Four times in the past century, a large chunk of the industrial world has fallen into deep and long depressions characterized by persistent high unemployment: the US in the 1930s, industrialized Western Europe in the 1930s, Western Europe again in the 1980s and Japan in the 1990s. Two of these downturns — Western Europe in the 1980s and Japan in the 1990s — cast a long and dark shadow on future economic performance.
In both cases, if either Europe or Japan returned — or, indeed, ever returns — to something like the pre-downturn trend of economic growth, it took (or will take) decades. In a third case, Europe at the end of the 1930s, we do not know what would have happened had Europe not become a battlefield following Germany’s invasion of Poland.
In only one instance was the long-run growth trend left undisturbed: US production and employment after World War II were not significantly affected by the macroeconomic impact of the Great Depression. Of course, in the absence of mobilization for World War II, it is possible and even likely that the Great Depression would have cast a shadow on post-1940 US economic growth. That is certainly how things looked, with high levels of structural unemployment and a below-trend capital stock at the end of the 1930s, before mobilization and the European and Pacific wars began in earnest.
In the US, we can already see signs that the downturn that started in 2008 is casting its shadow on the future. Reputable forecasters — both private and public — have been revising down their estimates of the US’ potential long-run GDP.
For example, labor-force participation, which usually stops falling and starts rising after the business-cycle trough, has been steadily declining over the past two-and-a-half years. At least some monetary policymakers believe that recent reductions in the US unemployment rate, which have largely resulted from falling labor-force participation, are just as valid a reason for shifting to more austere policies as reductions in unemployment that reflect increases in employment. And much the same processes and responses are at work — with even greater strength — in Europe.
However, most important has been what looks, from today’s perspective, like a permanent collapse in the risk-bearing capacity of the private marketplace, and a permanent and large increase in the perceived riskiness of financial assets worldwide — and of the businesses whose cash flows underpin them. Given aging populations in industrial countries, large commitments from governments to social-insurance systems and no clear plans for balancing government budgets in the long run, we would expect to see inflation and risk premiums — perhaps not substantial, but clearly visible — priced into even the largest and richest economies’ treasury debt.
Sometime over the next generation, the price levels of the US, Japan and Germany might rise substantially after some -government short-sightedly attempts to finance some of its social-welfare spending by printing money. The price levels are unlikely to go down. Yet the desire to hold assets that avoid the medium-term risks associated with the business cycle has overwhelmed this long-run fundamental risk factor.
However, the risk that the world’s investors currently are trying to avoid by rushing into US, Japanese and German sovereign debt is not a “fundamental” risk. There are no psychological preferences, natural-resource constraints or technological factors that make investing in private enterprises riskier than it was five years ago. Rather, the risk stems from governments’ refusal, when push comes to shove, to match aggregate demand to aggregate supply in order to prevent mass unemployment.