It can't happen to us again. This time it's different. This is a popular attitude about the U.S. economy. As we watched bank earnings from Goldman Sachs (NYSE: GS ) to JPMorgan (NYSE: JPM ) to Wells Fargo (NYSE: WFC ) rocket back from the depths of the crisis, and gross domestic product bounce back, victory was declared. The worst was over. And while growth wouldn't be as robust as traditionally seen coming out of such a sharp recession, we'd have sustainable growth.
But now the economy has decidedly slowed. Second-quarter GDP was revised downward to 1.6% from the initial 2.4% that compares with 3.7% in the first quarter. Companies aren't showing the same optimism as earlier in the year. Intel lowered its third-quarter revenue outlook on weakness in consumer demand for PCs, and Cisco's CEO expressed concern about an "unusual" uncertain economic outlook. Retailer J. Crew, which had been humming on all eight cylinders, lowered its full-year outlook.
And still the prevailing view is that we will avoid a prolonged period of contraction.
But maybe it's not different this time. This is something Yale professor Robert Shiller is concerned about. It's this sense of perhaps faulty complacency that he says could make us prone to repeat the same mistakes of the Great Depression. In an interview, Shiller -- co-creator of the S&P/Case-Shiller Home Price Index, the Arthur M. Okun professor of economics and finance at Yale, and co-founder and chief economist of MacroMarkets -- shared why he thinks there is a greater than 50% chance our economy double dips, why our economy is marginally into a Japan-like deflation regime, and why our institutions are ill-prepared for deflation.
Here is an edited transcript of our conversation.
Jennifer Schonberger: Are you at all concerned about a double-dip recession, or do you think we'll muddle along with a slow-growth scenario, especially if home prices fall?
Robert Shiller: I've been worried about a double dip. ... I think the probability is greater than a half that we'll have another double dip.
Schonberger: Would that be precipitated by home prices, or just everything?
Shiller: Just everything. Everything is interdependent. That's the problem with economics -- everything depends on Barack Obama. I wrote this book with [George] Akerlof called Animal Spirits, and we were saying that the economy is essentially driven by ideas. People think, and they get ideas, and certain stories are amplified. The outcome is really uncertain.
I define a double dip as a recession that comes before we've healed from an earlier recession. I like [using the long-term unemployment rate as a sign for healing]. As the long-term unemployment rate goes down around 1%, that's a historical norm for good times. It's up at 4.3% now. I think that's more than a 50% chance, even though historically those things are very rare.
Schonberger: Some experts are concerned about the prospect of deflation. Certainly, we're seeing a good deal of rhetoric out of the Fed, and some big investors are positioning their portfolios accordingly. Do you think the U.S. is on the cusp of deflation, and if so, will it prolong the recovery of the housing market?
Shiller: We actually have seen a couple months [of declines in CPI and PPI, but then it's popped back up]. People forget. They talk about deflation in Japan, but that's what deflation in Japan mostly looked like. That kind of thing kept repeating, and they couldn't get out of that. There were some years when -- not home prices, consumer prices fell like 1%. There was never big deflation in Japan.
So we're already marginally in that regime, and the question is whether we'll get out of it. And that's an uncertainty. It's possible that we will have deflation. I think Ben Bernanke is really committed to avoiding that, and I expect that he probably will. But I think there's still a chance of deflation.
What bothers me is that we are not prepared in our institutions for deflation. So we could have a repeat of the same problem that we saw in the Great Depression. One of the major causes of the severity of the Great Depression was a lot of deflation -- cumulative of about 25% by 1933. That meant home prices went down with the deflation. It wasn't because real home prices declined. It was because there was just massive deflation. But people's debts didn't go down, and so it caused millions to go bankrupt.
Economist Irving Fisher wrote a famous article in the '30s called the Debt-Deflation Theory of Great Depressions. That was his model of the depression: It was caused by deflation, and the way you would prevent that is to have inflation protection built into mortgages and other debts.
Schonberger: Is inflation protection for mortgages and other debt something that you would advocate that the government undertake?
Shiller: Yes. It's in my book Subprime Solution. We should change our mortgages so that they protect people against this kind of nonsense. If prices fall, wages fall, home prices fall, and everything goes down together, it shouldn't mean anything. But it does if people are stuck in debt that doesn't protect them against deflation. It's called indexation. It was a concept that was brought out 100 years ago. It seems people just don't have enough imagination to realize that those things that happened in the past could happen again. So, they become complacent. The title of [Carmen] Reinhart and [Kenneth] Rogoff's new book is This Time Is Different. It's a syndrome. People think that errors of the past couldn't repeat themselves, so they don't even protect themselves against it. That's why we're poised to have the same issues again.
For more insight from Shiller: