Yesterday, Christina Romer appeared before the Joint Economic Committee to give the assembled congressfolk an update on the administration's economic thinking. So far as these documents go, it's a pretty clear outline of the White House's approach, and it includes an interesting bit on the interaction of Romer's research on the Great Depression and her take on the current crisis. She begins with a jaw-dropping fact: "By one measure, she says, "household wealth has fallen by $13 trillion, or 20%, since its peak." But she argues that economic loss hasn't been the driver of the ensuing pain. Rather, economic volatility has done the most damage:
In a paper I wrote many years ago, I argued that the main effect of the crash of the stock market in 1929 on spending operated not through the direct loss of wealth, but through the enormous uncertainty it created. The initial crash in October was followed by wild fluctuations of stock prices. This volatility led consumers and firms to be highly uncertain about what lay ahead. I found narrative and statistical evidence that this uncertainty led to large drops in consumption and investment spending. This makes sense: when you don’t know what is likely to happen, the best thing to do may be to simply do nothing as you wait for more information.
The same factor may be at work today. While house prices have been steadily down, stock prices have been on a wild ride. Volatility, according to some measures, has been over five times as high over the past six months as it was in the first half of 2007.6 The resulting uncertainty has almost surely contributed to a decline in spending, especially in the last few months.