Sunday, October 21, 2012

Unemployment, growth and real interest rates

The United States still faces the worst depression since the Great Depression of the 1930s. As I have examined the Great Depression more closely over time, I am largely supportive of Professor David Glasner's basic explanation about the link between the Great Depression and the Gold Standard. He was introduced to the theory by Professor Earl Thompson and traces the theory to Ralph Hawtrey and Gustav Cassel. Basically, he said that the main problem was that the value of gold increased greatly, so that maintaining the parity between currencies and gold implied huge deflation. I would like to add a small detail, that a large decline in nominal income can be exacerbated by a large overhang of private sector debt. We all know that there were many problems which led to the huge decline in GDP in the Great Depression. There was a large overhang of private sector debt, a collapsing real estate and stock bubble and numerous banking panics before President Franklin D. Roosevelt declared the bank holiday and devalued the dollar relative to gold.

In the current depression, there was a real estate bubble that collapsed, various financial market problems including a run on the repo market, a brief period of deflation and real GDP declined to almost 8% below potential during two quarters in 2009. The graph below chronicles the relation between GDP, potential GDP and the level of unemployment above the natural rate.

As one can see, GDP growth began slipping below the growth in potential GDP midway through 2007 and reached its lowest point in the second quarter of 2009, well before the stimulus occurred. The growth rate reached the level to realize a stable unemployment rate around the beginning of 2010. Since that point, unemployment has gradually declined. GDP is still around 6% below potential. As one can see on the next graph, much of the time since the inception of the recovery appears to be sufficient to decrease the unemployment rate to about 6% in 8 years, if we continue to grow the economy at the pace since 2010.

The next graph begins chronologically at the point where the growth rate is roughly 0% and the annual average 5-year real interest rate was about 1%, in the third quarter of 2008 (this is the average rates from 2007:IV to 2008:III). The real interest rate rose to about 1/2 percent 6 months later. This indicates that the real interest rates at that point were depressing the economy further. This is due primarily to the brief period of deflation. After that point, the return of inflation and declining nominal rates helped turn the growth rate of the economy positive another 9 months later. The growth rate since then has been so lackluster that only 60% of the time was year-on-year growth sufficient to reduce the unemployment rate. Only 4 quarters had year-on-year growth rates sufficient to ensure a decline in the unemployment rate by 2 percent over 8 years.

The stimulus was passed in early 2009. Since then, the Obama Administration tackled health care reform (a worthy goal that has worked out fairly well), then it went in for deficit reduction, trying to keep an ill-advised election promise to cut the deficit in half (as if there were not better things to do at the time, like passing a new stimulus). As Professor Krugman has pointed out many times, total government purchases at all levels of government were gradually declining, undermining the recovery. Thankfully, the Federal Reserve has recently been more accommodative, with the introduction of "QE3". The federal government needs to bring a new round of stimulus, focusing on spending that will have a big bang for the buck, like investments in infrastructure, education, extended or even increased unemployment insurance benefits and/or temporarily increasing the federal government's share of decentralized welfare programs. The rates of growth are far too low to bring unemployment back down to 6%, much less the natural rate, which is 5%, within a reasonable timeframe.

Raising the growth rate by about 1/2 percent will double the speed of the recovery. There are some reasons to think that growth is set to accelerate somewhat, including a housing turnaround and the decrease in household debt that has been accomplished already, but the economy could still use a good jolt to return the U.S. to full employment.

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