Could We Be Facing
Another Depression?
By Christopher Farrell

Yes, says a minority of economic seers, whose warnings also remind us that enlightened government is the best protection against Hoovervilles.
"Prosperity is just around the corner," President Herbert Hoover infamously remarked in 1930. How wrong he was. Hoover's prognostication has gone down in history as a monumental goof, but what is forgotten is that, at the time, his utterance seemed quite reasonable.
Business activity in the U.S. had fallen in only seven of the years from 1869 to 1929 (excluding the years of the World War I). The average annual decline in real gross domestic product (GDP) during this period was 1.6%, with one downturn of 5.5%, according to Peter L. Bernstein in Against the Gods: A History of Risk. But 60 years of economic history proved irrelevant during the catastrophe known as the Great Depression, when GDP fell 55%, from a peak in 1929 to a trough in June, 1932.
After the terrorist attack of September 11, the U.S. economy has sunk into a recession. But the recent rally in the stock market shows that investors remain optimistic that fiscal stimulus and monetary easing will pull the economy out of the doldrums sometime in 2002. "The recovery should be robust during the second half of next year in response to the strong stimulus provided by monetary and fiscal policies," says Edward Yardeni, chief investment strategist of Deutsche Banc Alex. Brown. Adds James Paulson, chief investment strategist at Wells Capital Management: "The massive economic policy easing implemented since the terrorist attack has caused many to expect a 'V-type' economic recovery."
Are Yardeni and Paulson repeating Hoover's mistake? As anyone who reads this column regularly knows, I don't think so. Yet a minority of economists and investment analysts do. They point to ominous parallels between now and the interwar period. For instance, a new economy emerged in the 1920s, led by the automobile and electric power. The government plowed budget surpluses into paying off the national debt.
Worker productivity soared some 40%, and business invested enormous sums in new plants and equipment. Wall Street went on a long speculative binge. The Saturday Evening Post poetically captured investor irrational exuberance in 1929:
Oh, hush thee, my babe, granny's bought some more shares Daddy's gone out to play with the bulls and the bears, Mother's buying on tips, and she simply can't lose, And baby shall have some expensive new shoes!
Then, as we all know, the stock market boom went bust, and the Great Depression of the 1930s followed the Great Crash of 1929. While all this is fascinating to think about, the odds of another Great Depression in the U.S. seem remote. After all, a whole set of institutions from federal deposit insurance to unemployment insurance was established after the Depression to prevent another calamitous breakdown.
That said, a recent introduction to a collection of economic essays suggests that great depressions are far from relics of the past. The contributors to Great Depressions of the Twentieth Century study nine severe downturns around the world.
Several papers delve into the classic interwar depression of Europe and the U.S. But other scholars look into the depressions of Argentina, Brazil, Mexico, and Chile in the 1980s. These countries all suffered declines in economic activity comparable in magnitude to Canada, France, Germany, and the U.S. in the 1930s. New Zealand and Switzerland may have experienced depressions, and Japan is certainly sinking into an economic abyss. "The notion that the Great Depression is from the 1930s, and we don't have to worry about that now is wrong," says Timothy J. Kehoe, economist at the University of Minnesota and a contributor to the volume.
How do Kehoe and co-author Edward C. Prescott define a great depression in the introduction? They take the U.S., the world's technological and economic leader, as their baseline. The long-term secular growth rate in output per working-age person in the U.S. is 2% a year. A great depression is defined as a sharp and huge deviation from this 2% trend -- a drop of at least 20%. They only include in their study nations with a relatively modern economy. For example, their database includes Mexico but excludes Botswana.
By their definition, New Zealand experienced a depression from 1974 to 1992 since output per working-age person fell 32%. But Japan has steered clear of a depression after taking trend growth into account. Japan's output per working age person is down 13% from 1992 to 2000. The economists are quick to add that if the Asian giant's economy continues to stagnate its downturn will become a great one.
The authors use the classic general-equilibrium growth model as their framework for studying great depressions. They find that the quantity of savings isn't a problem. Nor are subsidies to investment the solution. Labor policies do matter, but not in all cases. Collectively, however, the economists are most intrigued that government policies that affect productivity and hours per working-age person are critical when examining great depressions. Their suspicion is that keeping competition among firms intense and letting inefficient companies fail has major positive consequences for productivity. Government attempts to limit competition and failure can backfire badly.
SIMILAR SHOCKS. For instance, both Chile and Mexico had great depressions in the early '80s, with output falling 30% below trend within a few years. Both countries were large international debtors. They were also hit by similar shocks: higher real interest rates (the interest rate after taking inflation into account), and lower commodity prices (copper for Chile and oil for Mexico). Yet productivity growth recovered fairly quickly in Chile but not in Mexico. The reason, the authors speculate, is that Chile reformed its banking and bankruptcy procedures and Mexico did not. Chile let unproductive firms go bankrupt while the government-dominated banking system in Mexico channeled low interest-rate loans to unproductive firms.
Kehoe and Prescott's contribution is a welcome reminder that depressions are not an economic catastrophe of the distant past. Their paper is also a timely nod that government policy combating a downturn is much more than fiscal and monetary stimulus. Open borders and a well-functioning bankruptcy system matter, too. Policymakers should continue to stimulate the economy. But they should also ignore calls to close borders to goods and immigrants, as well as calls to bail out the many industries hammered by the drop-off in economic activity since September 11. ___
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online. Edited by Beth Belton.


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