Anemic and Deflationary Recovery (EarlyWarningBlog)

MONDAY, JULY 12, 2010

Anemic and Deflationary Recovery

Buried in this post by Invictus over at the Big Picture, is the above amazing graph, showing final sales of domestic product following various economic peaks immediately prior to recessions.  This is in real (ie inflation adjusted) terms, and I double-checked a couple of the curves myself from the raw data since I was having a little trouble believing it.  Obviously, one thing going on here is that US economic growth has generally not been as strong in the last couple of decades as it used to be back in the 50s and 60s.

But the larger issue is that basically there is no real recovery following the great recession.

Paul Krugman also has a very interesting post looking at what the inflation data looks like if you don't use the year-over-year changes normally used (which are a lagging indicator during turning points), but instead look at the month-over-month changes (annualized), and just fit a trend-line to them to cancel out noise.  For one particular inflation measurement, he gets:

Not a pretty sight.

So this is deleveraging at work.  And of course deflation is the worst possible thing to happen when you are trying to deleverage, as it makes the real value of debt steadily greater over time, making it even more  difficult to repay.

Krugman's snarky comment at the end of the post inspired me to go reread Ben Bernanke's famous 2002 speech Deflation: Making Sure "It" Doesn't Happen Here.  In it, he argues that there are always ways for the central bank to inject money into the economy and prevent deflation.  In discussing why Japan was nonetheless unable to prevent deflation from occurring, Bernanke said:

First, as you know, Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, private-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies (for evidence see, for example, Posen, 1998). Fortunately, the U.S. economy does not share these problems, at least not to anything like the same degree, suggesting that anti-deflationary monetary and fiscal policies would be more potent here than they have been in Japan.

Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan's overall economic problems. As the Japanese certainly realize, both restoring banks and corporations to solvency and implementing significant structural change are necessary for Japan's long-run economic health. But in the short run, comprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy. As a natural result, politicians, economists, businesspeople, and the general public in Japan have sharply disagreed about competing proposals for reform. In the resulting political deadlock, strong policy actions are discouraged, and cooperation among policymakers is difficult to achieve.

So far, both factors seem to be just as operative in the US in 2010 as they were in Japan in 2002.  It will be interesting to see if policy-makers are able to mount a materially better response as the situation grinds on.