Monday, September 5, 2011

The Great Crash 2008, Part One

. Monday, September 5, 2011

In "Cause and Consequences", the last chapter of The Great Crash 1929, JK Galbraith offers his explanation for why the Great Depression rather than a typical recession followed the stock market collapse. Or, as he put it, why the economy was "fundamentally unsound" in the run-up to the stock market crash that led to a prolonged slump. There are five reasons given (beginning on pg. 177 of the 2009 Mariner paperback, for those wishing to follow at home), and it's worth thinking about each to see how they may or may not relate to today. I'm going to do them in a series for the sake of brevity. This is the first.

Galbraith's first reason given for why the stock market collapse plunged the real economy into deep depression is the large amount of income inequality. Galbraith writes:

This highly unequal income distribution meant that the economy was dependent on a high level of investment or a high level of luxury consumer spending or both. The rich cannot buy great quantities of bread. ... Both investment and luxury spending are subject, inevitably, to more erratic influences and to wider fluctuations that the bread and rent outlays of the $25-a-week workman. This high-bracket spending and investment was especially susceptible, one may assume, to the crushing news from the stock market in October of 1929.

It's well-established that US income inequality increased dramatically over the two decades prior to the 2008 crash. Here's a snapshot of the share of national income going to the top 10% of income earners from the famous Piketty/Saez historical study of the American income distribution (labelled and discussed by Krugman here)

The graph ends a few years before 2008 but the trend didn't reverse in that time. What I like about Galbraith's explanation of the role of income inequality in the Great Depression is that there is a plausible causal story: with increased inequality the economy becomes more dependent on the fortunes of the high-bracket folks to maintain demand and investment; a shock to their finances via a financial crash thus hurts more than it otherwise would. This can link up with demand-side and structural explanations of the sclerotic US recovery. Too often discussions of contemporary income inequality lacks such a mechanism, and are much more normatively framed and politically charged. That's fine, but it doesn't really help us understand how income distribution affects the broader economy.

The question is whether Gailbaith's causal story matches the present. Let's look at some data on private investment. We know that there was a slump in housing, so let's check that first:

It drops off a cliff, but notice that that begins in late-2005. This is in line with the usual story that the housing collapse preceded and perhaps caused the financial collapse by deteriorating the value of the underlying assets on which securities were backed. For Galbraith's story to be true, we'd need to see investment drop off after the financial collapse destroyed the wealth of those at the top of the income distribution. And we do:

Note that in percentage terms, the dropoff post-2008 is more severe than what occurred during the 2001 recession. My back of the envelope estimate is that investment at the trough post-2001 was ~ 88% of the pre-2001 peak; In 2008 it was 78%. Moreover, investment fell more steeply more quickly post-2008 than post-2001. But it also rebounded in a sharper V-pattern than in 2001. If Galbraith's logic held, we might expect to see the opposite: a deeper, longer investment drought. Sometime like an 'L'- or 'U'-shaped pattern of recovery.

Let's look at some consumption data:

Here we see a much bigger dropoff post-2008 than post-2001, and it persists for much longer. While we've gotten back to pre-2008 levels, we haven't yet caught back up to trend. But is this slack enough to explain the persistent malaise in labor and financial markets? And is the slack in spending and investment attributable to income inequality rather than high unemployment? Is high unemployment attributable to income inequality? There's no obvious mechanism that explains it. At least not that I can think of.

It may be that increased inequality was a symptom of structural shifts in the global economy that pre-dated the crash. An effect rather than a cause. Post-crash inequality becomes a cause of ongoing economic weakness. However as a first explanation for the Lesser Depression I'd look elsewhere.

In any case, the major political battles in the US since the financial crisis have been on issues related to income distribution: health care, financial regulation, and progressive taxation vs. expenditure austerity. Maybe we could add classic Phillips-curve battles over unemployment/inflation tradeoffs.* This suggests that the cleavages in the economy break down along at least some of these lines. But this could be a consequence of the weak economy rather than a cause of it, especially since the political scene has shifted from fire-fighting to deficit-cutting.

*Krugman and others argue that right now there isn't much of a tradeoff and I tend to agree, but neither the political leadership of the GOP nor most pundits seem to believe him.


The Great Crash 2008, Part One




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