The current UK depression will be the longest since at least the first world war. Without a dramatic surge in growth, it is also quite likely to generate a bigger cumulative loss of output than the “great depression”. All this is disturbing enough. What is even more disturbing is the near universal view that almost nothing can be done to change the prognosis.
A recession is a period of economic decline (from the Latin word for “retreat”). A depression may be defined as the period while output is below its initial level. Recently, three researchers have analysed such UK depressions, using a constructed set of monthly estimates of gross domestic product. This allows the authors, among them Martin Weale, now on the Bank of England’s monetary policy committee, to analyse the size and duration of UK depressions, starting with the one of 1920-24 and ending with today’s.
Hitherto, the longest depressions of the past century were those from June 1979 to June 1983 (under Margaret Thatcher) and from January 1930 to December 1933 (the great depression). For the present depression to be shorter than its longest predecessor, it must end not later than April 2012. But output is close to 4 percent below its starting point, with eight months to go. Even if growth now jumped to a 4 percent annual rate, it would take another year for it to end. If growth were to be 1.5 percent a year, the depression would last 72 months, making it some 50 percent longer than its longest predecessor in a century.
One can assess the depth of a depression by the steepness of the decline or by the cumulative losses, relative to the starting point. The depression of 1920-24 was the steepest, followed by the great depression, whose largest reduction in GDP was 7.1 percent. But the present depression is only a little behind, with a fall of 6.5 percent. The cumulative loss of GDP is likely to be worse this time even than in the 1930s. It was 17.7 percent of GDP back then, against 14.5 percent, this time, so far. But this depression is not over. If growth were to be 2 percent a year, the cumulative loss would be over 18 percent of GDP.
This then is a huge depression, by UK standards. Yet the response is a shrug of the shoulders. The view seems to be that this calamity was inevitable, deserved, or both. True, the cushion of the modern welfare state has made this a much less traumatic shock than the depressions of the interwar years. The superior employment performance compared with the early 1980s has also made this less painful than that slump. Even so, the scale and duration of this depression has been shocking.
Worse, what almost no one initially foresaw is now seen as next to irremediable. Many analysts take the view that potential output has fallen almost as much as output itself, which is now well over 10 percent below the pre-2008 trend. In an important pamphlet, Bill Martin, at the Centre for Business Research at Cambridge, forcefully attacks this pessimism. His conclusion is that the problem has been the collapse in demand, not in potential supply. Worse, he notes, the longer output remains depressed, the more likely it is that supply potential will be needlessly damaged.
Mr Martin observes the consensus that a good two-thirds of the lost output, relative to trend, is due to a collapse in potential output. He notes another, more plausible, explanation: “A demand deficient economy in which real wages fall sufficiently to contain the rise in unemployment and leave overall profitability at an acceptable level may manifest low levels of productivity that are also characteristic of a structurally weak economy. Unable to sell more, because of a lack of demand, industry may be content to live with low productivity, which, being persistent, is mistakenly interpreted by policymakers as a downshift in the economy’s productive potential.”
The danger results from what Mr Martin calls a “battle of the savers”. The private sector is seeking to improve balance sheets, by paying down its debt. Frightened by deficits, the government is now trying to do the same. This can add up, without a prolonged slump in activity, if and only if the economy shifts into huge external surplus. Yet nothing seems less likely, given the weakness of the UK’s trading partners.
The UK is in the midst of what is set to be the longest – and among the most costly – of its depressions in over a century. The characteristic of this depression, compared with its predecessors, is the frightening weakness of the recovery phase. It is far more plausible that this is due to weakness in demand than a collapse in potential supply. Yet the conventional view is that nothing much can be done. Beware such prophecies of doom. They can so easily become self-fulfilling.