MIT Economist Concludes That Depressions Are Still Possible According to NY Times Article.

Quote: "How much spending would Americans do," Krugman asks, "if the Dow Jones industrial average got up above 13,000 and then dropped to 7,000? Certainly a lot less than now."

OK, folks. Its official now. We're not fruitcakes if we say that another Depression is possible.

---------Alexi.

http://www.nytimes.com/yr/mo/day/news/financial/liquidity-trap.html

NY Times Article

------------------------ In Bad Times, Consumers Might Simply Refuse to Spend

July 2, 1999

In Bad Times, Consumers Might Simply Refuse to Spend

By LOUIS UCHITELLE

Anyone who lived through the Great Depression or studied economics in its aftermath quickly learned that even when the government prodded people to spend more, they would not do so in frightening times.

Then came the prosperous decades. Americans began to spend freely, in good times and bad, and the image of the recalcitrant consumer faded from college courses. Now, suddenly, it is coming back.

Robert J. Gordon, a Northwestern University economist, is helping to resurrect the old concept. In last-minute revisions to the latest edition of his textbook for undergraduate economics majors, he upgraded the discussion of the resistant consumer from a single, skeptical footnote to a respectful consideration. "When you go 50 years without a phenomenon being relevant, it dies out of the curriculum," he said. "Now it's relevant again."

What makes it relevant is the situation in Japan, where the central bank has reduced interest rates virtually to zero, yet consumers have stubbornly held back from borrowing or spending. Businesses have been similarly resistant. Not since the early years of the Great Depression has any major industrial nation gone through such an unnerving experience of offering, in effect, to give away money and finding few takers.

That is hardly the case in the United States, where the Federal Reserve on Wednesday raised interest rates by a quarter of a percentage point, and where consumers continue to enjoy a long spending spree. But even if a total collapse of consumer confidence seems improbable in America any time soon, it is increasingly viewed by mainstream economists as a real possibility.

"One could imagine that happening here," said N. Gregory Mankiw, a Harvard economist and textbook author who nevertheless puts the odds of a consumer freeze-up in America at less than 100-1, and does not yet mention the concept in either his beginning or intermediate economics texts. "I deal with rules, not exceptions," Mankiw said. "My market is mainly American students, not Japanese."

Mankiw, 41 and has known only economic prosperity in his lifetime, is on sabbatical this year. But if he were teaching, he said, he would put aside his grave doubts and, making an exception, lecture on the phenomenon of unshakable consumer resistance -- "in the context of Japan."

Gordon, 58, is already giving fresh emphasis in class to a concept that has received little attention since the 1970s. And so are other professors, although the idea of an utter consumer shutdown runs so counter to the standard, modern-day beliefs of their profession.

"I will make my students aware of the problem; in fact, I informally began to talk about it this past year," said Mark Gertler, a New York University economist. "A lot of students at NYU come from abroad, and they are interested in practical problems. When they see a connection between theory and what is actually happening, in this case in Japan, they get quite excited."

The professors are, in effect, dusting off a phenomenon first described by British economist John Maynard Keynes in the 1930s and soon dubbed, in economic jargon, a "liquidity trap."

It means that the demand for goods and services consistently falls short of a nation's capacity to produce them despite short-term interest rates as low as zero. The central bank loses its power to steer the economy. That may be hard to imagine in the United States today, where the Federal Reserve, with its constant attention to interest rates, has helped to keep consumer spending robust for the better part of a decade.

"I know that when you flood the place with money, people will spend it," Gordon said.

But even as Gordon and other economists insist that conditions in America will never drive interest rates on loans down to zero, they are being prodded on two counts to raise that very possibility in the classroom.

One prod is Japan, where rates are indeed that low, yet people are not borrowing or spending. The other is Paul Krugman, 46, a much quoted, traditional economist at the Massachusetts Institute -------------------------------------------------------------------------------- of Technology, who has broken with conventional wisdom and now argues that what is happening in Japan can happen in America.

That break did not come until Japan was already in deep trouble. "What sensible people like me believed just a couple of years ago was that basically demand -- the lack of it -- was not a problem; inflation was," Krugman said.

Holding to this view, he traveled to Japan to see conditions for himself. He constructed a mathematical model, a standard tool of modern economics, to demonstrate that printing more money and lowering interest rates, even down to zero, would succeed in stimulating demand and expanding an economy. "Instead, I succeeded in proving to myself that this was not necessarily true," he said. He concluded that a liquidity trap was possible after all. It was no longer just a historical curiosity -- a fading memory of the Depression and the teachings of Keynes. It had happened in Japan.

Among professional economists, Krugman was not the first to conclude that Japan had fallen into a liquidity trap. A small group of Keynesian economists already had this in mind. And as early as 1996, some conservatives, among them John Makin of the American Enterprise Institute, who does not consider himself a Keynesian, wrote that Japan was caught in a liquidity trap.

Interest rates controlled by the Bank of Japan, that country's central bank, had declined to nearly zero in 1995 from 7 percent in the early 1990s, just after Japan's stock market and real estate bubbles burst, shocking the nation.

A similar shock could frighten Americans enough to freeze up their spending, Krugman argues. A sharp and rapid decline in stock market prices, or another hedge fund failure, like that of Long-Term Capital Management last summer, or another big default, like Russia's -- any of these could do the trick. American interest rates would not have as far to fall as Japan's to get to zero. The short-term rate controlled by the Fed is 5 percent today.

"How much spending would Americans do," Krugman asks, "if the Dow Jones industrial average got up above 13,000 and then dropped to 7,000? Certainly a lot less than now."

However late he may be to come to his new position, Krugman, has one of the loudest voices in his profession. His clout stems, in part, from his prolific writing and his gift for explaining economics to noneconomists in simple sentences and easy-to-understand metaphors.

Drawing on these skills, he has been punching away at a set of beliefs that has dominated mainstream economics since the 1970s. With Milton Friedman and Robert Lucas at the University of Chicago taking the lead, an old, pre-Keynesian view emerged in new theoretical clothing.

People were declared to behave rationally. If for some reason they pull back as spenders, then prices drop until they buy again. There is always a price that pleases rational shoppers, who will then buy the existing supply of goods and services. Markets clear, as economists put it. And if they do not clear right away -- if companies resist cutting prices and a slowdown develops, even a recession -- well, the government can step up spending, or the Fed can cut rates and give the process a kick.

"For most of the people getting their graduate degrees in economics today, this explanation is comfortable," said David Romer, a 41-year-old economist at the University of California at Berkeley.

But no serious provision is made in this thinking for what Keynes foresaw. He theorized that consumers would stubbornly resist spending, a sensible move for a worried, hard-pressed family but irrational for the economy as a whole. Companies find themselves forced to cut production, and layoffs, lost wages, debts and defaults accelerate the slide toward a recession or even a depression.

Krugman has just expressed his concerns in "The Return of Depression Economics" (W.W. Norton & Co.), his fifth book for a general audience. For his colleagues, he has explained his new mathematical model in technical papers, including one in the current issue of the Brookings Papers on Economic Activity entitled, not so technically, "It's Baaack: Japan's Slump and the Return of the Liquidity Trap."

That paper has become a focus of the growing debate among economists over liquidity traps and what to do about Japan -- and whether its problem is truly a liquidity trap.

Alan Greenspan, the Federal Reserve's chairman, for one, blames inept government policy and a damaged banking system for Japan's dilemma -- not a liquidity trap. He asserts that the Fed, if put to a similar test, could revive consumer spending in America's healthier, more flexible system. For him, liquidity traps can almost always be avoided, however possible they might be in theory.

"Japan's current economic problems," Greenspan told a congressional committee two weeks ago, grew out of that nation's "failure to address the damage to the financial system in a timely manner." In similar fashion, he said, "while the stock market crash of 1929 was destabilizing, most analysts attribute the Great Depression to ensuing failures of policy."

But Krugman wonders whether America is so immune from the perils of liquidity traps, even if policy-makers take the right steps. "How can we be sure," he writes, "that next year, or the year after, our own system may not turn out to have hidden flaws, that we ourselves may not be vulnerable to crisis?"

| Copyright 1999 The New York Times Company

-- Alexi (Alexi@not-in-the-dark.com), July 02, 1999

Answers

Here's an interesting little graphic:

-- a (a@a.a), July 02, 1999.

In bad times consumers might simply refuse to spend...

Duh!!!

-- K Stevens (kstevens@It's ALL going away in January.com), July 02, 1999.

Damn.

"How can we be sure," he writes, "that next year, or the year after, our own system may not turn out to have hidden flaws, that we ourselves may not be vulnerable to crisis?"

____

Anybody know of any "hidden flaws" out there? Seems there were 50 out 54 economists who couldn't see any recently in some unimportant newspaper called the Wall Street Journal. 8<[

Wonder what problem the other 4 found?

-- Robert A. Cook, PE (Kennesaw, GA) (cook.r@csaatl.com), July 02, 1999.

alexi/"a"

you guys are right on the money. i have a great aunt. we'll call her "aunt". "aunt" was very depressed. "aunt" had tests run, complete with brain scans. "aunts" brain scans were almost an exact duplicate of "a's" graph. we might want to keep a sharp eye on this development.

-- corrine (corrine@iwaynet.net), July 02, 1999.

But - is the similarity in curves the result of a real trend of invester attitudes over time - or just a two "fractal" curves being scaled and plotted at the same time?

I'm willing to believe the "equal investor trend" theory - because the "real" value of the market (in my opinion) is about where the "btoom" of the 1929 curve stops - the rest is speculative money driven by the baby boomers: IRA/401K/life insurance policy money that is not spent yet.

Sorry about the aunt. Thought you were "corrine 1"? Does your mother know you changed your name?

-- Robert A. Cook, PE (Kennesaw, GA) (cook.r@csaatl.com), July 02, 1999.