GDII or Just Another Recession?

Do you remember when WWI was called the Great War or the War to End All Wars? Probably not unless you were of age before 1940, which makes you 90 something now, an unlikely demographic to be browsing the web. I know the terms thanks to Colonel Potter and his fond memories of the even-then outdated cavalry charge.

Most macroeconomists believe that the Great Depression was the depression to end all depressions. We learned a number of policy lessons during the Great Depression. With these lessons in hand and our ever expanding understanding of the global economy, depressions were a thing of the past. Indeed, a large group of economists began to believe that severe recessions themselves were a thing of the past. They believed that monetary policy had become so sophisticated in managing expectations that the normal cyclical swings in economic activity could be almost completely avoided. In papers published a recently as January (this paper also contains a good overview of the moderation literature), economists continued this debate.

I don’t know all of the answers, but I do know that if this recession ended today, if the global economy returned to 3½ percent growth rates, the certitude over the efficacy of policy should be over. With Canadian GDP data now in hand (-3.4 percent), the fall in fourth-quarter global GDP was a post-war record. This recession happened under the watch of the new and improved macroeconomic policy.

And as I have said before, there is a growing risk that we are now entering a period of global depression. That depression is imminent is not, of course, certain: We may escape with a deep and prolonged recession.

But, depressions are not that uncommon. In four episodes in the latter half of the 19th century, manufacturing output in the United States fell more than 20 percent. By my definition, four depressions. In the first half of the 20th century, manufacturing output met this definition 6 times, four if we don’t count 1938 as separate from 1930-32 and if we don’t include the draw down following WWII. Between 1950 and 2008, there were exactly zero episodes. In their broadest interpretation, those papers I referenced above on the Great Moderation are really discussing this phenomenon, although they believe they are discussing the post-1980 world.

Why do we believe depressions cannot happen any longer? Because they haven’t happened lately? Because economic policy can solve all of our problems? Because the world is different?

A lot of my concerns have been driven by the collapse of the Asian economies. Across Asia, industrial production has fallen more than 30 percent. The decline in production has been mirrored by falling trade volumes and is now showing through to domestic consumption. In most countries, production has now fallen farther than it did during the Asian Financial Crisis. But Asia is not falling alone. Every major economy (with the previously discussed exception of China), is experiencing a major fall in manufacturing IP. Countries as diverse as Brazil, Poland, and South Africa are all contracting.

Take a look at the following pictures:

Industrial production in the United States reached a peak in December 2007. In August 2008, the series began its nosedive, six months of not just falls but historically large falls. For comparison, look at the fall in IP during the 2000 recession. That recession was a manufacturing recession, recall that 20 percent of manufacturing employment disappeared forever at that time.

But the fall in production in the United States is small relative to the declines currently occurring in Asia. In Taiwan, production peaked in April 2008 and has since fallen 38 percent. Taiwan’s economy is completely dependent on its manufacturing sector.

Production in Europe has fallen roughly the same as production in the United States, down just over 10 percent from the peak. The decline is not confined to countries like Ireland or Spain that had experienced fast growth in recent years, both Germany and France are seeing dropping production levels.

Of course, with Europe in recession, Eastern Europe could not be expected to thrive. But many people had high hopes that Poland with its relatively good external balance might do well.

Likewise, the downturn in Brazil is sudden and startling. Brazil is a relatively closed economy. For a developing country, its growth was supported to a large extent by an expansion of domestic demand rather than by exports. Brazil’s IP peaked in September and has since fallen 20 percent.

Even South Africa has not escaped the downturn. South African IP peaked in June 2008 and has since fallen 14 percent.

The falls in production look like nothing less than a global collapse in manufacturing. Of course, manufacturing has become a smaller and smaller share of the economy over the past 30 years. So, a decline in manufacturing does not have to correspond to a decline in overall output. Wait! Yes it does, at least when the declines are this large.

Let’s think about the other sectors of the economy that might support growth. The services sector, in the advanced economies, is the first candidate. But which parts of services can grow. The financial sector is in disarray. Retail and wholesale services are about distributing manufacturing goods. Transportation services are primarily (thinking shipping and railroads) designed to move goods and manufacturing inputs, especially coal and oil for energy hungry manufacturing plants. Agriculture production should continue to grow, people still need to eat. But, it could also shrink as people move to cheaper sources of food. I can’t think of any combination of sectors that can support growth in the absence of a manufacturing sector.

We shall see. Nobody thought there would be another world war after the Great War was over.

My Advice to Governments: Give up on fiscal stimulus. The stimulus is unlikely to help and will place country balance sheets in an untenable position if the economy continues to deteriorate. Instead, governments should look to the solvency of their social support programs.

For example, in the United States foreclosure is already a significant problem. House prices are likely to fall a lot further as the economy deteriorates over the next year. Low house prices combined with high unemployment will induce a large number of additional foreclosures. At some point, these foreclosures will cause a rise in the number of homeless families. The time to plan for this contingency is now, not when it actually happens.