9 December 2008

Worse than the Great Depression

by Martin Hutchinson December 08, 2008

In spite of Friday's alarming rise of 533,000 in unemployment, when you look at the near-term future, there still seems little chance that the current unpleasantness will turn into a rerun of the Great Depression, or anything like it. Gross Domestic Product may decline by more than the 3%-to- 4% declines seen in 1974 and 1981-82, but there seems no immediate danger of it shrinking anywhere near the magnitude of the 1929-33 decline. However, in the long term, things are not so rosy; over the next 15 years, Americans and Europeans may suffer a worse fall in their living standards than during the Great Depression, albeit played out agonizingly slowly.

Benchmarking first: According to Bureau of Economic Analysis statistics, GDP declined 26.6% between 1929 and 1933 while real personal income declined 25.7%. Real personal consumption expenditures declined 18.2%. Per capita, with U.S. population increasing about 1.5% per annum during those years, real personal income declined 30% and consumption 23%. In terms of living standards, real per capita personal consumption expenditures did not recover to their 1929 level until 1941, giving American consumers 12 years of living standards lower than they had become used to.

There is only one way (apart from gross government ineptitude, which fortunately under President-elect Barack Obama seems fairly unlikely) that U.S. or Western European GDP could fall anything like it did in the Great Depression, and that is through globalization.

It is now abundantly clear that, through the simultaneous arrival of the Internet and cheap cell-phone technology, the pace of globalization increased markedly around 1995, with global supply chains for time-sensitive products and services being for the first time possible without enormous effort, thus propelling new participants, notably India and China, into the global free-market economy. This has had the apparently benign (though less so in reality) effect of allowing rich country monetary authorities, particularly in the United States, to keep monetary conditions lax without stoking inflation, except in the prices of stocks and housing. The low interest rates and easy credit produced by the lax monetary policy in turn sped globalization by increasing the availability of capital for emerging-market production facilities and reducing the cost of conducting global trade.

In the long term, a major economic effect of economic globalization is to reduce the income gap between rich and poor countries, by bringing the latter fully into the nexus of the global economy. While factors of differential education, capital, natural resources, infrastructure and work ethic remain, they can be expected to diminish as globalization proceeds. Thus the world becomes more equal, even as it becomes richer. Eventually, it may become fully equal, with difficulties of geography making no difference to earnings, and a capable hardworking educated Lesothan earning the same as a capable hardworking educated American. Kumbaya!

There is one snag, at least for rich countries such as the United States, Western Europe and Japan. If the world becomes more equal more quickly than it becomes richer, then living standards in rich countries must decline. If the world were suddenly to achieve equal income levels between countries, without a significant increase in output, U.S. living standards would fall by over three quarters.

Some quantification: the GDP per capita at purchasing power parity of the United States in 2007 was $45,800, thus 4.58 times the $10,000 average GDP per capita of the world as a whole. World GDP per capita grew by 2.58% in 1960-2000, a period of gradually increasing globalization involving no global wars and no depression eras akin to the 1930s. So 2.58% per capita per annum must thus be close to the available "speed limit" of global GDP growth.

If world per capita GDP grows at 2.58% per annum, it will come to equaling current U.S. GDP per capita of $45,600 in 60 years. Thus, if the globalization process attains final equality in that year, i.e., meaning that U.S. and Lesothan GDP per capita are equal, for instance, the Americans of 2067 will be able to enjoy just the same living standards they can today. To allow for any growth in U.S. living standards, we must suppose that even by 2067, the world will still be unequal, so that major areas of the world (not just "pockets of poverty") have failed to integrate fully into the world economy. That is quite possible, but not inevitable - one can imagine the liberalization pressures on say a repressive, self-reliant North Korean regime if not only South Korea but also rural China and Vietnam are enjoying Western living standards.

While the final approach to worldwide income inequality between countries may be slow, there is every reason to suppose that globalization's recent acceleration has greatly reduced the level of inequality at which the global economic system is in equilibrium. Whereas in an autarkic global economy with poor communications and limited trade, it is quite possible to imagine one country being 20 times richer than another, in a globalized world it is unlikely that two countries with literate work forces and free market economic systems could differ so much in per capita output.

Suppose, for example, that globalization's acceleration is sufficient to reduce the gap in global living standards by half in 15 years, so that instead of the United States having 4.58 times the world's living standard in 2022, it will have only 2.29 times that average. Then if global growth remains constant, the world's average GDP per capita in 2022 will be $14,653. 2022's U.S. per capita GDP, at 2.29 times global per capita GDP, would be $33,556, a 26.8% drop from today, close to the drop in the Great Depression. However, whereas the Great Depression enjoyed a softening effect from a sharp decline in the savings rate, to produce a drop in per capita consumption of only 23%, that option is not available today, since the U.S. savings rate is unsustainably low, ought to increase and would almost certainly be forced to increase as Asian investors proved reluctant to invest ever more billions in the T-bonds of a declining economy. Thus under the scenario painted here, per capita personal consumption in 2007-22 would decline at least 26.8%, compared with 23% in the Great Depression.

How likely is this scenario? Optimists may object that rapid globalization of this type would boost the global economic growth rate, and so reduce the hit to U.S. living standards. The current global growth rate of 2.58% is mostly caused by three factors: technological progress, capital deepening and worldwide diffusion of new capabilities. Rapid globalization would increase the rate of diffusion of new capabilities, and might also modestly increase the efficiency of capital allocation, but it seems unlikely to speed technological progress more than modestly. Even so, there would at first glance appear to be some hope of avoiding the "worse than the 1930s" scenario through faster global growth.

There are, however, a number of factors leading in the opposite direction, toward an even greater decline in U.S. living standards.

First, there is the political effect on the U.S. public and through them, on elected politicians, of a decline in living standards through globalization. Rather than a gradual decline in life's possibilities shared by all, the decline in U.S. living standards would probably take the form of an increase in unemployment save those in secure jobs that, safe from international competition and entrenched in their position, suffer no real reduction in income. Indeed, November's unexpectedly sharp unemployment increase, which was accompanied by a significant rise in real hourly income, could be an early indication of such a trend: education, heath and government, all immune to international competition, were the only sectors to enjoy job growth. The political result of declining U.S. living standards accompanied by rising unemployment, fairly clearly linked to globalization, would surely be harsh protectionism among both voters and political leaders.

In the days of U.S. domination, a rise in U.S. protectionism might have led to a reversal of globalization and maintenance of U.S. living standards, albeit at the cost of a marked reduction in global growth. That is to some extent what happened in the 1930s. Today, however, globalization has gone so far that U.S. self-reliance would be economically impossible except at inordinate costs. All kinds of global supply chains and product relationships would have to be unwound, as the U.S. consumer reverted to buying sweatshirts made in North Carolina rather than China or Vietnam. Emerging market manufacturing capabilities would not be lost, and emerging market living standards not much affected. Thus, the main effect of U.S. protectionism would be to reduce U.S. living standards still further.

A second factor intensifying the decline in U.S. living standards is the appallingly low U.S. savings rate and the reduction in the U.S. capital pool that has resulted from over a decade of excessively low interest rates. Capital is the principal ingredient of successful capitalism, and its concentration in first Britain, then the United States and Western Europe and later Japan was the major factor behind those countries' economic development and rising wealth. In the era of funny money since 1995, capital has been inadequately rewarded worldwide, and risk premiums have compressed, so that it is little more expensive to make a $1 billion investment in Hanoi than in Harrisburg.

Now capital will become once again scarce, but the U.S. and to a lesser extent European problem is that they no longer have a monopoly of it. Hence emerging markets will be better able to finance their own investment programs, assisting their economic growth but providing yet more competition to a suddenly capital-short West. Eventually the U.S. savings rate must rise, so that the capital stock can be rebuilt (and Americans can pay for their old age and medical care) but that rise will itself further depress consumption.

The final factor depressing long-term living standards is the unwise policy response in the last few months to the credit crunch and the beginnings of global downturn. Throughout the world, but particularly in the United States and Western Europe, governments have resorted to bailouts and "stimulus packages" that have exploded public sector deficits and increased the power of government in the economy. Contrary to popular and journalists' beliefs, these expenditures are not free; they must be borrowed. In a time of tight credit such as we are now experiencing and are likely to continue experiencing for some time to come, that borrowing crowds out other more productive uses of capital. It has been remarked the total cost of bailouts by the Federal Reserve, the Treasury and other public sector authorities approaches that of World War II, corrected for inflation. However, from World War II, we got the jet engine, rocketry and the computer, whereas no significant technological spin-off is likely to result from $600 billion invested by the Fed in redundant home mortgages.

Crowding out of lesser credits by the Treasury, which already appears to be happening with respect to Latin America, could theoretically have worked to the relative advantage of the United States in the days when the United States had all the capital. However, capital is today broadly spread and the biggest pools of it are in Asian and Middle Eastern public sector funds. Hence the principal effect of "crowding out" by national governments will be on their domestic economies, and in particular on the small and medium sized businesses from which growth, innovation and jobs principally come.

The speed of globalization and the balance between factors tending to mitigate its adverse effects on the U.S. and Western Europe and those tending to intensify those effects is unclear. Nevertheless, the probability of a long-term decline in U.S. living standards comparable to if not deeper than the Great Depression must be rated as fairly high. It will take the form, not of a single catastrophic collapse as in 1929-33, but of a series of sharp unpleasant recessions, interspersed with feeble unconvincing recoveries in a downward saw-tooth pattern. The result will be the same, albeit over a longer period. The only saving grace is that the decline will eventually bottom out and be followed by gradual recovery, as global growth continues and the United States shares in it. Even so, this is far from the future Americans have envisioned for themselves.

There are few policy responses that will do any good. Probably the most important is to raise the real return on risk-free savings as quickly as possible to around 5% to 6%, higher than the equilibrium rate, while eliminating the federal budget deficit. These actions will rebuild the U.S. capital stock, whose depleted state is currently the most dangerous factor facing the U.S. economy. Since the United States is still an important factor in the global economy, particularly if its money tightening is followed by the European Central Bank to solve the similar but less extreme savings problem there, interest rates and risk premiums worldwide will increase. That will raise the cost of building new production facilities in such emerging markets as India that are short of capital, though not in those such as China where capital appears to be plentiful. By doing so, the United States can slow the pace of globalization, so that the increasing wealth in emerging markets involves less wealth decline domestically.

Before you dismiss this speculation as far-fetched, remember: everyone used to think house prices could not fall nationwide.



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