Financial regulation: 2008-1939 and 2014-1929 – as we’ve written before

This longer version was published here on 15 December. In it Paul Krugman explains why our recession is very different from that of 2008: The general point to be made is this: the only…

This longer version was published here on 15 December. In it Paul Krugman explains why our recession is very different from that of 2008:

The general point to be made is this: the only time when economic history looks like this has been when the recession – or at least its onset – was fairly acute. An exceptionally mild recession in 1947 induced plenty of debt forgiveness, while we know that 1932 was exceptionally severe. But even when we only got this kind of debt forgiveness, as has happened this time around, the relief was temporary. So in this sense, we will never have a truly “slightly” mild recession.

Why should we change the formula? As David Mansfield explains:

During recessions there’s no sense in focusing on easing one type of saving vs. another. At the end of a recession, there will always be more saving than investment, just as there will always be more investment than savings when a business goes out of business.

That second sentence is not so much an explanation of what happened in 2008 as it is an explanation of why this time isn’t so bad. If the long recovery helps account for the difference, then the second sentence is partly true. But Mansfield is right that it doesn’t have to be. Abundant faith in financial markets will always make both saving and investment immune to rational expectations about future earning power. So a recovery based on faith alone may happen more often than a recovery based on markets, but it’s not an improvement in the economic system when it does.

“Consider this: since the beginning of the Great Recession, the US federal government has spent more money just on interest payments than it has spent on the full reconstruction bill in the years after the 1900s.” That’s correct. The government, not private finance, saved money that would have had to be spent on something else. This was the case even before the Bush tax cuts in 2001; I wrote a book about why. And it’s true even during the New Deal, which was a time when most people saw the government as a bad actor that needed to be regulated in order to protect the economy.

I will concede one point. Some people argue that the inflation-adjusted difference is no more than $100bn or so. I’m not sure it’s that high, or it might be that I’m conflating under two debts: inflation and debt growth. I don’t have the empirical evidence to tell us for sure.

Still, my thought was that the scope of the current recovery is quite different from the post-World War II one. By my calculations, it isn’t. The above estimate is just about right. But to get a better sense of the magnitude of the difference, I went back to Deb Tonkin’s chart from 2007 showing the debt to GDP ratio. Keep in mind that between 1991 and 2007, the ratio only declined slowly, from 69 to 68, and before that it was rising again.

But it was in 2009 that the picture started to change. It began to fall strongly, dropping to 66.6%. The 2009 collapse caused the ratio to drop sharply, to 63.6% at the end of 2018. The new ratio is high. But compared to the average of the past 15 years, it is much lower.

This graphic tells the same story:

The picture is clear. Since 2010 the volume of debt has fallen sharply while the adjusted level has risen. When growth resumes the ratio will fall sharply as well. And when GDP grows as it must again, then the ratio will fall further. But this time, unlike 2008, the reductions will be not slow but rapid, and the ratio will fall more slowly than it did in the previous episodes.

We can see from the above graphic that the cyclical elements of debt are as important now as they were in the past. For that reason, I’m sticking with my rule-of-thumb expectations, but I’m also sticking with all the preceding historical evidence. That is, you should expect the difference between the nominal debt as a percent of GDP and the adjusted debt to GDP ratio to gradually decrease over time.

While that sounds like old news, it’s an important one to remember. So as 2008-09 makes us all start to think about financial regulation, forget that we’re now the beneficiaries of the same kind of administrative waivers as we were in the 1930s.

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