Are Depressions Necessary?

Economists, particularly those of the ascendant Chicago school of free market enthusiasts, were in a triumphant mood at the beginning of this decade. Speaking at the annual meeting of the American Economic Association in 2003, Nobel Laureate Robert Lucas went so far as to say that macro-economics -- with its focus on the stable maintenance of national economies -- could safely be retired. "The central problem of depression prevention," he said, "has been solved for all practical purposes."

But if the technical challenge of depression prevention has rudely announced itself unsolved, the current crisis has also reawakened a long-obscured, but far more profound debate about the very nature of cyclical capitalism. That is: Are economic contractions, like the one we're currently experiencing, a good thing?

You won't hear this question asked in most mainstream political discussion of the crisis. It would be career suicide for any elected official to suggest that the widespread stress, misery and heartache being wreaked by the precipitous contraction were are a good thing. But scratch the surface a bit and you'll find a surprisingly vibrant school of thought, one that reaches back all the way back to the Great Depression, that holds precisely this view.

Famed economist Joseph Schumpeter said that "a depression is for capitalism like a good, cold douche," one that rinses off accumulated dysfunction. Robber baron Andrew Mellon (who served as Herbert Hoover's treasury secretary) welcomed the Great Depression with these infamous words: "It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people"

It's not hard to find this same view among bankers, financiers and sundry Wall Streeters today. Recently a bond trader told me he hoped that the Fed would raise interest rates and plunge economy into a truly deep, painful (but he hoped, quick) depression. "I don't think that would be good for you," I said. "Oh, I'd be fine," he responded. ( I meant politically: as in, there'll be people with pitchforks at your door. We were talking past each other I suppose.)

There's no question that economic contraction feels quite different to a bond trader and an unskilled worker. A spike in unemployment hits those on the margins of the labor market the hardest, while contractions also usher in deflation, which has a strong tendency to make the rich richer. But the faith in the salutary effects of economic misery also derives from a puritanical view of the economy, one that can manifest itself on both the left and right. Under this view contractions are collective punishment for our trespasses; we are sinners in the invisible hands of an angry God.

The stakes for this argument are very high: if steep economic contractions are like forest fires, a necessary part of the system's self-calibration, we should more or less let them burn. If they are more like five-alarms raging through dense city neighborhoods, we should call in the fire department.


Newsweek and Washington Post columnist Robert Samuelson is perhaps the most prominent and outspoken Mellonist writing today, and his last manifesto The Great Inflation and Its Aftermath: The Past and Future of American Affluence is best understood as a brief for the particular form of deregulated global capitalism that emerged in the wake of the stagflation of the 1970s, accelerated triumphantly through the last three decades, and is now crashing down around our ears.

At its root, the book is a morality tale of hubris and comeuppance, the macro-economic version of Icarus' flight. The story goes something like this: In the wake of the Great Depression, economists came under the sway of certain technocratic faith in the perfectability of the American economy. They believed business cycles were a thing of the past and that all downturns could be remedied with an injection of government spending.

The liberal technocrats of the Kennedy and Johnson administrations believed in the Phillips curve, an inverse relationship between inflation and full employment. And since the downsides of the unemployment were more obvious and immediate than those of inflation, they pushed the economy to maintain full employment as inflation crept upwards.

Samuelson calls this the "full employment obsession" and the effect, he claims was to spoil American workers beyond repair:

Booms and busts, recessions and depressions had long been considered and unavoidable aspects of industrial capitalism. But once people accepted the idea that the business cycle could be mastered, then the self-restraint that had silently kept prices and wages in check gradually crumbled.

We became, in Samuelson's words, "progress junkies." A wage-price spiral took hold in which higher prices pushed unions to bargain for higher wages, which in turn put more money in people's pockets and sent prices upwards. Eventually as the public came to expect increased government spending and loose monetary policy, Samuelson contends, the positive effect on unemployment waned, having already been priced in, and the result was high inflation and stagnating growth.

It's unclear however, whether the persistent inflation of the time was the result of the nature of the social contract, or a confluence of factors: a very long debt-financed war in Vietnam, combined with a loose monetary policy. And it is almost certainly true (and hardly controversial) that stable prices, while necessary for strong economic growth, are certainly not sufficient: George W Bush presided over one of the lowest average inflation rates of any post-war American president, yet his term left average wage earners worse off while precipitating the worst financial crisis in 80 years.

But for Samuelson, inflation is enemy number one, so much so that wringing it out of a system makes recessions look not so bad. "Recessions also have often-overlooked benefits," he wrote in his Newsweek column last year, echoing, in an albeit softer tone, Mellon and Schumpeter. "They dampen inflation. In weak markets, companies can't easily raise prices or workers' wages. Similarly, recessions punish reckless financial speculation and poor corporate investments. Bad bets don't pay off."

With the unemployment sword of Damocles hanging over their heads, workers will think twice about asking for a raise, and all of this will lead to a robust kind of capitalism for the capitalists: one with low inflation, low interest rates and very high return to capital. If that sounds familiar, it's an apt description of the economy of at least the last two decades, a kind of capitalism recently proven far less stable than it may have appeared, but one for which Samuelson is an unapologetic partisan: "The new economic order," Samuelson writes, "is indeed inferior to the imagined and romanticized version of the old order. But it's superior to the old order as it actually operated."


Paul Krugman, to put it mildly, disagrees. In 1999 he published a book with the prescient title the The Return of Depression Economics. While folks like Samuelson and Robert Lucas were celebrating the fruits of neoliberalism, a strange thing was happening: Financial crises of larger and larger scale and scope were wreaking havoc on the global financial system. Mostly, as Krugman notes, we ignored the tremors.

The original edition of Krugman's book offered a tour of a series of financial crises that rocked the world in the late 1990s (Japan, Mexico, South East Asia, Russia), and the new edition includes expanded treatment of some that came after the publication date (like Argentina in 2001) before getting the to the main event: our present troubles.

These crises tended to have a few things in common, but at the heart of many were central banks, governments and international lending institutions that had learned the lessons glossed in Samuelson too well. Low inflation became a central obsession of the so called "Washington Consensus," the term given for the uniform prescription of stiff free-market medicine -- balanced budgets, privatization of government services, and tight monetary policy -- that dominated global economic policy in the 1980s and 1990s.

What animated much of this advice was not just a rigid and dogmatic economic consensus, but also the puritanical normative assessment that a wicked economy must now pay its penance. (Of course said penance was never paid by those who caused the crisis: It was paid out of the pockets of the starving, the poor and working class.)

It's exactly this notion that Krugman seeks, above all, to dispel. To do so he repeatedly returns to the true story of a baby-sitting co-op in Washington, D.C.'s Capitol Hill neighborhood. The co-op allowed couples with young children to have babysitters for nights out in return. In order to track people's credits, the co-op issued scrip: a coupon good for one night out. But a funny thing started to happen. People wanted maximal flexibility and so started hoarding their coupons, meaning there were too many people wanting to supply baby-sitting, and not enough who wanted to use the service. The co-op ground to a halt.

Why, Krugman, asks did this happen?

It was not because the members of the co-op were doing a bad job of baby-sitting ... It wasn't because the co-op suffered from "Capitol Hill values" or engaged in "crony baby-sittingism" or had failed to adjust to changing baby-sitting technology as well as its competitors. The problem was not with the co-op's ability to produce, but simply a lack of "effective demand...The lesson for the real world is that your vulnerability to the business cycle may have little or nothing to do with your more fundamental economic strengths and weaknesses.

"[B]ad things," Krugman concludes, "can happen to good economies."

In the developing world in particular, a neighboring country's crisis can quickly become your own for no rational reason. Even in places where crises are caused by a panoply of deep structural problems (like, for instance, here), the initial shock is easily magnified through a positive feedback loop: People panic so they start selling their assets, which depreciates the price further, which causes more people to panic, who then try to sell, etc ... These are the "animal spirits" that Keynes famously invoked, people's hopeful optimism about the future of their dark fears both of which often become self-fulfilling prophesies.

More broadly, Krugman's point is that, contra Samuelson, recessions, and depressions and assorted downturns are not useful, cleansing opportunities to "purge the rottenness out of the system," but more often vicious cycles, auto-catalytic processes that result in massive amounts of human suffering, and waste human capital and an economy's productive capacity. More like the forest fire caused by a careless camper than the natural cleansings produced by mother nature.

The technical implication of this view for crisis management is that when an economy is stuck in a deep recession, like the one in which we are now mired, normal bromides of Chicago-style economics, those to which Samuelson clings so closely, cease to apply. Milton Friedman famously wrote "there's no such thing as free lunch," but when an economy slips into "depression economics" this is no longer the case.

Here, then, is where we hit the heart of the conflict. Equilibrium, with its sparkling promise of calm, is the promise of functioning markets. In Samuelson's view, that equilibrium can be counted on so long as the government doesn't interfere, artificially pushing government money. Indeed, under this view recession, perhaps even depression, are crucially part of that equilibrium. That is to say, suffering is necessary for a functioning capitalist economy. Krugman sees economic equilibrium as tenuous and elusive. And precisely since it is so hard to come by, deft and active management is necessary. Suffering is no badge or courage, but a sign of failure.

The intellectual tension here, though, runs parallel to a political one. Much of economic management, outside of avoiding obvious folly, is a political question: one of distribution and trade-offs. The economy of Keynes was very good for the (white) middle class, and perfectly fine for the rich. The economy of Friedman was bad for the middle class, but very good for the upper class and corporations. And the hybrid Greenspanism was an orgy for the rich and now is a disaster for all of us.

As Krugman persuasively argues, economies need management and policy to maintain some kind of equilibrium. If we agree they need to be saved from their own tendency to spiral into disaster, to cycle through booms and busts, then it will be politics, not technical expertise, which provides the principles and rules that regulate. Samuelson and those of the Mellonist school have an innate distrust of politics; meddlesome and vulgar and prone to demagoguery. Lately the political system as seemed to be working over-time to confirm their worst fears.

But ultimately there is not economics without politics, and as terrifying as this may be, economists can't save us from this crisis. Only politicians can.