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Why I'm Really Anxious, And Other Recession Thoughts

Some thoughts on the stimulus debate:  

1.) Put me in the Judis-Cohn-Krugman camp: My big anxiety is that we don't grasp the magnitude of the problem we face. In particular, I worry that we're using the wrong paradigm. By the standard of the typical postwar recession--or even 1981-2, the most painful one--$800 billion over two years is a big, ambitious stimulus package. By the standards of a depression-like scenario, it's not so large.

This is why, for example, I don't think it's relevant to cite the work of Christina Romer, Obama's soon-to-be Council of Economic Advisors chief, as David Brooks did yesterday. Yes, in their 1994 paper, Romer and her husband found that "monetary policy alone is a sufficiently powerful and flexible tool to end recessions" and that   “[d]iscretionary fiscal policy ... does not appear to have had an important role in generating recoveries.” But the whole point is that this recession is different from the ones the Romers studied, which were relatively brief and shallow. (The paper only considers the recessions that fell beween 1950 and 1994.) 

Consider: If the counterfactual--that is, what the economy would look like with no stimulus--is only two quarters of negative growth, then fiscal policy will almost certainly be too slow to be effective. If the counterfactual is several quarters (say, a year or two) of negative growth, and an even longer period of job losses, then fiscal policy could be pretty important. Unfortunately, the indications are that we're closer to the second scenario than the first. (Though, like Brooks, I think the complexity of Obama's stimulus plan could create legislative and administrative problems.) 

An analogy: Suppose you were a small-time country doctor who'd never treated a brain tumor, but had treated lots of headaches with aspirin. Drawing lessons from all those cured headaches wouldn't be particularly helpful, even though the symptoms might be similar. That's the problem with relying on the Romer paper as a guide in this case.  

2.) Monetary policy is a great tool if you live in a world where it works. Problem is, we're probably not living in that world. Money is incredibly cheap--that is, interest rates are incredibly low--and yet banks aren't making loans. The reason is that there's too much uncertainty about what is and isn't a good risk, and that their own balance sheets are in such lousy shape. That's where the terrifying analogies to the Great Depression and Japan come in--the banks often refused to make loans then, too. It's also another reason why looking for answers in our postwar history is unhelpful. (No such problems with the banks during those recessions, for the most part.)

Of course, that's not an argument for fiscal policy per se. It's an argument for fixing the financial system. No amount of fiscal stimulus is likely to produce a recovery unless banks start lending again. And they won't do that until the bad loans are a.) transparently accounted for (that will ease the fear and uncertainty) and b.) largely off their books (that will solve the balance-sheet problem).

Unfortunately, this will be a long, drawn-out process--we've barely started--and you don't want the economy cratering beforehand. That's why fiscal policy is so important. It's the only way to avoid disaster in the meantime. 

A related aside: Giving money to banks with lots of bad loans, as the Bush Treasury has, is a bad idea, since they'll just use the money to patch up the balance-sheet holes these loans have created. Worse, the holes continue to grow, so it's like throwing money down a bottomless pit. We'll probably end up having to kill off the least solvent banks rather than keeping them alive this way. Or at least force them to write off their bad loans, then inject money into them. Or have Uncle Sam take the loans off their hands. One way or another, the banking mess has to be cleaned up. Japan didn't really recover until that happened. (Apologies for the ever-changing metaphors.) 

3.) Politics looms very large here, obviously. I count two basic political problems, at least as far as the stimulus goes. (Don't get me started on the financial system.) The first is the one I alluded to at the outset: lawmakers' and pundits' inability to grasp what we're dealing with. This is quite understandable--people make sense of new events by extrapolating from the past, usually the recent past. But it's not especially reassuring. If you need $2 trillion to revive the economy, but you worry that anything above $500 billion is unprecedented, and that anything north of $1 trillion is nuts, then you will fail. This is a big problem at the moment.

The second political problem is that, even if most policymakers and pundits do accept the right paradigm, a powerful minority of them (let's call them "Republicans" for the sake of this hypothetical) may object to spending so much on ideological grounds. Worse, they may be able to block it. 

The benefit of World War II, from the narrow perspective of the economy, is that it solved (actually circumvented) both problems. It didn't matter that policymakers didn't recognize the chilling new economic paradigm, because a national security crisis forced massive spending anyway. Likewise, after Pearl Harbor, many of the people who opposed massive spending to revive the economy were okay with massive spending to win a war. (Obviously some isolationist opposition persisted on the right--and the left, for that matter. But it had mostly moved to the fringes.)

The reason I'm so depressed these days is that I'm not optimistic about overcoming these political problems through reasoned debate. And you can't exactly count on a World War II-style external event to solve the problems either. I don't even know what that would be these days...

--Noam Scheiber

Update: For what it's worth, I think Obama's economic advisors (certainly his top one, Larry Summers) grasp the severity of the situation. I just think they're hemmed in by political constraints on the Hill and the mandate to build a broad majority. I guess my advice to Obama would be screw the broad majority. The economic crisis is too severe to risk it.

On the other hand, if I were Obama's political advisor, I'd probably argue for a bill that could pass by wide margins, too. The political system just isn't set up to handle anything as radical as I'm proposing. Worse, Obama faces a lose-lose proposition. If he were somehow able to get twice as much money as he's asking for and avoid the crisis a lot of us fear, then his critics would say it wasn't necessary. And if he doesn't spend enough and we do go off a cliff, he also gets blamed. I'd probably want a big majority in my corner under those circumstances, too.