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A Primer on Depressions

By John H. Makin

A depression follows a period of euphoria about the outlook for the economy and the future earnings of "new" companies. The euphoria becomes unsustainable, and the stock prices of the new companies collapse. Large wealth losses replace large expected wealth gains. Consumption growth slows, then turns negative, and stock prices of more companies fall because weaker demand erases pricing power and, with it, prospective profits. Demand falls further, and deflation sets in.

In a depression, the central bank discovers (to its horror) that stock prices, not interest rates, become the major transmission mechanism running from financial markets to the real economy. That is because after a bubble earnings fall faster than any central bank can, or will, cut interest rates, and when earnings, or more ominously, expected earnings, fall faster than interest rates, then stock prices fall.

Earnings expectations for NASDAQ companies have fallen by more than 75 percent in many cases. The Federal Reserve is expected to have cut interest rates by 2 percentage points by May, from 6.5 to 4.5 percent, or by about 30 percent. That would be a large move by historical standards, but not enough to stabilize equity prices. So the Fed is left looking powerless, cutting interest rates aggressively, but failing to stabilize equity prices.

Economists are very shy about mentioning the word depression. If they do mention it, they "hasten to add" that it is "contained," as in Japan, or that it "can’t happen here," as in the United States. I have used these words myself. But history, specifically the aftermath of the 1929 stock market crash in the United States and the aftermath of the 1990 Japanese stock market crash, offers little consolation to those claiming that depression is not inevitable after an investment-led boom that ends with a stock market collapse. In the United States after 1929 and in Japan after 1990, the only two instances in this century in which stock market collapses followed investment booms, depression resulted.

Yes, Japan is in a depression complete with rapidly falling prices, zero interest rates that are not low enough to stimulate spending, public works expenditures on counterproductive projects with negative marginal products, and paralyzed policymakers at the Finance Ministry and the central bank. The nightmare that Keynes wrestled with in The General Theory of Employment, Interest, and Money, an economic equilibrium consistent with self-reinforcing falling prices, employment, and output, has settled over Japan like an invisible cloud of poison gas. Little wonder that Kiichi Miyazawa, Japan’s elderly but still acute finance minister, uttered recently before the Japanese Diet that Japan’s government finances were close to a "catastrophic situation."

The Linkage between Financial Markets and the Real Economy

The bursting of an equity market bubble that leads to a prolonged collapse of the real economy is the manifestation of a most basic and enduring theme of macroeconomics: the linkage between financial markets and the real economy. A powerful negative shock to the financial sector, like the collapse of a stock market bubble, sets in motion a deceptively straightforward set of events that seems, somehow, to leave policymakers caught like deer in the headlights. Leading up to the bubble, a virtual prosperity mania sets in, with households contemplating undreamed-of wealth, firms bidding for and stockpiling precious skilled labor, and governments marveling at—and promptly spending—tax revenues that far exceed their most optimistic expectations. The end comes, as it did during the past year in the United States, after extraordinary events like expected, unfailing growth of 25 to 30 percent per annum have come to be seen as ordinary. That perception makes investors view as unremarkable the purchase of equities at prices 200 times current earnings, or at more than ten times the normal price-earnings multiple. Such pricing cannot be sustained.

The most recent and spectacular example of the insanity that accompanies equity market bubbles is the experience of Yahoo!, a company whose primary source of revenues is online advertising. Not only have Yahoo!’s profits failed to grow, they have collapsed—virtually to zero in 2001 with a hoped-for rebound to $60 million in 2002—down sharply from earnings of nearly $300 million in 2000. Since Yahoo!’s share price surged because of an expected perpetual acceleration of earnings growth, the reality of a sharp deceleration in earnings growth has brought the stock from a high of about $240 early in 2000 to $17 on March 9, the first anniversary of the 5000-level peak of the NASDAQ. The NASDAQ itself, with its collection of dot.com and Internet stocks, fell by 60 percent, from 5000 to 2000, from its March 2000 peak to March 2001. The Yahoo! swoon alone wiped out nearly $80 billion worth of wealth, while the more general NASDAQ collapse has erased over $2.5 trillion in wealth. Taken altogether, U.S. equity market losses over the past year have totaled over $4.5 trillion. That wealth loss amounts to about 60 percent of a year’s household disposable income and over 12 percent of total U.S. household wealth from all sources.

Bubbles Can Mislead Policymakers

An insidious feature of a postbubble period is the unusual and—at first—deceptively benign behavior of the real economy. Such benign behavior creates serious problems for policymakers.

The onset of the U.S. growth slowdown over the past six months manifests a classic "postbubble" pattern. Since excess capacity resulting from accelerated, bubble-driven capital formation quickly becomes a problem after the bubble bursts, capital-spending growth slows. Indeed, U.S. capital spending growth went from a 21 percent annual rate in the first quarter of 2000 to a negative 0.6 percent annual rate in the fourth quarter. The initial reaction of markets is to embrace the idea of a capital inventory correction that can be remedied quickly with lower interest rates. Many commentators, especially those eager to sustain flows into stock market investments, suggest that the slowdown in capital spending is a healthy sign of the economy’s ability to regulate itself. The central bank consoles itself with similar notions of the therapeutic effect of a slowdown in capital spending. Although consumption slows, it does not collapse in an environment identified as a beneficial correction. Indeed, U.S. consumption spending, which grew at an extraordinary 7.6 percent annual rate in the first quarter of 2000, slowed only to a still-respectable 2.8 percent annual rate in the fourth quarter.

But the extraordinary investment surge that characterizes an investment-led boom carries the seeds of its own destruction. Normally, investment growth accounts for about one-sixth of the total growth of the economy. From 1959 through the end of 2000, investment growth accounted for 0.6 percentage points of an average 3.5 percent growth rate. However, during the twelve quarters ending in the first quarter of 2000, the peak of the investment boom, investment spending accounted for 1.5 percentage points of the 4.6 percent overall growth rate, or nearly a third of all growth. At the end of an investment boom, a sharp slowdown in investment spending produces an unusually sharp drop in GDP growth. The 5 percent annual growth rate at the beginning of 2000 became a 1 percent annual growth rate by the fourth quarter of 2000, with an unusually large portion of that slowdown attributable to a slowdown in investment growth.

The additional focus of a postbubble growth slowdown on investment spending creates a dangerous complacency among both investors and policymakers. Since consumption is two-thirds of total spending, it is easy to pin hopes on the notion that lower interest rates will support consumption and overall spending growth. Then, too, there is the usual denial that accompanies the shock of a rapid sell-off. In January of this year, retail sales surged by 1.3 percent, enough for an annual growth rate above 15 percent. But in February, retail sales dropped by 0.2 percent—resulting in a negative trajectory of year-over-year retail sales, down to 2.7 percent, just enough to cover inflation. Ominously, the consumption boom in January was financed by a $16.1 billion jump in consumer credit. American households, which collectively at the end of last year had lost more than $4 trillion on their equity holdings, entered a period of intense denial, splurging on automobiles, furniture, appliances, and clothing and paying by credit. The resulting "firming" of the economy together with firm growth of wages and employment contributed to an environment that kept the Federal Reserve from easing rapidly enough.

Consumption Will Fall Next

The outlook for U.S. consumption growth is bleak. In the November Economic Outlook, I asked: "How plausible is the heretical yet immensely dangerous notion of a sharp drop in U.S. consumption? If the stock market merely stays at current levels, it is quite plausible. If it falls another 15 or 20 percent, it is a virtual certainty." Since November, the Wilshire 5000 Index (the broadest measure of equity value) has dropped by 18 percent.

The linkage from wealth to savings and consumption suggests strongly that large equity losses will cut consumption spending as households add to savings out of income in an attempt partially to compensate for the severe damage to their balance sheets. During the 1990s, when capital gains came to augment and then to dominate saving out of income as the way in which American households accumulated wealth, on average the sum of saving out of income plus expected capital gains (calculated as a smoothed version of average annual capital gains during this expansion) constituted about 15 percent of after-tax household income. With after-tax disposable income equal to about $7 trillion, the 15 percent rule would call for $1.05 trillion in savings composed partially of capital gains and partially of savings out of income. If there were no capital gains this year, a full measure of savings would require a reduction in consumption by a full trillion dollars to achieve savings equal to 15 percent of disposable income. That, however, seems highly implausible, and indeed a look at past data suggests that in recessions, saving out of income and smoothed capital gains falls to 5 percent of disposable income, or about a third of the normal rate. But with zero capital gains, even a 5 percent increase would mean savings of $350 billion that would have to come out of consumption. That $350 billion is 3.5 percent of GDP; in other words, the drop in consumption growth during 2001 could subtract 3.5 percentage points from GDP growth.

With the sharp drop in investment spending subtracting 1.5 percentage points from GDP growth and the slowdown in consumption spending subtracting 3.5 percentage points from GDP growth, while falling exports from a global slowdown could subtract another half of a percentage point from GDP growth, the drag on GDP growth during 2001 could total 5.5 percentage points. Even with a modest contribution of a half percentage point of growth from government spending, well above the average 0.2 percentage points contributed since 1991, a drag on this year’s growth of more than 5 percentage-points is entirely plausible. With the underlying average growth rate of 3.5 to 4 percent, the 5-percentage-point drag means that negative growth in the region of 1 to 1.5 percent is highly plausible. That’s a nasty recession.

The assertion that the United States could experience a year of negative growth is certainly a long way from saying that the United States will enter a depression. It is not moving—and need not move—inexorably in that direction. Rather, the United States is probably moving toward an unusually intense recession wherein the growth slowdown will be longer and deeper than many have been willing to admit. It is the dangers inherent in making the transition from unusually good times to unusually bad times that need to be recognized. Spending will remain depressed for some time as the realization sinks in that the acquisition of wealth requires some saving out of income and not simply the acquisition of "hot" stocks whose value seems to rise inexorably.

Aggressive Stimulation Needed

Policymakers need to move away from a state of complacency about the need for stimulative measures. In 1962, a Democratic president, John F. Kennedy, proposed tax rate cuts equal to more than 2 percent of GDP to stimulate economic growth. He did this at a time when the ratio of publicly held debt to GDP was 44 percent and the deficit was higher than 1 percent of GDP. The U.S. economy was entering an expansion, but Kennedy wanted tax reform and sustained economic stimulus from a better-designed tax system. Today, as the U.S. economy enters what looks to be a serious recession, a Republican president is proposing tax rate cuts and a modest fiscal stimulus equal to barely 1 percentage point of GDP while the ratio of publicly held debt to GDP is 33 percent and falling and the surplus is approaching 3 percent of GDP.

Today’s protests about tax cuts being too large because the debt paydown is threatened are the result of a dangerous, mistaken idea that somehow debt paydown caused the prosperity of the 1990s. In truth, the prosperity of the 1990s caused the debt paydown. Tax rate reductions are an even better investment in 2001 than they were nearly forty years ago in 1962. It is worth noting that although the Kennedy tax cuts were not enacted until February 26, 1964, three months after the assassination of the president, they helped to sustain three years of noninflationary growth averaging 6.6 percent from 1964 through 1966. The Kennedy-inspired tax and tax rate cuts of 1964 were part of a fiscal revolution and ably chronicled by the late Herbert Stein (Herbert Stein, The Fiscal Revolution in America, second revised edition, AEI Press, Washington, D.C., 1986).

In 2001 the negative pressures on the U.S. economy, not to mention the global economy, are serious enough to justify far more aggressive tax rate reductions that, in fact, target moderate budget deficits and an attendant moderate rise in the ratio of debt to GDP. Some movement in that direction will occur when the sharp slowdown in the U.S. economy over the coming months turns fiscal policy debate from a quarrel about whether tax cuts are too large into a contest between Republicans and Democrats to determine who can cut taxes by the larger amount.

Monetary policy is also disconcertingly complacent in view of the dangers facing the U.S. economy. Although reductions in interest rates cannot eliminate the recession, they can cushion it. Holding the Federal Funds rate at a still-restrictive 5 percent (even after a reduction of 0.5 percent on March 20) throughout the onset of recession when a stimulative 3 to 3.5 percent is needed will unnecessarily prolong economic weakness. In addition, Fed chairman Alan Greenspan’s advocacy of a destabilizing fiscal measure that raises tax rates in a recession—the debt trigger mechanism—only reinforces the misplaced leaning toward restrictive fiscal policy at a time when stimulative measures are needed. Both monetary and fiscal policy will have to be sharply reoriented toward stimulation of the economy in coming months. A failure to do so would only reinforce the uncanny tendency toward depression after equity market bubbles have burst.

John H. Makin is resident scholar at the American Enterprise Institute. #12776

http://www.aei.org/eo/eo12776.htm

-- Martin Thompson (mthom1927@aol.com), April 19, 2001

Answers

This is one of the best articles on economics I have ever read.

-- R2D2 (r2d2@earthend.net), April 20, 2001.

Very good article. However, I take exception to one statement and that is that people will begin to save money as the economy contracts. This may be true for a few, but from what I read, families are so in debt from credit cards that I don't see how they can save when they are having a problem paying their bills. And certainly those that have lost their jobs are not going to be saving money. If they have savings, they will be using them. If they don't have savings they will have their credit cards maxed out.

-- Taz (Tassie123@aol.com), April 20, 2001.

Low interest rates cause capital to move to areas where it can get a higher return. I have always thought low interest rates are a cover for what the Fed is really up to which is slow the economy.

-- David Williams (DAVIDWILL@prodigy.net), April 20, 2001.