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Other post World War ll depressions

"Prosperity is just around the corner," President Herbert Hoover infamously remarked in 1930. The magnitude of Hoover's wrong forecast has gone down in history, but what's forgotten is that his prognostication was quite reasonable. Business activity in the U.S. had fallen only seven years from 1869 to 1929 (excluding the years of the First World War). The average annual decline in real gross domestic product was 1.6%, with one downturn of 5.5%, according to Peter L. Bernstein in "Against the Gods: A History of Risk." But six decades of economic experience proved irrelevant during the catastrophe known as the Great Depression.

While fascinating to think about, the odds of another great depression in the U.S. have long seemed remote. After all, a whole set of institutions from federal deposit insurance to unemployment insurance were established to prevent another calamitous breakdown.

Of course, now it appears that the risk of a global recession, let alone a depression, is at least possible. That's why I pulled out an essay I wrote after 9/11 on a collection of economic essays that suggest great depressions have been far from relics of the past. Indeed, there have been several in the developing world--a number in the very recent past.

Here's the relevant part:

The contributors to "Great Depressions of the Twentieth Century," study nine severe downturns. Several papers delve into the classic interwar depression of Europe and the U.S. But other scholars looked 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 his 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. In other words, 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 by 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 authors use the classic general equilibrium growth model as their framework for studying great depressions. They do find that the quantity of savings is not a problem and subsidies to investment are not the solution. Labor policies do matter, but not in all cases. Collectively, they are 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 consequences for productivity. Government attempts to limit competition and failure can backfire badly.

For instance, both Chile and Mexico had great depressions in the early 1980s, 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.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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