The Ghost in the Recovery Machine

NEW HAVEN – The International Monetary Fund’s October World Economic Outlook proclaimed that, “Strong public policies have fostered a rebound of industrial production, world trade, and retail sales.” The IMF, along with many national leaders, seem ready to give full credit to these policies for engineering what might be the end of the global economic recession. National leaders and international organizations do deserve substantial credit for what has been done to bring about signs of recovery since the spring. The international coordination of world economic policies, as formalized in the recent G-20 statement, is unprecedented in history. But one also suspects that world leaders have been too quick to claim so much credit for their policies. After all, recessions generally tend to come to an end on their own, even before there were government stabilization policies. For example, in the United States, the recessions of 1857-8, 1860-61, 1865-7, 1882-85, 1887-88, 1890-91, 1893-94, 1895-97, 1899-1900, 1902-04, 1907-8, and 1910-12 all ended without help from the Federal Reserve, which opened its doors only in 1914. Economic theorists long ago developed models that describe how recessions end on their own. In his 1959 book The Business Cycle, in a chapter entitled “The Lower Turning Point,” Cambridge University economist R. C. O. Matthews summarized a host of factors that business-cycle theorists of his day argued tend to bring on recovery automatically. For example, demand for investment goods may rebound, especially in certain hard-hit sectors, after a recession has caused physical capital to become technologically obsolete. Moreover, interest rates tend to decline in a recession, even if there is no central bank, stimulating investment demand further. Similarly, manufacturing can expand to restore inventories depleted by over-contraction of output, while random shocks such as major innovations or harvest variations may have an asymmetric effect in a recession, with upward shocks in some sectors having a greater impact than the downward shocks in others. On the financial front, the failure of weaker banks in a recession leaves survivors that benefit from greater public confidence and are therefore able to resume profitable business. Some of these factors, rather than just the actions taken by governments and multilateral organizations, plausibly played a role in the current economic improvement. Unpredictable human psychology also plays a role. Such factors, indeed, matter very much for the economic outlook, and for judging the success of the recovery program. One can start with the stock-market turnaround since March of this year, which has been stunning. Using monthly S&P Composite data, the 38% increase from March to September was the second-largest six-month increase since 1871, surpassed only by a 71% increase from February to August 1933, during the Great Depression. This rebound is all the more remarkable given that it followed the second-largest six-month decrease ever, as stock prices fell 38% from September 2008 to March 2009. (The largest six-month decrease was, you guessed it, during the Great Depression, when the index fell 47% from November 1931 to May 1932.) Moreover, this same sharp turnaround occurred in many countries – and for many assets, including oil prices, gold, and, in some countries, residential real estate. Any solid understanding of the causes of this turnaround is likely to prove elusive. People are still puzzling over the reasons for other major market upturns (1933, 1982, etc.). A market boom, once started, can continue for a while as a sort of social epidemic, and can foster inspiring “new era” stories that are spread by news media and word of mouth. The stories themselves help magnify the boom, becoming part of the feedback that sustains it. The agreements reached at recent G-20 meetings stand as one of these stories, for they suggest a new era of international cooperation and economic professionalism – a narrative that has probably been exaggerated in the psychology of recovery. The G-20 story is particularly salient in the developing world, for the international recognition that the G-20’s expanded role has given to developing countries is highly resonant psychologically. Beyond that, stories of highly profitable banks paying huge bonuses to their executives have also inspired people to think that things are not so bad in the business world. Anger at these profits and bonuses only tends to increase the contagion of the story.But any such speculative boom is inherently unstable, as the stories evolve in time and with new shocks, whose effect on markets is most uncertain. It was, in fact, an excessive speculative boom in the stock market and the housing market that got us into this financial mess in the first place.To be sure, governments and multilateral institutions made some reasonable attempts to restore confidence. But they did not “engineer” a recovery. They got lucky, and the G-20, as well as the governments that instituted stimulus packages, are currently in a honeymoon period of apparent success. Where our still-ailing world economy goes from here is as uncertain as the speculative markets that played such an important role in both the financial crisis and the recovery. We can only wish that formulating economic policy were as clear-cut as, say, mechanical engineering. It is not: a host of poorly understood natural cyclical factors play a role, and so do the vagaries of human psychology. Robert Shiller, Professor of Economics at Yale University and Chief Economist at MacroMarkets LLC, is co-author, with George Akerlof, of Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism. Copyright: Project Syndicate, 2009.www.project-syndicate.org