"I think the system has been stabilized.  I don't think people are going to bed at night wondering which major financial institution might have a problem."

To see what I’m talking about, consider the implications of the latest piece of terrible economic news: Thursday’s report on new claims for unemployment insurance, which have now passed the half-million mark. Bad as this report was, viewed in isolation it might not seem catastrophic. After all, it was in the same ballpark as numbers reached during the 2001 recession and the 1990-1991 recession, both of which ended up being relatively mild by historical standards (although in each case it took a long time before the job market recovered).

But on both of these earlier occasions the standard policy response to a weak economy — a cut in the federal funds rate, the interest rate most directly affected by Fed policy — was still available. Today, it isn’t: the effective federal funds rate (as opposed to the official target, which for technical reasons has become meaningless) has averaged less than 0.3 percent in recent days. Basically, there’s nothing left to cut.

…

What does all this say about economic policy in the near future? The Obama administration will almost certainly take office in the face of an economy looking even worse than it does now. Indeed, Goldman Sachs predicts that the unemployment rate, currently at 6.5 percent, will reach 8.5 percent by the end of next year.

All indications are that the new administration will offer a major stimulus package. My own back-of-the-envelope calculations say that the package should be huge, on the order of $600 billion.

So the question becomes, will the Obama people dare to propose something on that scale?

Let’s hope that the answer to that question is yes, that the new administration will indeed be that daring. For we’re now in a situation where it would be very dangerous to give in to conventional notions of prudence.

Some older theories of business cycles-usually associated with the “Austrian” school of economics- claimed that recessions and depressions were useful in helping to remove the poison from an economy that builds up during good times. For example, weaker companies are the first to go when the demand for an industry’s product falls during recessions. Employees who are allowed a lot of slack during good times are forced to work harder during recessions in order to keep their jobs.

Positive effects such as these may be somewhat important during very mild downturns, but they are overwhelmed during major recessions and depressions by the negative effects. I define a “major” recession as having an extended period of unemployment rates at 9 percent or more, coupled with declining GDP. It looks like the US and the world economies may be headed for such a recession for the next year or so.

Economists have underplayed the cost to individuals of mild to severe recessions in part because they have neglected the cost of the “fear” generated by bad economic times. In his1932 inaugural address in the midst of the Great Depression Franklin Delano Roosevelt reassured he American public that the “Only Thing We Have to Fear Is Fear Itself”. In fact they had a lot more to fear, but Roosevelt recognized the great importance of fear during depressions. In the present crisis too, consumers and workers have multiple fears due to various kinds of uncertainty. Homeowners fear that they may lose their homes after having used most of their savings as down payments on their homes. The employed fear that they will be laid off, while the unemployed fear that its duration will be quite long, and that they eventually will only get jobs that are much inferior to the ones they had. To be sure, some of the unemployed in many countries will receive unemployment compensation, but many unemployed American do not qualify for this benefit. Moreover, unemployed workers in this country usually receive much less than their earnings while employed, and after a while they run out of benefits, although benefits get extended during recessions.

The fear about losing one’s job interacts with fears about being unable to make payments on homes, cars, and other consumer durables. Unemployed persons start missing payments on their homes or cars. If this goes on for several months, they may have their cars repossessed, and their homes put into foreclosure, usually at a time when home prices are down a lot, so that can at best regain only a fraction of the equity they put into their homes.

In addition, the burden of a major recession is not shared uniformly. It usually falls disproportionately on unskilled workers, the young, and those in shaky financial positions, which tend to be persons with lower educations and incomes. For example, the unemployment rate of high school dropouts is traditionally several times that of college graduates, so when the average unemployment rate goes from 6 to 9 percent, that of college graduates may rise to about 4 percent, while that of dropouts will increase to over 20 percent. This recession may be a bit different since the financial sector is being hit so hard. Individuals and families already in shaky circumstances get hit especially hard by major recessions.

It is relatively easy to measure what happens to the unemployment rate during recessions and its differential incidence among different groups, or the number of persons who drop out of the labor force because they despair of finding a job. One can also measure relatively accurately the effects on profits, wages, the path of GDP and personal incomes, and other important variables. It is far harder to measure precisely the effects of serious recessions on individual welfare and happiness. Surveys of reported happiness find that workers who become unemployed are less happy than they were, and persons whose incomes have fallen reported a decline in their happiness, at least initially. Divorce rates and even suicide rates also tend to rise during major recessions, as does crime, discrimination against minorities and immigrants, and pressure toward greater protectionism.

Relative to these major costs, the alleged benefits of a recession to the United States seem quite small, and some of them could also be costs on balance. For example, how many infrastructure projects can be undertaken when states are already running deficits, and face even larger ones in the coming months? The federal government will have a huge deficit during the next year, perhaps a trillion dollars, because of the $700 billion bailout, the stimulus package, and the expected sharp declines in tax revenues.

A serious recession will certainly lead to increased regulation of business and labor markets. Some greater regulation of financial markets would certainly be desirable, as I have argued in prior posts, but some of the likely new regulations will be harmful, such as greater protectionism, wage-type controls over income of top executives, higher taxes on capital gains, and others.

The decline in oil prices by over 50 percent to $60 or less a barrel will certainly help American consumers and companies since the US imports about 2/3 of the oil it uses. It is also helpful to American interests to have less revenue flowing to Venezuela, Russia, and some of the Middle Eastern countries. On the other hand, the US is a major exporter of grains and beef, and the decline in their prices will cause considerable problems for farmers. On balance, I believe the decline in commodity prices is a plus for the US, but not a huge one, especially if oil prices begin to rise sharply after the world recession is over.

A serious recession will further erode the pay and bonuses of top executives at financial and other companies, which many will be happy to see. Managers of mutual and hedge funds and investment banks may have been making much more money than is justified by their productivity, but surely the misery inflicted on the lesser skilled workers, low income families, poor homeowners, and other economically weaker groups is not worth any benefits from a sharp fall in the incomes of those at the top.

So my bottom line in discussing the question whether depressions have a silver lining is that any such lining is very thin and small compared to the major costs to households, workers, and small businessmen.

Another day, another bailout: This time homeowners get to benefit from mortgage-modification programs, designed to stem the tide of foreclosures by making it easier for borrowers to stay current on their loans.

But the latest plans from Fannie Mae and Freddie Mac, joining banks such as J.P. Morgan Chase and Citigroup, hold plenty of risks.

Take investors in mortgage-backed securities. Modifications to mortgage holders’ interest rates could leave some MBS holders with reduced interest payments. Forgiveness of principal, meanwhile, could lead to capital losses.

A bigger worry could be that these modification programs are too effective. In that case, “many current borrowers will wave the white flag of surrender and also try to get a modification,” Rod Dubitsky, a senior strategist for asset-backed securities at Credit Suisse, wrote in a recent report.

The danger is that loan holders who otherwise could meet their payments would decide to fall behind to get their cut of the bailout. That could unleash a chain reaction that drives default rates even higher.

That means another dose of moral hazard. Federal officials stopped worrying months ago about that for companies, as they piled up bailout upon bailout to keep the financial system from collapsing. Now officials risk injecting warped incentives into the behavior of individuals.

If the programs take pressure off house prices, MBS holders and borrowers could both make out better than if there weren’t any modifications.

But the financial crisis has shown time and again that it is tough to anticipate the unintended consequences resulting from attempts to quell the turmoil.