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David Paul

David Paul

Posted February 26, 2009 | 12:53 AM (EST)

Will we Learn from this Recession that There are No New Paradigms?


Twenty years or so ago, when my I was planning a move to California for a new job position, I listened to an interview regarding a study of the psychological affects of recessions on individuals and communities. Specifically, the study compared the incidence of mental illness, depression and suicide in Los Angeles during the recession there in the early 1980s with New Hampshire during the 1970s.

Apparently, mental illness, depression and suicide were more prevalent in southern California at the time than had been the case in New Hampshire during the previous decade. The study attributed much of the different experiences of the affected communities to differences in family and community structure. In New Hampshire, people continued to live in extended families and extended communities. During the economic downturn, older members of the community would tell stories about earlier recessions, and pass on the wisdom of the elders:

Economic cycles are part of life, like the seasons. Families need to cut back and save as the downturn approaches. During the downturn, workers need to be patient and improve their job skills. And, like the seasons, this is normal, and like a hard winter, this too will pass.

Los Angeles was a very different place, where people had moved to the new world of optimism and opportunity. But in the face of an economic downturn, the perspective of life and the economic seasons was lost. Instead, lacking the wisdom of the grandparents and elders in the community, the fear and pessimism that comes with job losses and economic decline was exacerbated and reinforced.

Over the past months, our country has responded to the recession with fear and pessimism that has been largely unchecked by an historical perspective on economic cycles. We have responded as Los Angeles responded, and the politicians and the pundits are exacerbating the fears expressed in conversations around kitchen tables, in beauty salons and at Starbucks.

Looking back, it is apparent that the depth and severity of our current economic downturn is due in large measure to the success of the Federal Reserve in forestalling significant periods of economic downturn for much of the past twenty-five years. We forgot--as individuals, as families and as businesses--that the economy is cyclical.

But even worse, we lost the value of periodic recessions as a cleansing and humbling time. For individuals and families, recessions are a time to take stock, to cut back on our materialist tendencies, to save, to pay down debts, to retool our skills. For businesses, recessions are a time to rethink strategy, to close marginal operations, and improve attention to costs and excess. For bankers, it is time to learn to write off bad debts and tighten up lending standards, and perhaps teach young associates the basic principle that when there are no profits, there are no bonuses.

In 1997, Foreign Affairs magazine published "The End of the Business Cycle," trumpeting the success of the west in conquering the business cycle.

"Business cycles -- expansions and contractions across most sectors of an economy -- have come to be taken as a fact of life. But modern economies operate differently than nineteenth-century and early twentieth-century industrial economies. Changes in technology, ideology, employment, and finance, along with the globalization of production and consumption, have reduced the volatility of economic activity in the industrialized world. For both empirical and theoretical reasons, in advanced industrial economies the waves of the business cycle may be becoming more like ripples."

Lost in the triumphalism of the article was recognition of the important role that periodic economic downturns play in stemming the exuberance, the hubris and the bad habits that build up during the expansionary phase of the economic cycle. For the past twenty-five years, the Federal Reserve has managed to forestall the regular economic downturns that previously characterized the post-war years. The dramatic increases in labor productivity that came about through computerization and changes in information technology, and the suppression of wage inflation that resulted from globalization and outsourcing, combined to suppress inflationary pressures.

As a result, the economy ploughed forward through crisis after crisis, through failure and fraud. The collapse of Continental Illinois. The savings and loan crisis. The bankruptcy of Drexel Burnham. The Asian financial crisis. The Russian financial crisis. The Internet bubble. The collapse of Long-Term Capital Management. September 11th. Enron. WorldCom. At each point of crisis or threat to the financial markets and investor confidence, the Fed was able to forestall downturns and spur continued economic growth by flooding liquidity into the system or pushing down interest rates, with little concern to the normal inflationary consequence.

Ten years later, in 2007, Business Week Chief Economist Michael Mandel articulated the new economic paradigm on his Economics Unbound blog.

"We now may be in a world of mini-recessions--sharp falls in one or two sectors which do not pull down the whole economy... A sharp drop in one sector--say, housing--may pull down a couple of adjacent sectors, such as furniture. But the rest of the economy steams on, and maybe even accelerates, as resources are transferred from the weak sectors to the strong sectors.


"This picture of the world actually fits very well with neoclassical economics. We may get a couple of quarters of negative GDP growth, but deep economy-wide recessions may be an anomaly rather than the norm."

Now, we have learned that there is no new paradigm, and the business cycle is still with us. But this time, without periodic downturns to temper our exuberance and stem our excesses, we are paying a heavy price.

Consider this. Since Paul Volker stepped down as the Chairman of the Federal Reserve twenty years ago, median family income has increased ten percent in real terms. During that same period, household mortgage debt increased almost six-fold and consumer credit more than tripled, and financial institution debt grew more than eight-fold. Together, household and financial institution debt increased by over $24 trillion.

Even now, over a year into this financial crisis, we have yet to fully accept the depth of pain and dislocation that deleveraging may require. As we face the consequences of the boom years, we are going to need old wisdom as much as we need new policies. We are going to need to remain calm in the face of 24-hour cable shows playing on our fears and trumpeting every moment of our economic travails. Last night, President Obama tried to move beyond the position of policy wonk-in-chief, toward the role of the grandfather in New Hampshire. He scolded us for our excesses, while reminding us that the economy is cyclical and will rebound in time.

But what will we have learned when this moment is past? Will students of the Dismal Science no longer see the "end of the business cycle" as the Holy Grail of economic polity? Will we accept that the cycles of economic life are a necessary--and ultimately productive--check on human tendencies toward excess and exuberance? Or will we quickly fall prey to the hubris of policymakers and pundits who will as we ride the next wave, assure us that this time, once again, things will be different.