FEAR OF THE GREAT DEPRESSION

Economic Programs against Economic Crisis

By Olaf Storbeck

[This article published in: Handelsblatt, 1/12/2009 is translated from the German on the World Wide Web, www.handelsblatt.com/politik/oekonomie/_b=2124114,_p=30,_t=ftprint,doc_page=0,printpage.]

The governments must act quickly to prevent an economic catastrophe. US economists demanded this quick engagement at their annual meeting in San Francisco. However they rejected general tax cuts and pleaded for a massive increase of direct state spending.

San Francisco. Even Martin Feldstein, the 69-year old Harvard professor, an icon of supply-oriented economic policy who preached “More market and less state” since the 1970s, even this deliberate conservative economist has now \rediscovered John Maynard Keynes – and pleads for a massive state economic program to save the economy from collapse.

“State spending must increase – clearly and quickly,” Feldstein said at the annual meeting of the American Economic Association (AEA) in San Francisco at the beginning of January. This counsel was not easy for him since he was explicitly conservative in budget questions, he admitted. But he sees no alternative at the moment.

The worldwide financial- and economic crisis was the central theme at the conference of economists. More than 10,000 scholars traveled to the conference on the American west coast. Unlike Germany, top-flight international macro-economists across all schools were united: the industrial countries should quickly resolve massive internationally coordinated economic packages that are multi-layered, act quickly and can be extended if necessary.

Two years ago a broad consensus prevailed that fiscal policy is not sensible,” Feldstein said. “Today researchers who were very negative a short time ago support it.”

More and more economists are convinced the world economy is experiencing a historically unparalleled collapse of demand – in the worst case, the situation could expand to a second “Great Depression,” experts fear. The acute danger exists of a self-reinforcing downward spiral from deflation, increasing debts and new problems in the financial sector.

In the meantime a series of top-flight scholars even warn explicitly of a second “Great Depression.” The risk is small but extremely dangerous, said Olivier Blanchard, chief economist of the International Monetary Fund and macro-professor at MIT.

The former Fed governor and current Columbia professor Frederic Mishkin is convinced: “the shock coming from the financial system is greater in this crisis than in the Great Depression.”

Nobel Prize winner Paul Krugman was not in San Francisco but warned in the “New York Times”: “It now looks like the beginning of a second `Great Depression.’”

To prevent a mega-economic catastrophe as in the 1930s, the academics in San Francisco urged industrial countries to act quickly. The experiences from past financial crises had shown a hesitant monetary- and economic policy only made the macro-economic problems even worse. “Gradual action is completely inappropriate in the current situation,” Mishkin stressed.

The special character of the present crisis indicates that two strategies often applied in the past will hardly be promising this time, IMF-chief economist Blanchard emphasized. All attempts to become free from the crisis with exports are condemned to fail on account of the global dimension of the recession. In addition, the traditional monetary policy strikes its limits. Traditional monetary policy is not completely ineffective but cannot stimulate demand this time through lower key interest rates alone.

Many economists in San Francisco argued against general tax cuts, as many German politicians and economists urge. General tax cuts are expensive, entail enormous tax losses and can hardly be withdrawn later. The danger exists that households and businesses will horde the additional money instead of spending it. “Tax cuts will not help now,” Feldstein is convinced.

Many experts are also critical of a larger profits tax for a certain time, as the British government has resolved. “I am very skeptical whether two percentage points less in the profits tax will have a noticeable effect,” Blanchard said. “I believe consumers will ignore this.” Whether retailers will pass on the lower taxes to consumers is unclear.

If the state wants to directly support private consumption, then greater targeted consumer incentives are more sensible, Blanchard argued. As an example, he named earmarked consumer checks, perhaps to buy new trucks that are environmentally friendly. In general, the state should concentrate direct assistance on people affected directly and intensely by the crisis – for example, because they lost their job or cannot pay their mortgage any more. With these problem-groups, there is the higher probability that the money will not wind up in savings accounts.

Many economists saw a temporary massive expansion of direct state expenditures as the most important insurance against a second “Great Depression.” Even central bankers who traditionally have been very skeptical to debt-financed economic policy plead for state spending. “At the moment there are very strong arguments for an active state economic policy,” said Janet Yellen, president of the Federal Reserve in San Francisco. “We must pull out all the stops.”

Concretely Martin Feldstein recommended to the US government to pump $300 to $400 billion in the economy in 2009 and 2010 – as much as the expected loss in private demand. Money should not only be invested in streets and bridges; the conservative Feldstein also recommended increasing the defense budget.

Many counter-arguments rightly lodged in normal times against such a policy have now lost their weight, Feldstein and Blanchard argued. That higher state spending could drive up interests on the financial markets and push back private activities is unlikely, given the extremely loose monetary policy. An overheating of the economy and rising inflation should not be feared in view of the present economic weakness.

That state demand programs operate in a time-delayed way and therefore often came too late in the past are not crucial because the current recession may last a long while. “The average recession in the past was over after twelve months, Feldstein said. “This recession has already lasted a year and we would be happy if it ended in 2009.”

In the view of researchers, Keynesian economic policy alone will not be enough to end the crisis. Past experiences show: Whoever wants to overcome a recession caused by a bank crisis must first permanently solve the problems in the financial sector. “This has not happened for a long while,” Harvard economist Ken Rogoff lamented in San Francisco. Degenerate banks must be closed by the state in a controlled way. As in Japan, the US government was long frightened of this.

Psychology also plays a considerable role in ending the crisis. With a clear calculable course, politics must try to reduce the uncertainty of businesses and consumers and stabilize expectations, the macro-experts emphasized. Governments of industrial countries should do everything to prevent a new “Great Depression,” Blanchard urged. This could bring consumers to abandon their savings out of fear and spend more money again.