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And the Slump Goes On

Official economic statistics and the underlying economic reality sometimes differ starkly. Such discrepancies may be almost inevitable when a small group of macroeconomic experts sets the official dates for peaks and troughs of aggregate economic activity. The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) recently “determined that a trough in business activity occurred in the U.S. economy in June 2009.” According to the official announcement, this date “marks the end of the recession that began in December 2007 and the beginning of an expansion.”

Yet some data and sound theory, which take into account more than simple macroeconomic aggregates—higher GDP good, lower GDP bad—indicate that the U.S. economy has not fully recovered. The official unemployment rate is still over 9 percent, private long-term investment remains at low levels, and even GDP growth has been weak, in spite of the great increase in government spending for final goods and services (which adds directly to GDP, defined as consumption plus investment plus government spending plus net exports).

The weak recovery is clearly recognized by policy-makers, who have advocated and implemented additional fiscal and monetary stimulus by the Obama administration and perhaps the Federal Reserve. They seem to take for granted that an unexpectedly slow recovery requires even more expansionary government policies to keep the economy on track.

The slow recovery from the recession presents an analytical challenge, provoking debate among macroeconomists and pundits. As usual, there are many diverse explanations, some complementary, some contradictory. To an important extent these divergences reflect different conceptions of the business cycle. I will describe and briefly analyze four of the most common explanations.

The Keynesian Story

Let us start with the Keynesian story, filtered through the writings of Paul Krugman. (There are much more nuanced versions of Keynesianism than Krugman’s.) In his weekly column and popular blog at the New York Times, Krugman declares that the slow recovery and the persistence of high unemployment arise from a “lack of aggregate demand,” which is the main cause of the poor sales by private businesses and hence of the high unemployment rate.

In his characteristic self-confident argumentative style, Krugman asserts, “Businesses aren’t hiring because of poor sales, period, end of story.” This sentence is followed by a graph showing a substantial increase since late 2008 in the percentage of small businesses that named “poor sales” as their “single most important problem.” The remedy for this malaise is, of course, more public spending: “[T]he best thing government could do to help business would be to spend more, increasing demand.”

However, as many economists have written in recent years, Krugman’s focus on aggregate demand is simplistic, to say the least. First, one needs to ask, why is the growth of aggregate demand so weak? It may very well be that spending less and saving more is a healthy reaction to the previous unsustainable boom. Thus weak demand might be an inevitable consequence, not the deep cause, of the current bust.

Furthermore, what particular parts of the economy—which markets or industries—suffer most from low sales? As Austrian economists argue, we need to disaggregate the macroeconomic picture to understand what is going on. Nevertheless, such disaggregated analysis does not seem to be important for some Keynesians, such as Krugman and Brad DeLong. In November 2009, DeLong wrote, “At this point, anything that boosts the government’s deficit over the next two years passes the benefit-cost test—anything at all.”

The Monetarist Story

The monetarist story of Milton Friedman’s followers is usually presented as the free-market alternative to the Keynesian interpretation. However, these explanations have important though subtle points in common.

In simple terms the monetarist thesis focuses mainly on sudden bank credit contraction. Monetarists argue that the accumulation of vast amounts of excess reserves by banks—which basically means that instead of lending money to the private sector, they are keeping it to themselves—has negative effects for the whole economy. Given that credit is usually considered the economic equivalent to the human body’s blood circulation, a credit contraction is seen as invariably dangerous. If a person suffers a sudden loss of blood, the cure would be to inject blood into him. The same cure applies to credit, the monetarists claim.

Economists from this perspective usually refer to how the velocity of money—the average frequency with which a unit of money is spent in a specific period—collapsed in the second half of 2008. To compensate for this reduction, monetarists recommend an expansionary monetary policy by the central bank.

Although one might think that Fed Chairman Ben Bernanke’s strategy has been to respond precisely in this way, some economists, such as Scott Sumner, argue otherwise. Sumner claims the Fed’s monetary policy since the end of 2008 has actually been contractionary relative to what the economy needed at that time. Bernanke should have been more aggressive, Sumner argues, to avoid the contraction of nominal GDP that finally occurred.

This explanation suffers from several problems, similar to the shortcomings of the Keynesian story: (1) excessive aggregation of key concepts—making extensive use of GDP as the key indicator of the cycle does not allow the monetarists to explain the crux of the matter, which is the real microeconomic distortions in the productive structure of the economy that had been created during the boom; (2) the analysis of the crisis and the sharp credit contraction as exogenous shocks, rather than consequences of the previous unsustainable credit expansion. From Sumner’s point of view, it seems that the fall in nominal GDP was something to be avoided.

The Austrian Story: The Adjustment Problem

For economists drawing on the Austrian story, GDP contraction was a symptom of the bust, the inevitable hangover after a credit spree that led to bad decisions—malinvestments and excessive leverage. As the Austrian business cycle theory emphasizes, the economy has to go through a process of adjustment that cleanses the massive errors resulting from economic decisions taken in the past. This restructuring involves not only reallocating factors of production (capital and labor), but also reducing debt a significant amount (deleveraging), which has contractionary effects on demand and aggregate economic activity.

This consideration leads to the first element of the best explanation for the prolongation of the recession: the fact that the necessary adjustment process has not been completed. As a recent report by the Bank for International Settlements (BIS) concludes, the debt reduction of private economic agents still has a long way to go. But as the Spanish economist J. R. Rallo argues, keeping interest rates extremely low for a prolonged period, as the Federal Reserve has, creates incentives for people not to reduce debt and adjust to the new circumstances. Moreover, government “stimulus” policies may have made things worse by massively increasing federal government debt.

Furthermore, the necessary reallocation of the factors of production—both intersectoral (from sectors overexpanded during the bubble to sectors that will yield higher profits in the future) and intrasectoral (among different products and services in the same sector) may take a long time, especially in the labor markets. Apart from the fact that the adjustment in relative prices and wages may take longer than desirable because of rigidities, there are additional issues worth considering.

Research on markets with search frictions—which won Peter Diamond, Dale Mortensen, and Christopher Pissarides the 2010 Nobel prize in economics—may fit in this context. For several decades mainstream neoclassical economists have depicted the market as a mechanism that perfectly and instantaneously coordinates supply and demand. The Nobel laureates, however, have emphasized that economic agents often have to spend time and resources in making that adjustment (search frictions). Moreover, finding satisfactory employment for people who have just lost jobs may require the acquisition of substantially different skills and capabilities. The features of this process depend on the degree of specificity and complexity of the economy’s capital structure. Thus not only physical capital but also human capital has to go through an adjustment process. All this takes time.

Regime Uncertainty

The second main piece of the puzzle of the recession’s duration is the “regime uncertainty” argument formulated by Robert Higgs. He first elaborated this concept to explain why the Great Depression lasted so long, finding that the Roosevelt administration, with its constant attacks (in rhetoric and in policies) on the free-enterprise system and its threats to private property, was largely responsible for the failure of long-term private investment to recover fully until World War II ended.

Not surprisingly, in a series of commentaries since 2008, Higgs has found parallels in the Obama administration’s actions and in the stagnant private investment that help to explain why sustained economic recovery has not yet taken place.

Higgs points to several particular causes: the surge in the federal deficit and debt; the likely introduction of new taxes to finance the recent massive public spending, or changes in existing tax rules; the potential burdens on businesses brought about by environmental and energy regulations; and the still uncertain real effects of Obamacare and the new financial regulatory framework.

Problems related to the adjustment process, along with the existence of regime uncertainty, might form a relatively complete explanation of why the U.S. economy is still suffering from the Great Recession, complementing the analysis expressed in the Mises/Hayek business cycle theory.

The importance of this debate, and how current economic events are interpreted, can hardly be exaggerated. As economist Mario Rizzo has noted, the resolution of this puzzle “will affect economics and public perceptions for a long time to come,” just as the debate between Hayek and Keynes in the 1930s had profound (and unfortunate) consequences for the future of the economics discipline. Let us hope that the outcome will be different this time.

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