The Art of Economic Recovery

It has been seventy-five years since the world economy has had a real depression. There have been plenty of recessions, some of them painful, but nothing to match the slump suffered in the 1930s.

But consider the following. Imports in China are down 45 percent year on year. Unemployment in the United States is rising at 600,000 a month. The German economy shrank by 2.1 percent in the final three months of last year. Factory output in Britain is dropping at a rate not seen since industry was on a three-day week during the miners' strike of 1974.

So is this the “Big One”? The honest answer is that we don't know and we might as well admit it. One reason we are in this mess is that we assumed far greater foresight than actually existed. All the fancy models purporting to show only a minuscule risk of financial blow-out were flawed. They assumed the complexity could be captured by mathematics and pseudo-science. One silver lining to the storm cloud over the global economy is that there will now be an overdue revolution in how we do economics. Already, the cutting edge of the profession is looking to other disciplines—biology and psychology in particular—to explain why models that work in theory come to a cropper in practice.

Passions

As Richard Bronk notes in his fascinating new book: “Standard economics assumes that economic agents are perfectly rational; that is the basis of its predictive equilibrium models. Modern versions generally allow for certain types of information problem and market failure, and recognize that institutions and even history play a role; but they still assume that these factors do not call into question the underlying model of agents as rational utility maximizers within those constraints.”

Bronk's book is about the lessons economists can learn from the Romantic movement, from Wordsworth's poetry and the philosophy of Nietzsche. We all have passions, paranoias, dreams, and delusions, he says, and thee shape our future. “In many cases, economic activity is as much a function of creativity, imagination, and sentiment as is the act of writing a poem or painting a picture.”

Many economists down the years have expressed skepticism about reducing their discipline to a mechanistic subject. Malthus told Ricardo to be wary of becoming too attached to abstract hypotheses; Schumpeter talked of creative destruction; Hayek saw the market as a voyage of discovery; Keynes stressed the importance of “animal spirits.” Somewhere down the years, these insights have been lost. It is as if physicists still thought that the Newtonian view of the world was all that mattered, and that Einstein had never been born.

In retrospect, Chuck Prince of Citigroup best summed up why life does not always turn out the way the models say it should. Three weeks before the crisis broke, Prince said there was so much liquidity around that the financial markets could not be disrupted ty the turmoil already evident in the US sub-prime market. “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing.”

Prince's comment is now seen as the height of folly, but it was not seen as such at the time. One commentator noted that defaults on junk bonds were running at their lowest rate since 1995 and it made sense for Citigroup to make money while the going was good. Most other players in the financial markets behaved the way Prince did, and those that didn't were investors who put their trust in judgment, feel, and experience rather than on market signals.

Dispensing with rationality

What we now know is that even the very recent past is an unreliable guide to the future; that risks are not distributed in a linear and predictable way; that human beings do not always act rationally even when they think they are; and that shocks are much more likely than economic orthodoxy would suggest.

All of which explains why it is virtually impossible to say where the global economy goes from here. The big picture is of globalization going into reverse, with industrial production and trade flows collapsing. Dharval Joshi, economist at RAB Capital, says that if history is any guide the UK and the US could well be braced for the Big One.

On the four occasions in the past 100 years when households in a major country have seen their net worth shrink there has been a strong correlation with lost output. For every three percentage point drop in net household worth in the US during the Great Depression, the Japanese crash of the 1990s, the UK housing collapse of the late 1980s, and the US dotcom bust, there is a subsequent one point drop in output.

In the downturn, lower house and equity prices have seen wealth as a percentage of GDP fall by op percent in the US and 80 percent in the UK. That would imply a 25-30 percent shortfall in output in the US and Britain relative to trend—which would fully justify [economist and British politician] Ed Balls's comment that this could be the most serious global recession in more than 100 years.

This is not yet the conventional wisdom, though the mood is getting gloomier. Mervyn King [economist and governor, Bank of England] says Britain is in a deep recession; he says cheap money, fiscal expansion, and the “unconventional measures” the Bank of England has up its sleeve will eventually work. Even so, at its worst point later this year, King thinks the economy will be contracting at an annual rate of 4 percent—with the risk that it could be worse than that.

Interestingly, the governor cited Keynes at the Bank's inflation report press conference, noting that animal spirits were currently depressed. With confidence so weak, it is hard to envisage an early or a robust recovery.

Having said that [“it is hard to envisage an early or a robust recovery”], we may be as blind to the potential for an upswing as we were to the looming crisis. There have been a few signs in recent weeks of buyer interest returning to the housing market, surveys of manufacturing, services, and construction that were slightly less dreadful than the previous month, a gradual thaw in the credit markets.

Clearly the good news is outweighed by the bad, but it should not be dismissed out of hand. The consensus is that 2009 is a write-off and that 2010 will not be much better, and if I had to stake my life on it, that's probably what I would say. But the consensus is invariably wrong, and anybody claiming to know for sure where the economy is heading is lying.

We have had more than enough strident professions of certainty, it is time to admit we know a lot less than we think. Let's read some Wordsworth instead.