Sunday, January 20, 2013

On Banging One's Head Against the Wall

Before getting to Les Miserables, I want to discuss a few Paul Krugman columns that I have been saving up for some time.

The first one is this, in which Krugman discusses the (conservative) assumption that a deep economic plunge automatically means a rapid recovery.  He, in turn, is citing Noah Smith, quoting a research paper to the effect that financial crises lead to very severe recessions, followed by rapid recoveries.  The underlying thesis here is that the more severe the recession, the more rapid the recovery.  Not surprisingly, the paper has been used to criticize the Obama Administration for the slow recovery from our latest recession.  Smith comments that:
[T]hey [the authors of the paper] claim that deeper recessions will be followed by faster recoveries; in this model, one reason for a slower recovery under Obama is that the recession of 2009 was not as deep as recessions during the 1800s. . . . Obama slowed the recovery by reducing the severity of the recession.
Krugman makes a similar comment:
What all this also tells us is the folly of using growth from the recession trough as a measure of success: the worse you screw up the original response to the crisis, the better this measure looks!
 Both men take it as self-evidently absurd that anyone would want to make the initial recession as deep as possible in order to ensure rapid recovery -- sort of like the man banging his head against the wall because it feels so good when he stops!  But I have seen conservatives make this very argument, have debated the subject with them in comments threads.  Their basic argument is that "distortions" have been made in the economy and have to be "shaken out," that only when the necessary shake-out has taken place can recovery begin, and that any attempt to soften the decline only delays the inevitable bottom that must be reached before recovery can begin.

I agree that there have been distortions in our economy that have to be shaken out.  Specifically, we had too much residential investment and our construction and finance sectors became bloated and needed shrinking.  But it does not logically follow that the entire economy has to shrink, as opposed to those particular sectors.   Quite the contrary, if there has been too much residential investment, it logically follows that there has been too little of some other type of investment; that if the construction and finance sectors are bloated, some other part of the economy must be stunted.  What sense does it make to insist that the healthy as well as the unhealthy sectors of the economy must shrink?  The main response I got, so far as I can tell, is that there is simply an inevitable bottom to be reached, and that the faster the economy shrinks, the sooner it will hit that bottom and start bouncing back.  Hence, yes, they would agree that the most painful and damaging response is the best because it hits the inevitable bottom soonest.

The thread died before I could pose my not-entirely hypothetical response.  Conservatives strongly criticized the Obama Administration for bailing out Chrysler and GM.  What if it had failed to do so?  Conservatives like to propose a private rescuer instead, but the whole reason the government bailed out the auto industry was that no private rescuer could be found.  Alternately, Chrysler and GM might have failed and Ford, the healthiest auto manufacturer, might have moved to fill in the space they had left.  In that case, one might argue it was a case of necessary but painful shakeout.  But there was a very real possibility, one that Ford feared enough to make it support the bailout, that the failure of Chrysler and GM might cause so many subcontractors to fail that Ford would not be able to buy necessary supplies and even the (relatively) healthy company would have been brought down.  Such an outcome was by no means a certainty, but neither was it an impossibility.  And it would obviously have made the economy shrink more.  Do the shakeout school think such a development would be healthy?

Or let us imagine another not-entirely-hypothetical.  Suppose a very small country -- we will call it Iceland.  Iceland's economy is so small, it only has two industries, fishing and investment banking.*  Of course, not all employment is in these two industries, but the rest of Iceland's employment is in services like retail, construction and so forth that service people in the banking and fishing industries, as well as each other.  The investment banking industry has become grossly bloated and has to shrink.  The service sector will necessarily wither if loses much of its investment banking clientele.  So to me it would logically seem to follow that what Iceland needs is for the fishing industry to grow.  Unfortunately, it will probably not grow as fast as the banking industry shrinks, so services will still wither.  It would therefore seem to make sense for government to provide some sort of short-term stimulus (if it can) to keep the service sector going until the fishing sector has grown big enough to support it.  The economy's problems, after all, are solely in its bloated financial industry, not in fishing or services.  But the shakeout crowd, so far as I can tell, would say no, the banking industry and the fishing industry and the service industry all need to shrink in order to accomplish shakeout and hit bottom, and that any interference with this process is counterproductive.  Some wag commented that if we just shut the entire economy down for one year, growth the following year would be astronomical.  Head, wall, bang!  (It feels so good when I stop).

So far as I can tell, financial crises lead to hitting an inevitable bottom, followed by rapid recovery in only one instance.  That is when the crisis is brought on by large-scale borrowing in order to prop up an overvalued currency.  Letting an over-valued currency fall is, indeed, traumatic and leads to a temporary but severe economic fall.  But once it is reached, recovery is usually rapid.  But there is a funny thing about such crises.  The longer a country allows them to go on, the more over-valued its currency becomes, the deeper the "inevitable" bottom turns out to be.  For countries that devalue sooner, the "inevitable" bottom is not as deep.  More on that (and other thing) in my next post.
*Actually Iceland also has aluminum smelting, geothermal power, and tourism, but you get the picture.

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