Street banks -- including J.P. Morgan & Co., the predecessor to the "white knight" in the Bear Stearns case -- caused a cataclysmic loss of confidence in the entire national banking system. That fueled a panic that historians regard as a key cause of the Depression.

The Fed's relative powerlessness in 1930 led directly to New Deal reforms that vastly expanded its authority. Some of the agency's new powers, such as its ability to lend directly to brokers and investment banks, were seldom or never used until the current crisis.

Fed Chairman Ben S. Bernanke, an expert in the central bank's Depression-era history, is also knowledgeable about the instruments at its disposal in a crisis...

But as Fed Vice Chairman Donald L. Kohn conceded in testimony before a Senate committee this month, the most serious challenges generally arise not from scenarios that can be forecast but from the unforeseen.

Alluding, in effect, to the tendency of regulated industries to burst at their weakest seams, Kohn blamed "the most sophisticated banks" for allowing credit rating agencies such as Moody's and Standard & Poor's to paper over the unsoundness of mortgage securities on their books.

The agencies bestowed lofty AAA ratings on some extremely complex mortgage bundles even though their inherent risks were not understood. The banks and firms that packaged the securities and hawked them to clients simply accepted the rating agencies' conclusions, which were often favorable to the packagers. The dubious valuations of many of these securities are at the core of the credit crisis roiling the financial markets today...

There are also limits to what monetary policy -- the Fed's responsibility -- can achieve on its own to forestall a drastic economic downturn. The Franklin D. Roosevelt administration not only reformed the Fed but also experimented with stimulative fiscal policy, such as unemployment relief.

New Deal programs aimed at staving off a wave of home foreclosures may be especially relevant today. Among the most important was the Home Owners Loan Corp., or HOLC, which is one of several models for homeowner relief being considered by Congress.

HOLC took over 1 million mortgages in default starting in 1933, worked to keep the owners in their homes and made new loans to strapped mortgage holders. When the agency was finally liquidated in 1951, it even returned a small profit to the U.S. Treasury.

So what next?

The Fed's recent actions were "a temporary palliative" to the fundamental problem in the economy, which is the rapid fall in home prices and its ripple effect on mortgage bonds and other securities, said Barry Eichengreen, a professor of economics and political science at UC Berkeley. "You have to reorganize the system, but the discussion about that has only begun."