Saturday, July 07, 2007

Why isn’t there depression?

Bradford Delong, the celebrated economist reeled out some interesting economic history to suggest that the current day global imbalances and misaligned real exchange rates threaten to bring about a mild recession and also possibly a significant and prolonged depression. Yet these are not happening, he says, for three reasons.

Let us first look at the economic shocks that he has listed:

  • 1987: America’s stock markets tanked for technical reasons in the fall of that year.
  • 1991: Saddam Hussein’s adventure in Kuwait shocked the world oil market.
  • 1992: Europe’s fixed exchange rate system collapsed.
  • 1994: Mexican peso crisis
  • 1997-98: East Asian Financial crisis
  • 2000: The dot com bubble
  • 2001: The terrorist attacks on the twin towers in New York, US.

The three possible reasons why recession and depression are not likely to happen:

  1. The world simply has been lucky. Though the streak of luck may not continue.
  2. Central bankers have finally learned how to do their jobs, especially after 1987. The lack of far sighted decision making meant that economic policy lurched from stop to go to accelerate to slow down. Consider this: before 1985, central bankers switched their objectives from year to year. One year, they might seek to control inflation, but the previous year they sought to reduce unemployment, and next year they might try to lower the government’s debt refinancing costs, and the year after they might worry about keeping the exchange rate at whatever value the political masters prefer.
  3. Financial markets have calmed down. Today, the smart money in financial markets takes a long-term view that asset prices are for the most part rational expectations of discounted future fundamental values. Before 1985, in contrast, financial markets were overwhelmingly dominated by the herd behaviour of short-term traders. Thus central bankers were stuck trying to control a world economy shocked by random changes in the animal spirits of investors and traders.