Economic Predictions For 2009

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John Maynard Keynes pointed out in the 1930s that when prices go up slowly or not at all, monetary policy is much less effective because people are inclined to hold money instead of spend it. Moreover, once interest rates are reduced to 1 percent—which the federal funds rate reached in October—the Fed can’t cut them much further, and other, more drastic means of stimulating demand have to be used, such as introducing a tax cut and financing it by printing money. (Back in 2002, Bernanke advocated such a policy as an antidote to deflation.) Setting aside the political difficulties of adopting such a plan, the very prospect of it could well spark a run on the dollar, which would force the authorities to reverse course.

We are, of course, still a very long way from the Great Depression, which, after all, wasn’t just any old depression: It was a slump of such longevity and enormity that, even now, it is unlikely to repeat itself. Between late 1929 and early 1933, inflation-adjusted G.D.P. fell by some 30 percent, industrial production plunged 47 percent, and the unemployment rate rose to more than 20 percent. And that four-year period wasn’t the end of it. After appearing to recover for a few years, the economy entered another deep downturn at the beginning of 1937 that lasted until the middle of 1938. Unemployment didn’t drop back below 10 percent until the country mobilized for World War II.

The decline in economic activity during the Depression was quite remarkable. In terms of lost G.D.P., it amounted to more than 10 times the decline seen in all the other recessions of the 20th century combined. In many urban areas—in New York’s Central Park, in the Anacostia section of Washington, along the banks of the Mississippi in St. Louis—tent villages of homeless people, known as Hoovervilles, sprang up, while in the drought-stricken interior, countless families lost their homes and followed the “dirty plate trail” to California.

While the financial system was contracting dramatically, a big fall in wholesale and retail prices, as well as the values of real estate and most financial assets, subjected the rest of the economy to ruinous “debt deflation.” If wages and prices gradually rise, as they do in normal times, the inflation-adjusted value of debts diminishes. But if wages and prices fall sharply—between 1929 and 1933 the wholesale price index fell by a third—debt burdens increase.

Borrowers who can’t meet their interest payments are forced into distress sales of assets, putting more downward pressure on prices.

Between 1929 and 1933, that is what happened. Even today, with an economy much less dependent on bank loans than it was in 1930, a wholesale failure of the banking system, together with an extended fall in prices, could have a devastating impact. The reason most economists discount this possibility is that they don’t believe policymakers will make the same disastrous mistakes their predecessors made in the 1920s and 1930s, when the authorities stood by as the financial system imploded and withering deflation developed.

After approving the foundation of the Federal Reserve in 1913 to help guard against future financial panics, Congress and the executive branch neglected to establish a system of deposit insurance, which left the system acutely vulnerable to runs. (Franklin D. Roosevelt quickly rectified the omission.) Then, after the stock market crash of 1929 dealt a serious blow to the economy, the young Fed, rather than extending credit to troubled banks, did next to nothing. Some of its top officials actually welcomed the growing number of bank failures as a sign that bad debts were being purged.

Bernanke is an expert on the Depression, and under his leadership the Fed was never likely to repeat its earlier errors. In November 2002, shortly after he became a Fed governor, Bernanke attended a conference to celebrate Milton Friedman’s 90th birthday. It was Friedman who, with economist Anna Schwartz, popularized the view that the Fed blundered in the 1930s. “I would like to say to Milton and Anna: Regarding the Great Depression, you’re right. We did it,” Bernanke told the crowd. “We’re very sorry. But thanks to you, we won’t do it again.”

Yet it isn’t entirely clear what he should do. During Japan’s “lost decade” of the 1990s, it discovered that navigating a deflationary real estate and credit bust is far from easy, no matter what you do. To be sure, the Japanese government made some initial mistakes in following an inflexible monetary policy and allowing banks to hide losses. Eventually, though, it did most of the things that outsiders such as Bernanke had recommended, like recapitalizing the banks at the taxpayers’ expense and experimenting with new monetary rules. Even then, prices kept falling, and the economy barely managed to expand.

As for the Japanese stock market, I can hardly bear to talk of it. In 1989, when I first visited Tokyo, the Nikkei was approaching 39,000. Ten years later, when I returned, it was languishing at about 14,000. Today, it is below 10,000. Before shifting what remains of your retirement fund into an S&P 500 index fund to take advantage of a coming rebound, you might want to take a look at the Nikkei chart. It is quite a sight.

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