Talking about depressions: an interview with Timothy Kehoe

Timothy Kehoe is an American economist currently working as a professor of economics in the University of Minnesota. He is also an advisor for the Federal Reserve Bank of Minneapolis and the President of the Society for Economic Dynamics. He has worked a great deal with macroeconomics and great depressions. In 2007, he published with Ed Prescott the book Great Depressions of the Twentieth Century where they describe the depressions that Europe and North America faced in the 1930s, and the one Latin America experienced in the 1980s. The TSEconomist met with him during the annual Society for Economic Dynamics (SED) Congress organized in Toulouse this past July.

  1. How do you define a great depression?

Ed Prescott and I said that a great depression is when you have a 20% deviation downwards from what a potential balanced growth path would be. We use output per working age person and in the United States this has grown at a 2% rate in per-capita terms since 1875. So, we look for big deviations downwards from that. Big deviations upwards, the US has not had. But they have had big deviations downwards like in the 1930s and that was a great depression.

Basically, the episodes we identified were in Europe and North America in the 1930s, in Latin America in the 1980s, and some other isolated cases. In Latin America, the period of depression is called “The Lost Decade” because the countries lost ten years in terms of economic progress. A country that is in a great depression right now is Greece. Some other countries like Spain, Italy, and Portugal are close to that. It looked like they were starting to grow the past two years, but now I have doubts whether that’s going to keep up.

  1. How can we explain an economic crisis with macroeconomic theory?

There is something called business cycles, and business cycles are small deviations around the growth path. They occur mainly because of shocks—such as shocks in the terms of trade for a small open economy or interest rate shock.

Great depressions are something much worse. They last for a longer period, and are much deeper. Prescott and I found out from the cases we looked at that the depressions were a result of bad government policy. We tried to identify what that policy was. Sometimes we could just say what it was not. The big question is: What kind of mistakes can a government make that leads to 10 years of falling output?

I specifically worked on comparing Mexico and Chile. Both Chile and Mexico started the 1980s with very big economic downturns, but then Chile righted itself and started growing very rigorously. After 4 years of severe contraction they just started growing. This continued for 15 years and is considered as one of the best economic growths in the world. Chile used the opportunity to make reforms, to clean up the banking sector, and to get growing—whereas Mexico did not. Instead they nationalised the banks which operated inefficiently.  They had bad bankruptcy procedures. Mexico also had companies that were hiring a lot of workers, but that were not growing or innovating. They were doing nothing better than surviving. The companies were zombie institutions. This went on in Mexico for about 10 years and it killed the economic progress in the country during the 1980s.

  1. What are often the causes of great depressions?

Government behaviour is the main cause. For example, Finland was in a severe economic downturn because people make mistakes. This lead to the Scandinavian banking crisis in the early 1990s. But if there is a reform you can get out of this situation. Finland nationalised half of the banks and within two years they had either gotten rid of the banks or reprivatized them.  This is similar to what happened in Chile.

The 2008-2009 financial crisis in the US was not that severe and so it didn’t lead to a great depression, but it was government policy that deregulated financial markets without thinking of the consequences. Actually when the financial market was failing due to activities that should have been judged as criminal for the people in the financial sector, the US decided it was more important to get growing again, and they didn’t prosecute any of these cases.

  1. Which structural reforms have most commonly been used to escape a recession?

It depends on what goes wrong. Great depressions can be caused by a lot of things, so what you should do is fix what goes wrong. In most cases the financial system failed. In other cases, there may be big problems in the labour market, and so there is need for reforms in the labour market. Often it is a financial problem, but whether the financial system is the cause of the crisis or that it just collapses under the weight of crisis, we cannot always tell. It might not be the shock that causes the crisis, but if you let it collapse and do nothing to fix it then you are going to have a problem and a great depression. This is what happened also in Japan. When Japan found out that banks were collapsing, the government would prop things up without doing anything to change their incentives. This wastes lot of money without making anything better. Another example is Spain. Here they were doing a lot of government spending as well. What they were doing was tearing up all the pavements in the city and then putting down pavement again. I mean what you could do is destroy 10% of the housing stock and hire constructions companies to rebuild the houses. But that might be a crazy policy. There is nothing wrong with having policies that help a certain industry or city, but you should try to make the spending have some social sense.

  1. What are your thoughts on today’s situation?

To have depressions you need mistake after mistake along with a period of economic contraction. Countries in European Monetary Union (EMU) got into trouble because the fiscal coordination imposed by Maastricht Treaty did not work. Actually, some of the first countries to openly violate this treaty were Germany and France. In 2013, Mario Draghi was willing to do whatever he could to keep EMU going and people interpreted that like he was willing to bail out and give loans at arbitrary low interest rates. Now worldwide interest rates are so low that he did not have to worry about it.

Italy and Spain are paying interest rates with 150 basis points—i.e. 1.5% above interest rates on German bonds—but they haven’t done anything to clean up their fiscal situations. If interest rates go back up, they would be in trouble again. Because they have massive debts and deficits they need to borrow. Investors would see that they would have difficulties paying back and thus would not buy the debt of Italy and Spain, and they would be back in the same situation as in 2011-2012.

  1. Would you think it is necessary to impose similar reforms in Europe as those imposed in South and Central America?

They’re going to have to do something. Both the European Stability Mechanism and European Central Bank are aware that this situation is a dangerous one. At some point, they need to clean up the banking system. Also Brexit is a real challenge. There is some fear that Brexit could break up the European Union and that’s why there are people in the EU that want Britain to have an unpleasant exit so that they don’t encourage this for anyone else.

  1. What is a balance of payment crisis?

A classic balance of payment crisis occurs when countries, especially less developed countries, would try to control inflation by fixing the exchange rate. It was common up until the 1980s or early 1990s.

Suppose you are in a developing country and for all kinds of different political reasons you would like to spend. You want to make transfers and it is tough to collect taxes because of corruption or other reasons. Pressure to spend implies running a deficit. What you would like to do then is borrow. Then if foreigners become unwilling to lend to you, you print money. At that stage you could get a lot of inflation. In order to keep the inflation under control, the government makes promises of controlling nominal interest rate. Say the government wants to keep the exchange rate of pesos to 10 pesos per dollar. They could sell as much as they’re willing of their reserves of dollars to keep the exchange rate low. And at some point, they run out of the reserves. That is the classic balance of payment crisis.

The more unclassical one is when we mix exchange rate policies with government bonds or financial systems such as banks. A run on currency could lead to the banking system collapsing. This is because the banking system had indexed or denominated things in dollars. This is referred to as the twin crises by Reinhart and Kaminsky. This was the case in Mexico in the 1980s and in Argentina in 2000-2001.

  1. Why do we see less occurrences of the classical balance of payment crisis?

I think countries have realised that they need to use monetary policies to control inflation and not exchange rate policy. Using exchange rate policy to cause inflation seems to work if the short run, but in the long run you are going to get in trouble.

  1. How can you explain a balance of payment crisis with macroeconomic theory?

The government has an intertemporal budget constraint. They can violate this constraint anytime by borrowing or printing money, but they cannot do that forever. So ultimately they run into a crisis because they try to push the constraint too hard. The government cannot spend or make transfers without paying attention to how much revenue it can bring in. If the government wants to run deficits in a situation of crisis to smooth consumption, they will need to run surpluses later to reduce the debt. They cannot have the debt growing faster than the economy.

by Kristina Hagen