Flatter and Flatter

With the economy more sluggish than predicted, could we be in a long recession?

Listener: 30 October, 2010.

Keywords: Macroeconomics & Money;

That another long recession started in 2007 can’t be ruled out. In more than a third of the past 150 years, our economy – measured as gross domestic product per person – has been flat or falling for %periods of five or more years. Although most of these times of “stagnation” were in the first 100 years, two long recessions have occurred in the past 50 years: the 10 or so years that followed the wool-price crash in 1966, and the seven or so years of the Rogernomics recession from 1986.

Are we entering another one? When everyone decided in 2009 that a second Great Depression was not going to happen (after the international monetary authorities responded more intelligently this time), people tended to think things were back to normal and the economy would return to its growth path.

Little thought was given to the possibility that once the monetary stage of the crisis was over, the economy would stagnate over a long period as the country got its balance sheets in order. The notion that growth is the normal state of an economy has been so central to our thinking that the possibility of stagnation was hardly considered.

Yet history shows growth is not inevitable. There are parallels with the 17-year Long Depression of the 1880s and 1890s, precipitated by a banking crisis in the financial capital of the world – London – followed by a long sluggish world economy. New Zealand’s Long Depression had been preceded by the Sir Julius Vogel-inspired borrowing boom, which resulted in a lot of overvalued assets and consequential financial, farm and business collapses. One of the roles of long recessions is to squeeze out overvaluations.

My interest in economic history has moved on to the first part of the 20th century, when economic stagnation lasted for about 30 years: from the first decade of that century to the end of the Great Depression (followed by a very rapid recovery). Those who can think back only a decade or two may be unaware that economic growth is not guaranteed and that long periods of stagnation are real possibilities.

That we are in another long recession could explain the failures to predict the current state of the economy. The economy has been a lot more sluggish than the pundits predicted. Economic forecasting involves putting in a medium-term trend and fitting a business cycle around it. If the forecasters get the trend too high, their predictions about the short-term fluctuations will be wrong, too; so they keep expecting an upturn that never occurs.

A natural optimism makes it difficult to contemplate a long stagnation. Who would support a political party campaigning that the economy is going to be stagnant under its care, even if that is a realistic assessment? Better to claim to have a strategy to reach parity with Australia, even if this is more ideological than economically credible.

To think clearly about the economy, one has to stand back from such muddle-headed optimism. I can’t be sure what will happen, but we need at least to contemplate the possibility of another long recession.

After all, New Zealand output per head is about 3% below its peak of three years ago, and many commentators expect the world economy to be sluggish (little increase in real incomes with high unemployment) for up to a decade. (China is an exception.)

Or to put the issue the other way round, where do the growth optimists expect the sustainable expansion to come from? Economic growth is not some magic number; it is the consequence of myriads of production and expenditure decisions that affect the total output. That is what economists should be analysing and explaining.

Taking a more realistic approach – instead of borrow and hope (as we did in the past decade) or just hope (this decade) – is not only more sensible, but also provides the basis of a practical strategy, as I shall develop over the next few months. Unless others adopt a similar realism, public commentary will remain dominated by the current misleadingly optimistic confusion.