The Gains From Preventing a Depression

John McCain says we have to avoid another financial calamity:

We must not bailout the management and speculators who created this mess. They had months of warnings following the Bear Stearns debacle, and they failed to act.

We should never again allow the United States to be in this position. We need strong and effective regulation, a return to job-creating growth and a restoration of ethics and the social contract between businesses and America.

What would a world without the possibility of Great Depressions -- however unrealistic that may be -- look like? According to research published last year in the Journal of Monetary Economics (working paper version), Stayajit Chatterjee of the Philadelphia Fed and Philip Dean Corbae of the University of Texas at Austin estimate that consumption would increase by between 1 and 7 percent per year "in perpetuity." The biggest reason for the gains comes from diminished volatility in consumption.

A big caveat, however, Chatterjee and Corbae don't factor in the costs of the regulation needed to reduce the risk of a depression to zero. How much would that hurt growth?

It's very hard to tell, but we can use history as some guide. In 1997, Rutgers' Eugene White looked at what would have happened in a world where the Federal Deposit Insurance Corporation never existed. Here is White's argument for why the FDIC is inefficient:

"Although deposit insurance has often been discussed as an important guarantor of the stability of the banking system and hence the economy, the expansion of deposit insurance cannot be justified on macroeconomic grounds. The general view today is that while the failure of individual banks might begin a panic, a systematic collapse may be prevented by proper intervention by the Federal Reserve as the lender of last resort."

While White admittedly called his results "tenuous," he concludes that "for a broad range of estimates, it appears that the FDIC did not reduce costs and may have raised them." He estimates the annual cost of FDIC bailouts between 1945-1994 to be $770 million (a bit over $1 billion in today's dollars). This figure is much less than a 1 to 7 percent gain in annual consumption predicted by Chatterjee and Corbae, though there are surely other things that could chip away at that advantage).

Chatterjee and Corbase also estimate, based on past data on contractions and expansions, that the U.S. will be in a depression once every 83 years. Since the last depression started 79 years ago, one would think it's almost time for another.