The National Bureau of Economic Research (NBER) finally told us what most of us already knew – the U.S. economy has once again entered a recession. According to the NBER, the recent business expansion peaked in December 2007.
Thus, as of December 2008, the economy has been in a recession for 12 months vs. an average post-war recession duration of 10 months. The longest post-war recessions, 1973-1975 and 1981-1982, lasted 16 months.
We do not expect the next expansion to commence until the fourth quarter of 2009. Therefore, we estimate that the current recession will set a post-war record for being the longest. During the so-called Great Depression of the 1930s, there were two periods of business contraction – August 1929 through March 1933 (43 months) and May 1937 through June 1938 (13 months).
This forecaster is now expecting real GDP to contract by 2.9 percent on an annual average basis in 2009. (We lowered our 2009 forecast by 0.1 percentage points from what was published in the latest Blue Chip survey.) From 1946 through 2007, the largest annual average decline in real GDP occurred in 1982 at 1.9 percent. So, if our forecast or our even more pessimistic competitor’s forecast is on the mark, the current recession, in terms of a one-year decline in real GDP, would be the most severe recession in the post-war era. (The decline in annual average real GDP in 1946 was considerably larger, at 11.0 percent. However, this decline apparently was associated with the transition to a peace-time economy and was not designated as a recessionary period.)
So, perhaps this current recession will be the worst since the Great Depression. Sounds ominous. But let’s see how bad the Great Depression was in terms of real GDP contractions. Annual average real GDP contracted by 8.6, 6.4 and 13.0 in 1930, 1931 and 1932, respectively. In 1938, real GDP contracted by 3.5 percent. Our point is that even if this recession is the most severe since the recessions of the 1930s, the severity of the current recession is unlikely to come anywhere near as severe as those during the Great Depression years.
It is not our intention to minimize the severity of the current recession. But to say that the current recession is the worst since those of the Great Depression years could cause some to conjure up an economic calamity that just is not likely to occur.
As an aside, observe how strong real GDP growth was in 1934, 1935, 1936 and 1937 – 10.8, 8.9, 13.0 and 5.1 percent, respectively. Even though the economic recovery, which began in April 1933, a month after President Franklin D. Roosevelt was inaugurated for his first term, was quite strong, real GDP did not get back to its 1929 level until 1936 and the unemployment rate did not drop below 20 percent until 1936. Thus, the so-called output gap, the gap between potential real GDP and actual real GDP must have been very wide during these years.
And if the output gap was wide, deflation must have persisted, right? Wrong! The annual average CPI increased by 3.5, 2.6, 1.0 and 3.7 percent in 1934, 1935, 1936 and 1937, respectively.
To generate this kind of turnaround from deflation in 1933 to inflation in 1934, the Fed must have really had its money printing presses working overtime. The annual average of commercial bank reserves in 1934 was up 56.8 percent vs. 1933. The year-over-year increase in bank reserves in October 1934 was 70.7 percent.
All of which brings us to back to the current economic environment. In the two months ended November, commodity prices fell 10.0 percent. Prior to this, the largest decline was 9.7 percent in the two months ended March 1921. During the 1930s, the largest decline in commodity prices was only 5.2 percent in the two months ended July 1930. So, are we likely to see persistent declining prices for commodities, goods and services in the next couple of years? Not if the Fed has anything to do with it. The rate at which the Fed has been increasing bank reserves is 10 times that at which it was doing so in 1934. The year-over-year increase in bank reserves was 603.6 percent in November 2008. The Fed’s seasonally-adjusted net acquisition of assets – primarily securities, commercial paper and loans to financial institutions – represented 100 percent of the seasonally-adjusted total borrowing by the U.S. nonfinancial sector in the third quarter of 2008. Talk about monetizing debt!
The incoming Obama administration is reported to be busy planning a two-year increased government spending program – spending on goods and services, above what will be spent on replacing “depreciated” financial capital – perhaps as much as $1 trillion. Total government spending on goods and services – federal, state and local – was 19.4 percent in 2007. The highest this ratio was during the 1930s was 16.1 percent in 1939. Let’s assume that nominal total government spending on goods and services in 2009 is $500 billion over its average for the first three quarters of 2008 ($2,871.9 billion). That would put nominal total government spending at $3,371.9 billion for 2009. Let’s also assume that 2009 nominal GDP is the same as its average over the first three quarters of 2008, or $14,288.6 billion. (We think there is a good chance that nominal GDP could decrease in 2009, which has not happened since 1949.)
With these assumptions, the ratio of nominal total government expenditures to nominal GDP would rise 23.6 percent in 2009 – considerably higher than it was during Roosevelt’s New Deal era, slightly higher than Johnson’s Great Society era and the highest since 1953.
Our hunch is that the Fed will be a major purchaser of the federal debt issued to fund this massive increased government spending program. Recall how quickly the CPI went from falling to rising in the 1930s. We think it is safe to say that the output gap in 2010 will be smaller in percentage terms than it was in 1934. It looks as though the Fed has its printing presses working 10 times faster now than it did in 1934 and is likely to keep them running at high speed through 2009. Do you really think that deflation is a likely outcome over the next few years?
On political grounds, deflation is “not an option.” The U.S. is a net debtor economy to the tune of about $7.1 trillion. Households are up to their eyebrows in debt. In a deflation, nominal income growth slows or contracts and the nominal value of assets may decline.
But the nominal principal value of debt remains constant. Thus, in a deflation, the real value of debt increases. This is why debtors hate deflation. Although it is true that for every borrower there is a lender, a single lender probably has extended credit to more than one borrower. Thus, it is likely that there are numerically more voters who are net debtors than there are voters who are net lenders. If so, the political pressure on the Fed to inflate will be enormous.
If 1934 is any guide, the Fed, starting in 2010, may have to invest in industrial size vacuum cleaners to start sucking up large quantities of credit that it had previously created!
