'Keynesian' economic policies and the shape of the 2007 'Great Recession' compared to the 1929 'Great Depression'

Executive summary

The present article compares the US ‘Great Recession’ of 2007-2011 with the ‘Great Depression’ of 1929-1933 from the angle of the internal structure of the US economy. The reason for such a comparison is that it casts significant light on the structural effects of ‘Keynesian’ economic responses to the international financial crisis - in particular the consequences of large budget deficits and expansionary monetary policies on the underlying structure of the US economy. The implications for the short, medium and long term growth of the US economy of these trends are considered. It is shown that present policies will not reverse the long term decleration of the US economy that has been analysed previously.

Downturn

In the 4^th quarter of 2010 US GDP regained the peak level of the previous business cycle – the latter having been achieved in the 4^th quarter of 2007. The frequently used term ‘Great Recession’ to describe the course of the intervening three years of the business cycle is accurate insofar as it indicates that this was the deepest US economic downturn since World War II – Figure 1. The maximum fall in US GDP in the current business cycle was 4.1 per cent, compared to the previous greatest post-World War II decline of 3.2 per cent, which occurred in the cycle commencing in 1973. The duration required in the present cycle to recover the previous peak level of GDP, twelve quarters, was as long as the total length of the double dip recession commencing in 1981, but the latter recession was much shallower than the post-2007 downturn - Figure 1.

Figure 1

 

Comparison to 1929

However, while the term ‘Great Recession’ is entirely accurate in indicating that the fall in GDP in the present business cycle was the deepest since World War II, nevertheless it is exaggerated if taken to imply any serious comparison to the Great Depression itself – the significance of the impact of the current downturn is quite different to that of the Great Depression, as will be analysed below. Outlining the differences between the two economic downturns casts light on present trends as well as issues of economic analysis and policy. 

Evidently the first difference between the current business cycle and the Great Depression is the scale of the respective downturns – Figure 2. The trough of the post-1929 decline came in 1933, by which time US GNP had fallen by 29.7 per cent from its 1929 peak.¹ In contrast, the bottom point of the present recession was the decline of 4.1 per cent in the 2^nd quarter of 2009. The decline after 1929 was therefore seven times as deep as the present downturn. For this reason talk of ‘two depressions’ cannot be justified.² As will be seen, however, the two downturns differ not only in scale but in pattern.

Figure 2

 

Dynamics of GDP during 1929-1933

To show the difference in shape, as well as in scale, between the Great Depression and the Great Recession, the shape of post-1929 downturn will first be outlined and the present business cycle will then be compared to it.

Figure 3 therefore shows the change in components of US GDP between 1929 and 1933 in percentage terms. Figure 4 shows the change in components of US GDP in constant price dollar terms.

Considering first Figure 3, it may be noted that the dominant percentage downturn in the components of US GDP after 1929 was in private fixed investment. ³ Rounding to the nearest percentage point, US GDP fell by 30 per cent between 1929 and 1933. US government consumption over the same period rose by 5 per cent. US consumer expenditure fell by 20 per cents, imports fell by 35 per cent and exports declined by 46 per cent. However the drop in private fixed investment was 74 per cent.

Figure 3

 

Decline in investment and consumption during the Great Depression

Turning to the differing quantitative contributions to the decline in US GDP after 1929, consumer expenditure constituted then as now a far higher percentage of GDP than fixed investment - in 1929 US consumer expenditure, at current prices, accounted for 74 per cent of GDP compared to 14 per cent for private fixed investment.⁴

Technically in assessing the quantitative impact of the changes in different components of GDP it should be noted that constant price components cannot be precisely compared due to index number issues. Fortunately for analysis, however, the trends in changes in most different components of US GDP after 1929 were sufficiently distinct as to leave no doubts as to the underlying development.

Although consumer expenditure accounted for a higher proportion of US GDP than fixed investment, the percentage decline in the latter after 1929 was so severe that its quantitative contribution to the decline in GDP was approximately the same as the fall in consumer expenditure.

In 1982 constant price terms the decline in consumer expenditure in 1929-33 was $93bn and that in private fixed investment was $95bn – see Figure 4. It may therefore be stated qualitatively that the decline in fixed investment and the decline in consumer expenditure contributed approximately equally to the post-1929 GDP decline. In contrast, decline in inventories was only $22bn, a fall in imports offset the decline in exports so that the decline in net trade was only $6bn, and government consumption rose by a marginal $4bn.

In summary, the Great Depression was characterised in percentage terms by the fall in fixed investment, and in terms of contribution to the total decline in GDP approximately equally by the fall in consumer expenditure and the decline in fixed investment. As will be seen this pattern differs sharply from that during the post- 2007 recession.

Figure 4

 

The 2007 business cycle

To illustrate the contrast of the Great Recession to the Great Depression, Figure 5 shows the changes in percentage terms of components of US GDP following the 4^th quarter of 2007. It may again be seen that in percentage terms the decline in private fixed investment in the current business cycle is by far the largest element in the downturn - as after 1929. By the 4^th quarter of 2010, i.e. three years after the peak of the previous business cycle, US GDP had just regained the level of its previous peak in 4^th quarter 2007 - technically reaching 0.05 per cent above the previous peak. US exports were 5.9 per cent above the 4^th quarter of 2007 and government expenditure 5.1 per cent above. Consumer expenditure was 0.9 per cent above the 4^th quarter of 2007 and imports 3.2 per cent below. However private fixed investment was 18.3 per cent below its previous peak level – a decline more than three times as much as any other component of GDP.

It may be noted that recovery in the current business cycle has already begun. Therefore to avoid any distortions caused by making a comparison of present trends to the pattern between 1929 and 1933, i.e. to the low point of the Great Depression, it is also useful to make a comparison between the 4^th quarter of 2007, the peak of the previous business cycle, and the trough of the current recession in the 2^nd quarter of 2009. At that point GDP had declined by 4.1 per cent, government expenditure had increased by 5.8 per cent, consumer expenditure had declined by 2.4 per cent, imports had declined by 18.0 per cent and exports by 10.7 per cent, while private fixed investment had declined by 23.4 per cent – Figure 5.

Figure 5

 

Quantitative changes during the 2007 business cycle

If the quantitative contribution of different components of GDP to the overall post-2007 economic decline is considered it may be seen that the pattern in the current recession is substantially different to that following 1929. Figure 6 shows the comparison, in terms of the movement of components of GDP in constant price terms, between the latest available data for the 4^th quarter of 2010, and the peak of the previous cycle in the 4^th quarter of 2007.

It may be seen from Figure 6 that the post-2007 business cycle is entirely dominated by a decline in fixed investment – compared to the essentially equal contribution of the decline in fixed investment and consumption during the post-1929 downturn. By the 4^th quarter of 2010 all other components of US GDP, with the marginal exception of inventories, were already above their level at the peak of the previous business cycle. Measured in 2005 dollars, US GDP was $7bn above its previous peak level, consumer expenditure was $84bn above its level in the 4^th quarter of 2007, government expenditure $124bn above, and net trade $165bn above. Inventories were a marginal $6bn below. However private fixed investment was $386bn below its level in the 4^th quarter of 2007. It may, furthermore, be noted that this latter figure understates the actual decline in US fixed investment, as this peaked as early as the 1^st quarter of 2006 and between then and the 4^th quarter of 2010 US fixed investment fell by $471.3bn.

To make a comparison to the low point of the present business cycle, i.e. the 2^nd quarter of 2009, in 2005 prices the decline of GDP was $554bn at that point compared to the 4^th quarter of 2007. Consumer expenditure fell by $225bn and inventories by $174bn. Government consumption rose by $94bn and net exports by $214bn. Private investment however had fallen by $495bn, i.e. twice as much as any other component of GDP - see Figure 7.

Contrast of the 1929 and 2007 downturns

Turning to comparison of the patterns of economic decline following 1929 and folowing 2007 it may be noted that in both 1929 and 2007 government final expenditure rose during the recession – in the earlier period, contrary to some popular impressions, this also occurred under Hoover and before Roosevelt’s election. However following both 1929 and 2007 such an increase was entirely insufficient to offset the declines in other components of GDP.

In addition to the differences in scale of the downturn by far the biggest divergence in economic pattern between 1929 and 2007 was that of the difference in balance in the respective downturns between household consumption and investment. In both cases by far the greatest fall in percentage terms was in fixed investment. However in quantitative terms, as already seen, there was an approximately equal decline in private fixed investment and consumer expenditure after 1929. In contrast, the post-2007 downturn was overwhelmingly dominated by the decline in fixed investment with, in comparison, a far smaller decline in consumer expenditure.

These different patterns may be held in mind while analysing the Great Recession and the Great Depression.

Figure 6

Figure 7

 

Comparison of 1929 and 2007

It was noted above that after 1929 the contribution of the decline in consumer expenditure to the total fall in GDP essentially matched that of the decline in private fixed investment. In the 2007 cycle, in contrast, the contribution of the fall in consumer expenditure, even at the lowest point of the downturn, was less than half that of the drop in private fixed investment and by the 4^th quarter of 2010 US consumer expenditure was already above its previous peak level.

Given the radically different scale of the events of 1929 and 2007 it would not be reasonable to draw conclusive quantitative causal connections between the present economic events and the governmental  policies pursued. It may, however, be noted that the pattern of economic events after 2007, compared to 1929, was consistent with the economic policies pursued. Furthermore, noting the divergent trends in the private sector and government policy, it is difficult to escape the conclusion that the latter bore a large measure of responsibility for maintaining consumption during the Great Recession.

The US private sector and US government policy

By themselves developments in the US private sector after 2007, both directly and indirectly, undoubtedly operated to produce a sharp downturn in consumer expenditure. In terms of direct effects, unemployment rose sharply, reducing incomes and therefore potential purchasing power of those made unemployed, while there were also widespread reductions in wage rates and other measures which reduced income. US real wages have continued to decline – in March 2011 US nominal wages had risen by 1.7 per cent in the last year whereas inflation in the same period was 2.0 per cent. (Reddy, 2011) Indirectly, precautionary motives due to the impact of the financial crisis, fear of unemployment, and other reasons, initially led to a sharp increase in personal savings rates. These have remained significantly above pre-crisis levels despite their recent decline – also exercising a depressive effect on consumer expenditure.

However, in contrast to private sector trends, US government policy was strongly counter-cyclical as regards consumer spending – alongside the modest increase in final government consumption already noted. If the operation of the private economy reduced consumer demand then state policy deliberately boosted it – such support coming via tax reductions, prolongation of unemployment pay, mortgage support and other measures. The maximum decline in US consumer expenditure was 2.4 per cent, in the 2^nd quarter of 2009, and by the 4^th quarter of 2010 consumer expenditure was already 0.9 per cent above its 4^th 2007 level - despite the fact that unemployment remained at high levels and that the real wage reductions since the start of the financial crisis had not been reversed.

It is not possible to state definitively that this relatively strong sustaining of US consumer spending was due to government policy, although this would be a reasonable supposition, however it was evidently consistent with the policy.⁵

The US Great Recession is not a fall in consumption

This relative lack, in comparative terms, of a severe fall in consumer expenditure during the Great Recession is important to note as it refutes a widely held interpretation of the impact of the Great Recession that its primary effect would be to reduce US consumption (see Ross, 11 February 2010). On the contrary, not only did consumer expenditure recover relatively rapidly but the share of consumption in US GDP increased significantly – see Figures 8 and 9.

The percentage of consumer expenditure in US GDP rose from 69.9 per cent in the 4^th quarter of 2007 to 70.8 per cent in the 4^th quarter of 2010. The share of total consumption, i.e. both personal and government, rose from 85.8 per cent to 87.7 per cent of US GDP in the same period.

This failure of US consumption to fall significantly during the Great Recession therefore contrasts strongly with post-1929 developments.

Figure 8

Figure 9

 

US government policy and fixed investment

If, however, developments in the post-2007 US economy were consistent with US government policies to prevent a sharp fall in consumption, no such correlation existed with any government policy attempting to reverse the decline in fixed investment. On the contrary, as already noted, post-2007 US private sector fixed investment fell sharply and the marginal increase in state fixed investment was entirely insufficient to offset this.

Between the 4^th quarter of 2007 and the 4^th quarter of 2010 US defence fixed investment rose by $25.7bn, Federal non-military fixed investment rose by $9.2bn, and there was a decline of $11.1bn in fixed investment by the individual US states. This was entirely inadequate to offset the $325.5bn decline in private fixed investment.

The scale of the fixed investment decline shows that policies such as low interest rates had no effect in preventing this drop which were comparable to trends preventing the fall in consumer expenditure.

It may therefore be argued that US government policy was successful in preventing a severe decline in consumption, and certainly in this field economic events and the goals of policy coincided, but clearly no equivalent success was achieved in preventing a decline in fixed investment. It may also be noted that there was no equivalent US government practical policy announced to halt the decline in fixed investment that compared in scale with the tax reductions, extension of the period of unemployment benefit, mortgage protection and other measures that were counter-cyclically deployed to sustain consumer expenditure.⁶

As a consequence of its sharp decline, the share of US fixed investment in GDP fell from 19.0 per cent of GDP in the 4^th quarter of 2007 to 15.6 per cent of GDP in the 4^th quarter of 2010 – see Figure 10.

Figure 10

 

Implications for medium and long term US growth

Finally, regarding the consequences of the pattern of economic trends, it is clear that this post-2007 decline in fixed investment has substantial implications for the medium and long term performance of the US economy. Investment is the main factor in US economic growth – more than fifty per cent of US GDP growth being accounted for by capital inputs. (Ross, 8 September 2009) The current decline in fixed investment is therefore likely to continue the long term slowing of the US economy – the annual moving average for US 20 year growth having declined to 2.5 per cent and the 10 year moving average having fallen to 1.7 per cent. (Ross, 9 January 2011)

A case can therefore clearly be made, on the basis of the trends in the US economy since 2007, that US government policy moderated or halted the decline in consumption. It did not, however, halt the investment decline and the fall in the latter will continue the trend to a slowing of the US growth rate.

Were post-2007 policies those of Keynes?

Turning from factual economic trends to the implications for economic analysis and theory it may be noted that in references to the economic policies pursued since 2007 the term ‘Keynesian’ in this article has been placed in inverted commas. The reason for doing so is that it not to be implied that the US policies pursued to deal with the Great Recession – budget deficits, and accommodative monetary policy but no significant intervention in investment – are in fact the gamut of policies advocated by Keynes in the General Theory of Employment Interest and Money. For reasons dealt with elsewhere, the policies advocated by Keynes in the General Theory included centrally, and may be said to have focussed on, investment - see (Ross, Winter 2010). However, as already noted, US government policy in dealing with the post-2007 economic downturn focussed on consumption and not investment.

Authors such as Paul Krugman have presented budget deficits as the central issue of 'Keynesian' economics – see for example (Krugman, 2 September 2009), (Krugman, 21 March 2011) and and (Krugman, 2 April 2011). However this is not actually in accord with the General Theory of Employment Interest and Money.

The policies pursued post-2007 by the US government may, therefore, be taken as a partial test of the efficacy of the policies of budget deficits and highly accommodative monetary policy, but they cannot be taken as a test of Keynes policies - as they did not correspond to the policies set out by Keynes himself. To clarify this distinction the term ‘Keynesian’ economics (in inverted commas) is therefore used to describe the policies advocated by Krugman and others, while Keynes economics (with no inverted commas) may be used to describe the policies advocated by Keynes himself. A further analysis of the difference is given elsewhere (Ross, Winter 2010).

Conclusion

The following conclusions may therefore be drawn from the above analysis of the comparison of the pattern of economic trends in the Great Recession and Great Depression, in addition to the different magnitude of the two developments:

• A fall in consumption during the Great Recession contributed proportionately far less to the economic downturn than in the Great Depression.
• The relative resilience of US consumption during the Great Recession, compared to the Great Depression, was consistent with US government policies aimed at sustaining consumption.
• No comparable policies to sustain US fixed investment in the Great Recession were deployed comparable to those utilised to offset the decline in consumption.
• A fall in fixed investment contributed proportionately far more to the decline in US GDP in the Great Recession than in the Great Depression.
• The fall in fixed investment will ensure that the trend to a long term slowing of the US economy will continue.

In summary, policies of budget deficits and monetary accommodation deployed by the US government, which are popularly but inaccurately referred to as ‘Keynesian’, may well have contributed to the relative shallowness of the decline in US consumption during the Great Recession. They are, however, insufficient to prevent the fall in fixed investment and therefore the long term slowing of the US economy.

Notes

1. The latest version of the Bureau of Economic Analysis NIPA Table 1.1.6 shows a decline of US GDP of 26.7 per cent between 1929 and 1933 (Bureau of Economic Analysis, 2010). However the data in this table does not give a breakdown between private fixed investment and inventories. For this reason the GNP data from The Economist’s One Hundred Years of Economic Statistics is used for calculations (Liesner, 1989). Given the order of magnitude difference between the economic downturns after 1929 and after 2007 the difference in percentage between the new NIPA data and that used by the Liesner does not affect in any significant way the different patterns found.

2. For an example of such a type of analysis see ‘A Tale of Two Depressions’ (Eichengreen & O'Rourke, 2009). For their update of this analysis in 2010 see (Eichengreen & O'Rourke, 2010).Paul Krugman also characterised the present economic situation as a depression: ‘We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression [after 1873] than the much more severe Great Depression… And this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation.’ (Krugman, 27 june 2010)

3. Keynes diagnosed this correctly from the beginning of the 1929 recession and well before the publication of The General Theory of Employment Interest and Money (Keynes, 1936). In his The Great Slump of 1930, published in December 1930, Keynes noted: ‘If, then, I am right, the fundamental cause of the trouble is the lack of new enterprise due to an unsatisfactory market for capital investment… By the middle of 1929 new capital undertakings were already on an inadequate scale in the world as a whole, outside the United States. The culminating blow has been the collapse of new investment inside the United States, which to-day is probably 20 to 30 per cent less than it was in 1928.’ (Keynes, 20 & 27 December 1930)

4. Calculated from (Liesner, 1989).

5. The importance of transfer payments and other state measures in sustaining consumption in modern business cycles, compared to 1929, has of course rightly been highlighted by a number of economists - including Hyman Minsky. (Minsky, 1986)

6. It should be made clear that what is being considered here is the macroeconomic category of household consumption. During the Great Recession the distribution of incomes, and therefore of consumer expenditure, was shifted away from the worst off sections of the population.

 

Works Cited

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