View from the Top

Here are words from the horse's mouth, Christina D. Romer, chair of Obama's CEA (Council of Economic Advisors). Well, actually here are some bit I found interesting...

I feel strongly that the shocks that hit the U.S. economy last fall were at least as large as those in 1929. In both cases, the economy had been in a gentle decline before the crisis—the recession that became the Great Depression began in August 1929; the current recession had been going on for nine months before the Lehman Brothers collapse. And in both cases, a financial crisis greatly accelerated and strengthened the decline.

A key precipitating shock in both episodes was a decline in household wealth. The Great Crash of the stock market reduced stock prices by 33 percent from September to December 1929. However, the Crash followed a run up in stock prices of 27 percent from June to August; over the whole year the market declined by a more modest 14 percent. Since house prices declined only slightly, the fall in household wealth was just 3 percent between December 1928 and December 1929. In 2008, the collapse in wealth was far more dramatic. Stock prices fell 24 percent in September and October alone, and house prices fell 9 percent over the year. All told, household wealth fell 17 percent between December 2007 and December 2008, more than five times the decline in 1929.

Economic theory suggests that such declines in wealth can have important contractionary effects on consumption and investment. Volatility in asset prices can also have important impacts. ...

Asset price volatility, which was very high in late 1929, was even greater in the fall and winter of 2008. We can measure the volatility of stock prices using the variance of daily returns. Using the S&P index, this measure was more than one-third larger in the current episode than in the final four months of 1929.

If a decline in asset prices was the precipitating factor in both 1929 and 2008, the defining feature in both cases was a full-fledged financial panic. In 1929, the financial system actually weathered the stock market crash fairly well, in part because of a timely injection of liquidity by the Federal Reserve. It was not until late 1930 that the economy suffered what Friedman and Schwartz describe as the first wave of banking panics, highlighted by the failure of the official-sounding Bank of the United States in December.

In 2008, the U.S. financial system had similarly survived the initial declines in house and stock prices, again in considerable part because of a vigilant Federal Reserve. But the outright failure of Lehman Brothers proved too much for the system. As has been described by many others, the breakdown in funding relationships in the week following Lehman’s collapse was almost unfathomable. The financial system truly froze and liabilities once assumed to be completely safe, such as money market mutual funds, threatened to trade at a discount.

...

This discussion suggests that the shocks affecting the U.S. financial system in the fall of 2008, whether measured by their impact on wealth, volatility, or risk spreads, were at least as great, and probably greater, than those at the start of the Great Depression. Consistent with this, the U.S. economy went into freefall shortly following Lehman’s collapse. From where we sit now, it is hard to believe that last fall there was still debate about whether Wall Street and Main Street were connected. The experience of the past year is dramatic proof that credit market disturbances affect production and employment.

...

This comparison between the initial months of the 1929 and 2008 crises makes real the frequent claim that the U.S. economy following the collapse of Lehman Brothers did come to the edge of a cliff. That we did not go over is a tribute to vast differences in economic policy. In 1930 and after, the initial shocks were compounded by even more shocking policy mistakes. In 2008 and 2009, in contrast, policy has counteracted rather than exacerbated the effects of the initial shocks.

...

[In the Great Depression] Only after three and a half years of depression and after the unemployment rate had reached 25 percent was genuinely expansionary policy instituted.

The policy response in the current episode, in contrast, has been swift and bold. The Federal Reserve’s creative and aggressive actions last fall to maintain lending will go down as a high point in central bank history. As credit market after credit market froze or evaporated, the Federal Reserve created many new programs to fill the gap and maintain the flow of credit.

...

The American Recovery and Reinvestment Act of 2009 was the Obama administration’s signature rescue measure. Providing $787 billion of tax cuts and spending increases, it is the boldest countercyclical fiscal expansion in American history. To put its size in perspective, the ARRA provides fiscal stimulus of roughly 2 percent of GDP in 2009 and 2½ of GDP in 2010. During the New Deal, the largest swing in the budget deficit was a rise of 1½ percent of GDP in 1936, which was followed by a counteracting swing in the opposite direction in the very next year that was even larger.

...

Though conditions could have been far worse given the shocks we have endured, it is still the case that the economy is in severe distress. The unemployment rate reached 9.7 percent in August, and we anticipate further rises before it finally begins to decline. Real GDP has fallen 4 percent since its peak in the second quarter of 2008, and its level is now more than 7 percent below most estimates of trend production. Employment has declined by 6.9 million since the business cycle peak in December 2007, and will surely decline further before growing again. But just as we saw in the aftermath of the Great Depression, effective policy and the resilience of the American economy and American workers are helping us turn the corner on this recession. Data on industrial production and surveys of manufacturers show that American factories are starting to produce again. To put it bluntly, in the year following the collapse of Lehman Brothers, the American economy, and American workers in particular, have been through hell.

...

A common misperception is that the recovery from the Great Depression was anemic. In fact, real GDP growth averaged nearly 10 percent per year between 1933 and 1937, and the unemployment rate fell more than 11 percentage points over that period. The source of this second recession was an unfortunate combination of monetary and fiscal contraction. The Federal Reserve, fearing that it might not be able to tighten when it needed to, tried to legislate away banks’ vast holdings of excess reserves by raising reserve The reason that we tend to think of the recovery as slow is that it was interrupted by a second severe recession from mid-1937 to mid-1938.

The source of this second recession was an unfortunate combination of monetary and fiscal contraction. The Federal Reserve, fearing that it might not be able to tighten when it needed to, tried to legislate away banks’ vast holdings of excess reserves by raising reserve requirements—only to discover that nervous banks wanted excess reserves and so contracted loans to replace them. On the fiscal side, Social Security taxes were collected for the first time in 1937, and government spending declined substantially following the one-time veterans’ bonus of 1936.

The economic historian in me cringes every time I hear mention of “exit” from fiscal stimulus and rescue operations in the current situation. ... But to talk seriously about stopping policy support at a time when the unemployment rate is nearing 10 percent and still rising is to risk nipping the nascent recovery in the bud.

Go read the text of the speech to get the full context of the bits I pulled out.