Now the words. Edward Harrison of Credit Writedowns has a guest post at naked capitalism presenting the arguments for a robust recovery and for no recovery at all. He cites Joseph Stiglitz for the proposition that statistical GDP growth isn’t everything, and extends the point to argue that  you can have “low-quality” GDP growth if that growth is financed by debt without corresponding investment. When you happen to control the world’s reserve currency you can do this for quite some time, and there’s no saying we can’t do it for a while longer. So one possibility Harrison foresees is a reasonable growth fueled by cheap money, yet no change to some of our underlying economic problems, including a financial sector with a put option from the federal government.

By James Kwak

We are now in that phase of the crisis when there is a lot of arguing about whether things are going well or poorly, and that largely comes down to whether the current slowdown in the rate at which things are getting worse (that’s all it is so far) will be followed by a healthy recovery, a prolonged period of stagnation, or an accelerated contraction brought on by higher oil prices, a new bank panic caused by defaults in credit cards and commercial mortgage-backed securities, or one of any number of other factors. I discussed this topic somewhat impressionistically a month ago; this time I’m going to highlight some analyses done by other people around the Internet.

Last time I cited James Hamilton and Calculated Risk, both of whom thought that a peak in the four-week moving average of new unemployment claims was a good predictor of the end of a recession. Hamilton in particular has been following this closely, and while we may have passed the peak, the number isn’t falling like it should. Here’s Hamilton’s picture from last week’s post:

Look at the smooth line in each chart and note how it falls in 1991 and 2001 but doesn’t fall in 2009. The original post also has charts for the three previous recessions.

Paul Krugman looks at the same data and estimates that even though new claims are down from their recent peak, as long as the number remains above 400,000 aggregate employment is still going down, not up. 

If charts are your thing, Paul Swartz of the Council on Foreign Relations has eight pages of them (hat tip Brad Setser), comparing the current recession to all postwar recessions (it’s the worst on most measures) or to all postwar recessions and the Great Depression. Here’s one striking example:

Fascinating late-night reading.

By James Kwak

On to the interesting bit: the last price for this market was 56.3, meaning that the market assigns a 56% probability to the occurrence of a “depression” as defined by Intrade. The average forecast collected by the Wall Street Journal shows a “cumulative decline” of 7.8% (from Q3 2008 to Q2 2009 the forecasts are for contractions at annual rates of 0.5%, 4.3%, 2.5%, and 0.5%), or a peak-to-trough contraction of about 1.9%. Of the 54 individual forecasts collected by the Journal (you can download the data to a spreadsheet), 22, or 41%, are predicting a depression by Intrade’s definition.

So Intrade is more pessimistic than the experts. There has been a lot of talk about the accuracy of prediction markets like Intrade, but a lot depends on the liquidity of the individual market, and this one doesn’t have much (you can see all the outstanding bids and asks). We’ll just have to wait and see who wins this contest.

More than 22% of the unemployed have been out of work more than six months, which is usually when unemployment benefits expire. For this and other reasons, only 32% of the unemployed were receiving state benefits in October. These are more reasons to expand unemployment benefits in multiple directions, at the very least for a limited time period. Alan Krueger has described the other ways our unemployment insurance system is broken.

Unfortunately, there is fear that President Bush (remember him?) will veto the stimulus package, including extended unemployment benefits, that the Democrats want to pass in November, thereby accomplishing nothing except delaying it by two months. Sigh.

So, it looks like we’re in a recession. What’s a recession?

A recession is a period when overall economic activity contracts. In most times, overall economic activity increases, for two reasons. First, each year there are more people in the workforce, because the population of the US, like most but not all countries, is increasing. Second, most years, the average person is able to produce a bit more than in past years because of improvements in technology, processes, and so on. For a recession to occur, per-capita economic activity has to decline more than enough to compensate for population growth.

How is economic activity measured? The most common (and official) measure is gross domestic product (GDP), which is the aggregate value of all the goods and services produced or provided in the country. GDP is calculated by adding up private consumption (all the stuff that ordinary people buy), capital investment (factories, houses, etc.), government spending, and net exports (exports minus imports).

Why does GDP matter? Because GDP measures all the stuff that we produce, it also, roughly speaking, measures all the stuff that we can have as consumers. I say “roughly speaking” because, in the short term, we can consume more than we produce, by importing more than we export. But in the long term, while it may be possible to maintain a reasonable trade deficit indefinitely, it’s tougher to finance increases in consumption – what we need to have a higher standard of living – through ever-increasing imports. So if we want our children to lead better (material) lives than we do, we need GDP to increase.

Why do recessions happen? There are many, many reasons, but every recession is overdetermined – you can point to multiple explanations of why it happened, so you can never isolate one specific cause. One important thing, however, is that however they start, recessions are self-reinforcing. As consumers spend less, businesses sell less, so they need to reduce costs, so they lay people off or reduce hours, so consumers have less money, so they spend less, etc. As business profits decline, stock prices fall, so people feel less wealthy, so they spend less, etc. As people have less money, housing prices fall, so people can get less money from their home equity lines of credit, so they spend less, etc. As people make less money, state and local tax revenues fall, so those governments have less money to spend, reducing government spending, etc. And so on.

There is another self-reinforcing factor at work that may be particularly pronounced this time around. The more people hear about a recession (or a global economic crisis), the more worried they get, the less they spend, etc. And this is one reason why many economists are worried about this quarter (October-December). We arguably have never before seen the concentration of bad news, amplified by the always-on nature of the contemporary news media, that we saw between the Lehman bankruptcy on September 15 and the bank recapitalization announcement of October 15. Very little of that impact showed up in the Q3 (July-September) personal consumption figures, which were already bad; given how jittery many people are about spending (on which I’ve already expressed my opinion), this quarter could be much, much worse.

What can you do about a recession? As you might guess, there is a wide variance of opinion on this question. However, the following three options cover most of the spectrum:

1. Stimulate demand. If consumers and businesses won’t spend enough, the goal is to get them to spend more, or to otherwise compensate for their lack of spending. This can be done via tax rebates, increased welfare benefits, or other measures that put more money in people’s pockets, or through increased government spending. In either case, the goal is to break the self-reinforcing cycles described above.
2. Stimulate supply (aka “supply-side economics”). The goal is to increase incentives to produce stuff by reducing tax rates on things like income and capital gains. This is different from stimulating demand because the focus is not on putting money in people’s pockets so they will spend it, but on giving people the incentive to produce more.
3. Reduce interest rates. In general, reducing interest rates makes it easier for people and businesses to get credit, which increases their purchasing power and therefore their spending and investment.

One problem we have today is that there is little additional benefit to get by reducing interest rates. First, interest rates that the government has control over are already extremely low (the federal funds rate is currently 1.0%). Second, the availability of credit seems to be constrained more by banks’ low capital ratios and fear of risk than by the price of money.

That leaves government action to stimulate demand or stimulate supply. I separately discussed the stimulus plans of Barack Obama and John McCain. Roughly speaking, Obama favors stimulating demand; McCain, stimulating supply.

I’m not a personal financial advisor, but I think this can be broken down logically. Let’s assume that, before the current downturn, you chose with your level of spending (and, by implication, your level of saving) rationally. Then there are three main reasons why you might want to reduce spending today: (1) you don’t have the purchasing power you need to maintain your spending; (2) you are going to lose your job (I know there’s a problem with that statement, and I’ll come back to it); or (3) the assets you are counting on for retirement have fallen enough that you need to increase savings in order to replenish them.

(1) applies if, for example, you were going to remodel your kitchen but you can’t tap your home equity line anymore because you have less equity than you used to, or your bank has cut your credit card limit below the level you need to maintain your spending. In these cases, you have no choice. If, however, your bank just reduced your credit card limit from $20,000 to $10,000, but you never use more than $5,000 of the limit anyway, then this doesn’t affect you.

(3) applies if you are relatively close to retirement and you didn’t have a big cushion to begin with. If you were just barely on track to meet your retirement savings objectives, and now your 401(k) has lost 40% of its value along with the stock market, then you may have to boost your savings rate. However, if you are in your 20s (or your 30s, if you spent an inordinate amount of time in school), you probably don’t have enough assets to have suffered much losses. What you care about (roughly speaking) is the value of the global stock market when you retire in 2045, which depends on the state of the global economy in 2045, which, one can argue, is pretty much unaffected by whatever happens now. In fact, the fall in asset values may be good for you, because most of your wealth accumulation is ahead of you, meaning you will be able to buy the same assets more cheaply than you could have a year ago. (If you are one of the many people who never earned enough to accumulate much for retirement – and I know this is a huge problem in our society – and are therefore relying on Social Security, then (3) doesn’t affect you either.)

(2) applies if you are going to lose your job. But even in a deep recession, not that many people lose their jobs. The forecasts I see are roughly that unemployment will rise from about 6% now to about 8.5% in a bad recession – could be better, could be worse. That means that 2.5% more people will be unemployed than are unemployed now, or 1 in 40 people. (This is a simplification, because more than 1 in 40 people will be laid off, but some people currently unemployed will get jobs, and some people will get laid off more than once, and so on.) The problem is that most people don’t know if they will be laid off or not. If you think there is a decent chance that you will get laid off, and that you will have trouble finding a job afterward, then it makes sense to increase your savings to protect against that possibility. But if you are sure that you won’t be laid off, or sure that you could find another job relatively easily, then (2) doesn’t affect you.

(1), (2), and (3) collectively will apply to a fair number of people. But if you are young, are secure in your job and your employment prospects, and still have enough credit to buy what you want to buy, then I don’t see why a recession should cause you to change your habits significantly.

In any case, you shouldn’t buy or not buy because of what you think the US economy needs. It’s not your responsibility. If collective thrift by the American people threatens to plunge us further into recession, then it’s the government’s job to compensate by increasing spending, as Krugman argues (and as we’ve been repeating on this blog). So do what you need to do for yourself and your family.