Wednesday, October 17, 2012

Causes of the Great Recession and the Slow Recovery

My views on the macroeconomic landscape in America and abroad over the past five years, much like the landscape, have been in flux. Here is my current view as to the approximate causes of the Great Recession itself and the reason the recovery has been so poor. I'm limiting my evaluation to the more immediate and direct causes--therefore, the notable absence of multi-decade-long TBTF bailout contributions and regulatory failure including subsidization of housing, et al.

Causes of the recession:

  1. Federal Reserve policy failure allowing NGDP growth to fall extraordinarily below trend (the tightest money policy since Hoover). This is the shorter-term portion of the causes. For this I'd approximate 50% of the responsibility. (HT: Scott Sumner)
  2. Structural problems perhaps best understood through a Patterns of Sustainable Specialization and Trade (PSST) framework. Included in this grouping is malinvestment playing a major role. This is the longer-term portion of the causes. For this I'd approximate 40% of the responsibility. (HT: Arnold Kling)
  3. Everything else. 10% responsibility.
The combination of factors 1 and 2 created the perfect storm for this event to be so damaging. A recent post by Scott Sumner relates to this. Either 1 or 2 would have been sufficient causes for a recession or recession-like events. Cause 1 creates much more acute, short-term pain. Cause 2 creates much more hidden dead-weight loss by changing the fundamental glidepath of growth. Perhaps we lose one-half to one percent off of average annual growth for 10-30 years. This would be a truly colossal loss--remember, growth is a compound number that affects results with many orders of magnitude. 

The reason the recovery has been so poor:
  1. Federal Reserve policy failure to get us back to or toward trend NGDP levels. Our inability to close the potential-real gap will make future generations both laugh and cry. I'd give this 55% responsibility.
  2. Prolonged PSST difficulties. This is hard to avoid given how bad the PSST problem was. Some good portion of it, mind you, was an unavoidable consequence of free market growth in a less than free market world. Government makes creative destruction less creative and more unnecessarily destructive. I'd give this 25% responsibility.
  3. Regime uncertainty and undesirableness, which has many facets. Tax policy is a mess. Government spending is on an unsustainable trend with no likely solution or solver to be found. Regulation continues to respond on cue--more complications and gamesmanship (Dodd-Frank), more intrusions and forced bargains (Obamacare). Minimum wage increases and unemployment benefits extension get the incentives backwards from the goal. I'd give this 15% responsibility.
  4. Everything else. Surely there is something else, or are these categories jointly exhaustive? Potentially 5% responsibility. 
As with any economic period, there are many contributing factors and some are and may remain hidden.