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Tuesday, November 17, 2009 7:42 PM

DeLong Says Odds of Another Great Depression Reach 5%; I Assess Odds of Various Scenarios

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Economist Brad DeLong, Department of Economics, U.C. Berkeley, is getting increasingly pessimistic. DeLong says: Chance of Great Depression Now 5%...

For 2 1/4 years now I have been saying that there is no chance of a repeat of the Great Depression or anything like it--that we know what to do and how to do it and will do it if things turn south.

I don't think I can say that anymore. In my estimation the chances of another big downward shock to the U.S. economy--a shock that would carry us from the 1/3-of-a-Great-Depression we have now to 2/3 or more--are about 5%. And it now looks very much as if if such a shock hits the U.S. government will be unable to do a d----- thing about it.

We could cushion the impact of another big downward shock by a lot more deficit spending--unemployment, after all, goes down whenever anybody spends more (even though sometimes falling unemployment comes at too-high a price in rising inflation), and the government's money is as good as anybody else's. But the centrist Democratic legislative caucus has now dug in its heels behind the position that we cannot undertake more deficit spending right now because we have a dire structural health-care financing problem after 2030.

The Republican legislative causes has now dug in its heels behind the position that the fact that unemployment is 10% shows not that policy earlier this year was too cautious but rather that it was ineffective. And the Obama administration has not been able or has not tried to move either of those groups out of their current entrenchments.

So if another big bad shock hits the U.S. economy, what could the Obama administration possibly do?
Depression Debate

For starters it is clear we are in a depression. However, this gets back to the Depression Debate: Is This A Depression?

I say it is, for reasons given in the article. However, while this is "A" depression, this is clearly not the "Great Depression". Delong calls it 1/3 of the Great Depression. For the sake of argument let's accept that.

Who's To Blame?

DeLong is blaming Democrats and Republicans for not wanting to spend enough. He is right about the increasing odds, yet he is badly misguided as to the the reason why.

The problem is debt. One does not cure a debt problem by going deeper in debt. We should have let failed banks actually fail instead of making zombies out of them. We are repeating the very same mistakes Japan made, and ironically Delong's wants to to make the same mistakes only much bigger.

Sadly, that is how Keynesian economists think.

Rather than not doing enough, I claim U.S. Faces Second Lost Decade "Because" of Misguided Stimulus.

Repeating The Mistakes of the Great Depression

We have made all the wrong policy decisions just as Hoover and FDR did in the 1930's. Contrary to popular belief, it was not failure to keep up the stimulus that lead to a relapse in the late 1930's, but a rather a whole series of policy errors on top of the basic problem: Eventually stimulus will always run dry because by definition it must, and when it does the artificial boom ends but the debt overhang still remain.

WWII ended the Great Depression at a huge expense to the rest of the world.

The US was a shining beacon of growth after the war for the easily explainable reason that our productive capacity was not destroyed while productive capacity was destroyed everywhere else.

Debt Implosion

Japan is on the verge of imploding right now with debt-to-GDP at close to 200%. Yet somehow, Keynesian economists think more debt and more stimulus is the answer.

What the administration should have done is let failed banks fail. Instead we propped them up, just as Japan did.

So much capital has been wasted propping up failed banks, that the risk of another serious implosion has increased. I think it is much higher than the 5% DeLong says.

However, let's be careful here. Social safety nets are much bigger now than in the 1930's. Another "Great Depression" will look much different because of food stamps, foreclosure policy, unemployment insurance, etc.

In another implosion, expect those nets to expand. Such a policy response would cost jobs and prolong the agony of course, but it will be tried. Indeed, it has already. Fannie Mae is renting foreclosed houses back to people.

The US government is in effect the nation's biggest landlord.

Assessing The Odds

I have the odds of a severe downturn at 15% (unemployment exceeds 13% perhaps by a lot) and a less severe fashion at 30% (unemployment exceeds 12% or higher). In both of these scenarios there is a double dip recession. This is the "L" or "WW" scenario. In the milder form we flirt in and out close to recession for a number of years and unemployment essentially flatlines for years before finally turning lower.

"Muddle Through" means things do not get much worse nor do they get much better (Unemployment tops out under or near 12% and we do not double dip or if we do it is barely noticeable). Unemployment peaks, then very slowly starts to drop. Let's put the odds of "Muddle Through" at 35%. "Muddle Through" might be labeled a "U Shaped Recovery" but it would feel more like an "L". Realistically this is about the best we can hope for.

Slightly better than muddle through has about a 15% chance (A genuine U-Shaped Recovery). Unemployment peaks, then drops at a modest pace.

The vaunted V-Shaped recovery with strong growth in jobs has about a 5% chance in my estimation. Even in a V-Shaped recovery, the odds of unemployment dropping to 6% or less by 2015 are close to zero.

In general, expectations about what this recovery will look like are far too optimistic, perhaps even by me.

Mike "Mish" Shedlock
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