Why is there a long depression?

In his latest post, Keynesian economist, Noah Smith considered the question of why there has been such weak recovery in the world economy since the Great Recession ended in mid-2009 (http://noahpinionblog.blogspot.co.uk/2013/02/on-iatrogenic-explanation-of-post.html).  Smith takes this up by criticising the comments of leading neoclassical economist John Cochrane, who attacked Keynesian explanations of the crisis and the subsequent weak recovery.

Cochrane was withering about the Keynesian explanation: “a spontaneous outbreak of thrift, to the point of valuing the future a lot more than the present, seems a bit of a strained diagnosis for the fundamental trouble of the US economy.  That a bit more thrift is a great danger to the economy, rather than the long awaited return to normal after decades of debt-financed consumption, seems strained as well.”   He went on: “The question before us is not really why consumption fell so drastically in 2008 and 2009. The question is, why did consumption get stuck at so low a level starting in 2010?  This question and controversy is much like those surrounding the Great Depression. The controversy there has not been about why the stock market crash and recession happened in the first place. (Though perhaps it should, as we really don’t know much about that process.)  The controversy is, why did the US get stuck so low for so long? Was it bad monetary policy (Friedman and Schwartz), bad microeconomic policy, war on capital and high marginal tax rates (Cole, Ohanian, Prescott, etc.), or inadequate fiscal stimulus (Keynesians)?”   Cochrane goes onto to dismiss the Keynesian explanation of the crisis as “unexpected negative shocks” as less than convincing.

I won’t go into the ins and outs of the arguments here – you can read it yourself if you want.  But Smith responds to Cochrane’s criticisms by saying that: “I think that, while there are definitely problems with the New Keynesian interpretation of the world, there are even more problems with the idea that government policy (and far-sighted citizens who guessed government policy years in advance) caused our long post-crisis stagnation. My intuition says the most likely explanation – unfortunately – is that there are some very deep things about how economies work that no macro model yet encompasses.”

The inference here is that Keynesian explanation of the ‘post-crisis stagnation’ (namely “unexpected negative shocks”) is inadequate,but then so is the neo-classical one (that government policies stopped the market economy from ‘cleansing’ or restoring  the system).  So Smith concludes that neither neoclassical nor Keynesian  mainstream macroeconomics has an explanation for the current stagnation, or depression as I prefer to call it.  That’s not surprising really as mainstream economics had no explanation for the Great Recession in the first place (see my paper, The causes of the Great Recession, The causes of the Great Recession).

While Smith and Cochrane struggle to explain the stagnation, Keynesian guru Paul Krugman seems to be staggering towards a more ‘Marxist’ explanation.  He calls his latest post on profits and business investment, “a note to himself” (http://krugman.blogs.nytimes.com/2013/02/09/profits-and-business-investment/).  In the post, he notes how far out of line corporate profits and business investment have got.  It seems that, despite the recovery in US business profits since the trough of the recession, business has not been restored and corporations appear to be hoarding cash rather than investing.

Readers of this blog will already be aware of this ‘investment strike’ as it has been taken up on many occasions (https://thenextrecession.wordpress.com/2011/11/25/us-investment-strike/).  But even though Krugman has started to look to the relation between profits and investment as the cause for the stagnation/depression, he still has no real explanation for this ‘cash hoarding’.

In my blog, I argue that a Marxist explanation gets to the heart of things.  There are two main reasons why the world capitalist economy has subsided into what I call a Long Depression, like that of the 1880s and 1890s in the US and the UK; or the Great Depression of the 1930s (although with some differences).  The first is that the profitability of the accumulated capital in the major economies has been in secular decline and has not been restored to the level reached before the Great Recession of 2008-9 (see my paper, The world rate of profit, (roberts_michael-a_world_rate_of_profit)
and several posts (https://thenextrecession.wordpress.com/2012/01/04/the-uk-rate-of-profit-and-others/).

Sure, in the US the total level  of profits has surpassed the previous pre-crisis peak, but not the rate of profit.  And in many other advanced capitalist economies, even the mass of profit has not reached the previous peak.  We don’t have to look for uncertain and ‘unexpected negative shocks’ or ‘government interference in the market’s pricing of labour and capital’ to explain the stagnation.  There just ain’t enough profit to get capitalists to invest at previous levels.

And that leads me to the second reason for the depression.  The recovery after the great slump has been hampered and curbed by the dead weight of excessive debt built up in the so-called neo-liberal period after the early 1980s and particularly during the credit and property bubble from 2002.  The ‘normal’ way that capitalism resumes a period of expansion in the cycle of boom and slump is for dead and unprofitable capital to be devalued or even liquidated in a slump through bankruptcies, takeovers and higher unemployment (lower wage bills).  Profitability is then restored and expansion resumes.  However, in this Long Depression, the level of debt (what Marx called fictitious capital) circulating is still so large that it is takes a very long time to ‘deleverage’ and reduce the burden of debt against profit.  Indeed, I reckon it will probably require a new slump to do so.

Moreover, we can connect these two reasons if we add financial capital to tangible assets and then see where profitability is.  I attempted this in a recent paper, Debt matters, that I presented at last November’s’ London Historical Materialism conference, with mixed success (Debt matters).  Alan Freeman has also published a recent paper which attempts to recalibrate the rate of profit in the UK and the US by including debt or fictitious capital (freeman13).  The results are still unsatisfactory, in my view.  Nevertheless, there is no doubt that the extent of the fictitious capital in the world economy is contributing to the inability of capitalism to recover from the Great Recession quickly.

What is interesting here is that the level of debt in the world economy has not fallen despite the Great Recession, the banking crash and bailouts.  Deleveraging is not really happening, at least not to any great extent.  According to Gerard Minack of the investment bank, Morgan Stanley (If it can’t happen, it won’t happen), developed economy non-financial sector leverage continues to rise.  Non-financial sector debt includes all debt held by governments, households and corporations.  It excludes financial sector debt.  Non-financial sector debt in the US, Europe and Japan (G3) is now over 285% of GDP compared to 275% at the start of the Great Recession.  It’s true that business debt to GDP has fallen a little and in some countries like the US, so has household debt.  But government debt has rocketed as governments bailed out the banks and were forced to borrow more to spend more on unemployment and social benefits in the slump while tax revenues dropped.  Financial sector debt did fall too, by 20% from its peak.  But if we add up all debt – non-financial and financial – in the G3, it fell from 409% of GDP to 379% of GDP in September 2011, but has now risen back to 400%.  So not much deleveraging there.

In fact, Minack points out that the US is the only economy that has seen any deleveraging and that largely reflects mortgage defaults in the household sector. Moreover, new dollar-denominated debt issuance is at an all-time high and very high relative to US GDP. The high gross issuance is in part to refinance existing debt at lower rates, although there are pockets where leverage is rising (such as student loans).

Minack reckons that this failure to deleverage and indeed even a rise in debt has been made possible because interest rates are very low, thanks to the efforts of central banks to push the floor on rates of interest down to zero.  So the cost of servicing the high debt is relatively low, for now.  The key sector for capitalist growth is the business sector.  In the US, corporate debt is near all-time highs, although down from the peak in 2008.  But debt service payments as a percent of GDP have fallen to near four decade lows (and by $150bn from the 2007 peak).

The average effective interest rate paid on the entire stock of US debt is at the lowest level since at least 1960. But the underlying issue of too much fictitious capital is revealed by another measure: gross interest payments relative to GDP, an economy-wide measure of the debt-service burden.  This rate remains well above pre-1980 levels and the gap between the average interest rate paid (interest payments relative to the stock of debt) and the debt service burden (interest payments relative to GDP) is widening because of rising leverage (the debt-to-GDP ratio).

The current low-growth world is a reflection of the burden of still high debt levels on the cost of borrowing relative to potential return on capital and thus on growth.   The job of a slump (to devalue assets, both tangible and fictitious) has not yet been achieved.  And if interest rates should start to rise, that could easily trigger a new slump. as the cost of servicing corporate and government debt would rise to unsustainable levels.   That is what the monetarists (Bernanke) and the Keynesians are worried about.

The research on how long it takes to deleverage after a credit and financial boom and bust is now well established.  Kenneth Rogoff and Carmen Reinhart have done a number of historical studies on the issue over the past few years.  This has provoked debates with Keynesians like Paul Krugman, who deny that it is necessary to deleverage when an economy is in deep depression.  On the contrary, more government spending through borrowing can restore growth and that will eventually enable debt levels to fall, as happened after the second world war.  I have discussed these arguments many times before in previous posts (https://thenextrecession.wordpress.com/2012/04/14/the-austerity-debate/).  The point is that these criticisms of Reinhart and Rogoff’s work do not change the empirical results, whatever the causal direction.  In historical case after case, high debt levels are associated with financial crashes and then with low growth often for up to a decade or more.

In a recent paper, Debt overhangs: past and present, Reinhart, Reinhart and Rogoff  identified major public debt ‘overhang episodes’ in the advanced economies since the early 1800s, characterised by public debt to GDP levels exceeding 90% for at least five years.  They found that these overhang episodes were associated with growth over 1% lower than during other periods.  And among the 26 episodes looked at, 20 lasted more than a decade especially if the post-war episodes are excluded.  The length of these overhang periods suggests that the debt has not risen because of any recession causing economic growth to slow, but on the contrary, the recession continues because of the debt build-up.  And the three RRRs find that “the growth effects are significant even in the many episodes where debtor countries were able to secure continual access to capital markets at relatively low real interest rates. That is, growth-reducing effects of high public debt are apparently not transmitted exclusively through high real interest rates.”  So the problem is not the Keynesian liquidity trap, but the Marxist fictitious capital burden.

Even more compelling is recent research by the mainstream but unorthodox economist at the Bank of International Settlements, Claudio Borio.  Along with William White, back in the early 200s, Borio presented evidence to suggest that when credit gets very high relative to trend GDP growth over a period, there was an 80% chance of financial crash (see the paper, The financial cycle and macroeconomics: What have we learnt? borio395).  Borio and White predicted the financial crash of 2007, one of the few economists to do so .  Now Borio has claimed to have identified what he calls a ‘financial credit cycle’, similar to the cycle of boom and slump in capitalist economies, or to the pr0fit cycle that I have identified (see my book, The Great Recession).   Borio argues that “it is not possible to understand business fluctuations and  the corresponding analytical and  policy challenges without understanding the financial cycle.”  

Borio points out that, as traditionally measured, the business cycle (by which he means the cycle of boom and slump in modern capitalist economies) involves frequencies from 1 to 8 years . By contrast, he finds that there is a financial cycle in seven industrialised countries since the 1960s of around 16-18 years.  The length of this cycle is similar to 16-18 year profit cycle that I have identified for the US economy (with slightly different lengths for other capitalist economies), although with different times for turning points.

Borio does not want to accept that the financial cycle is a recurrent, regular feature of the economy. “Rather, it is a tendency for a set of variables to evolve in a specific way responding to the economic environment and policies within it. The key to this cycle is that the boom sets the basis for, or causes, the subsequent bust.”  That implies that if macroeconomic policies are used to avoid deleveraging, like fiscal expansion or easy money, then the length of the cycle could be extended, only for a bigger collapse later.  That may be the story now.  In that sense, the neoclassical argument of Cochrane may have some validity, but, of course, not his solution, namely leaving the market to its own devices.

Indeed, Borio argues that Keynesian fiscal expansion policies designed to get economies out of this depression don’t work when the financial cycle operates: “If agents are overindebted, they may naturally give priority to the repayment of debt and not spend the additional income: in the extreme, the marginal propensity to consume would be zero.  Moreover, if the banking system is not working smoothly in the background, it can actually dampen the second-round effects of the fiscal multiplier: the funds need to go to those more willing to spend, but may not get there.”

I hope to deal with this thorny issue of cycles in capitalism in an upcoming research paper for this summer. In the meantime, if Borio’s evidence proves robust, then it suggests that the bottom of the current financial cycle is still to come. But the end of deleveraging will only be reached after a new slump in the global economy.