Quick Recovery? No; Great Depression Act II? Nyet

Those who cannot remember the past are condemned to repeat it.--George Santayana

History does not repeat, but it rhymes.--Mark Twain

After ignoring history for far too long, it seems that financial market participants are learning the wrong lessons from it. Great Depression Act II, Japan lost decade (or two decades) are the templates currently in vogue. While there is no sugarcoating the economic outlook over the next year, the bright side is that the US and the world economies are NOT likely to experience a repeat of the Depression nor of Japan. Policymakers have learned their lessons from the 1930s and the Japan in 1990s. Policymakers around the world, in particular the Fed and the Treasury, recognizing the gravity of the situation have already displayed a willingness to massively and creatively use government balance sheets to cushion the transition. Fed and Treasury actions (and actions by the respetive authorities in the case of UK as well) have been far, far more aggresive and quick than Japan in 1990s, let alone the US in the 1930s. Consider some of the differences with Japan:

• Japan's bubble burst in 1990 and the Bank of Japan did not lower overnight borrowing rates to below 3% until 1993. Rates were lowered to zero only in 1999! The Fed got to practically zero in less than a year in contrast!
• Japan's government was running a surplus until 1992 and the deficit was 2% of GDP in 1993, a swing of 3 percentage points from 1992 and 4 percentage points from 1990. In contrast, the US federal government deficit is projected to be a whopping 12.1% of GDP in 2009 (CBO estimate) , a massive swing of nearly 9 percentage points from 2008!

Now, one can argue about the long run consequences of these measures (and I will go into that in posts), there is little doubt that that kind of stimulus is bound to have positive short-run effects. The stimulus naysayers will point to the still weak economy and stock markets and argue that the measures are ineffective. But that argument assumes that things would be no worse without the stimulus. The real benchmark for assessing the efficacy of the stimulus is unfortunately a counterfactual--how would things be if we did nothing. We simply do not know for sure. Economics is not a pure science like physics or chemistry--we cannot run controlled experiments to generate counterfactual scenarios. We have to live with uncertainty in estimates. The reality is that we did nothing during the 1930s (actually, that is not literally true, but by today's standard, nothing is close enough) and Japan did a lot but not enough and not quickly enough (recall that homily about a stitch in time). Using those as rough (very rough) guides, it is fair to say that US will experience a crisis that is less severe than the Depression and less prolonged than Japan's stagnation. Unfortunately, that may not be good enough for those expecting a return to the boom times.

The World is Free Riding on the Back of the American Taxpayer

Forty years ago Charles De Gaulle railed against the unfair gains that accrued to the US from dollar's hegemony and today an UN panel egged by Russians and Chinese is egging the world to move away from dollar as the reserve currency. It is ironic that this development is happening even as European banks have received billions from the Fed via AIG. That is the Fed has been subsidizing European governments effectively. It is not clear at all that the ordinary US taxpayer benefits much from the dollar's reserve status. If anything, the dollar's reserve status most likely visits some version of the Dutch disease on the average American worker, who has seen tardy improvement in living standards and considerably more career and income insecurity over the past two decades. I won't digress into that topic now. I want to focus on the free riding the rest of the world does.  

The ECB and the Eurozone gets kudos from perennial hyperinflationistas and the usual American baiters who would like to see the US fall hard. But if the Fed took a leaf out of the ECB's book and the Federal government followed the European governments, then the world economy would be in a deepening crisis (not that it is out of the woods now by any stretch of imagination). And judging by the developments of the last two quarters, the rest of the world would have been considerably worse than the US. After all Japan, Korea, Germany among others have seen their activity fall off a cliff and at a much faster pace than the US. However, the moment the US succeeds in injecting a sense of stability, the dollar tanks, world equities outpace US stocks, and everybody gets to lecture the US on the crappy outlook for the dollar. While the US taxpayer is carrying the full burden of the stabilizing, they will capture only a small fraction of the upside (I know, I know, the US holds risky foreign assets, which will appreciate more in a stable world than safe dollar assets held by foreigners). Seems like a bad trade to me.