There are, of course, a wide variety of opinions. This paper discusses most, if not all, of them. Take your pick.
Archive for the ‘Great Recession’ Category
From marketobservation.com, a great graph showing how easy money, deregulation, reckless leveraging and market failure led t0 crisis, collapse and bailouts.
These 50 items were collected and posted by The Economic Collapse blog. Together, they paint a terrifyingly ugly picture of economic conditions in what was once the “wealthy” United States of America.
The blog’s authors blame everything on the Fed and want it to be shut down. While their analysis and recommendation are, shall we say, a bit extreme, facts are facts.
Here’s the list:
“Those who do not remember the past are condemned to repeat it.”
– George Santayana
Few quotes are more frequently mentioned than this one. Keep it in mind while taking a few minutes to read (and ponder) this article from the Economist’s December 10th issue.
In 2008 the world dodged a second Depression by avoiding the mistakes that led to the first. But there are further lessons to be learned for both Europe and America
“YOU’RE right, we did it,” Ben Bernanke told Milton Friedman in a speech celebrating the Nobel laureate’s 90th birthday in 2002. He was referring to Mr Friedman’s conclusion that central bankers were responsible for much of the suffering in the Depression. “But thanks to you,” the future chairman of the Federal Reserve continued, “we won’t do it again.” Nine years later Mr Bernanke’s peers are congratulating themselves for delivering on that promise. “We prevented a Great Depression,” the Bank of England’s governor, Mervyn King, told the Daily Telegraph in March this year.
The shock that hit the world economy in 2008 was on a par with that which launched the Depression. In the 12 months following the economic peak in 2008, industrial production fell by as much as it did in the first year of the Depression. Equity prices and global trade fell more. Yet this time no depression followed. Although world industrial output dropped by 13% from peak to trough in what was definitely a deep recession, it fell by nearly 40% in the 1930s. American and European unemployment rates rose to barely more than 10% in the recent crisis; they are estimated to have topped 25% in the 1930s. This remarkable difference in outcomes owes a lot to lessons learned from the Depression.
Debate continues as to what made the Depression so long and deep. Some economists emphasise structural factors such as labour costs. Amity Shlaes, an economic historian, argues that “government intervention helped make the Depression Great.” She notes that President Franklin Roosevelt criminalised farmers who sold chickens too cheaply and “generated more paper than the entire legislative output of the federal government since 1789”. Her book, “The Forgotten Man”, is hugely influential among America’s Republicans. Newt Gingrich loves it.
A more common view among economists, however, is that the simultaneous tightening of fiscal and monetary policy turned a tough situation into an awful one. Governments made no such mistake this time round. Where leaders slashed budgets and central banks raised rates in the 1930s, policy was almost uniformly expansionary after the crash of 2008. Where international co-operation fell apart during the Depression, leading to currency wars and protectionism, leaders hung together in 2008 and 2009. Sir Mervyn has a point.
Look closer, however, and the picture is less comforting. For in two important—and related—areas, the rich world could still make mistakes that were also made in the 1930s. It risks repeating the fiscal tightening that produced America’s “recession within a depression” of 1937-38. And the crisis in Europe looks eerily similar to the financial turmoil of the late 1920s and early 1930s, in which economies fell like dominoes under pressure from austerity, tight money and the lack of a lender of last resort. There are, in short, further lessons to be learned.
Riding for a fall
It was far easier to stimulate the economy in the 2000s than in the 1930s. Social safety nets—introduced in the aftermath of the Depression—mean that today’s unemployed have money to spend, providing a cushion against recession without any active intervention. States are more relaxed about running deficits, and control much larger shares of national economies. The package of public works, spending and tax cuts that President Herbert Hoover introduced after the crash of 1929 amounted to less than 0.5% of GDP. President Barack Obama’s stimulus plan, by contrast, was equivalent to 2-3% of GDP in both 2009 and 2010. Hoover’s entire budget covered only about 2.5% of GDP; Mr Obama’s takes 25% of GDP and runs a deficit of 10%.
Roosevelt raised spending to 10.7% of output in 1934, by which point the American economy was growing strongly. By 1936 inflation-adjusted GDP was back to 1929 levels. Just how much the New Deal spending helped the recovery is still debated. Some economists, such as John Cochrane of the University of Chicago and Robert Barro of Harvard, say not at all. Fiscal measures never work, they say.
Those who think that fiscal measures do work nonetheless tend to believe that, in the 1930s, spending was less important than monetary policy, which they see as the prime cause of suffering. In a paper in 1989 Mr Bernanke and Martin Parkinson, now the top civil servant in Australia’s finance ministry, wrote that rather than providing recovery itself “the New Deal is better characterised as having ‘cleared the way’ for a natural recovery.” Others, such as Paul Krugman, would ascribe a more positive role to stimulus spending.
Whatever relative importance is assigned to monetary and fiscal policy, though, there is little doubt that their simultaneous tightening five years into the Depression led to a vicious relapse. Spurred by his treasury secretary, Henry Morgenthau—who worried in 1935 that “we cannot help but be riding for a fall unless we continue to decrease our deficit each year and the budget is balanced”—Roosevelt urged fiscal restraint on Congress in 1937.
By that point the national debt had reached an unheard of 40% of GDP (huge by the standards of the day, but half what Germany’s debt is now). Congress cut spending, increased taxes and wiped out a deficit of 5.5% of GDP between 1936 and 1938. That was a larger consolidation than Greece now faces over two years (see chart 1), but is much smaller than what is planned for it in the longer term. At the same time the Federal Reserve doubled reserve requirements between mid-1936 and mid-1937, encouraging banks to pull money out of the economy. The Treasury began to restrict the money supply in step with the level of gold imports. In 1937 and 1938, the recession within a depression brought a drop in real GDP of 11% and an additional four percentage points of unemployment, which peaked at 13% or 19%, depending on how you count it.
The Snowdens of yesteryear
Today’s monetary policy hasn’t turned contractionary, as America’s did in the 1930s. As The Economist went to press, the European Central Bank (ECB) was expected to announce a further reduction in interest rates. But in many places fiscal policy is moving rapidly in that direction. Mr Obama’s stimulus is winding down; state- and local-government cuts continue. Republican candidates for the presidency echo the arguments of Mr Morgenthau, claiming that deficit-financed stimulus spending has done little but add to the obligations of future taxpayers. Mr Obama, like Roosevelt, has started to stress the need for budget-cutting. If the current payroll-tax cut and emergency unemployment benefits were to lapse, growth over the next year would be reduced by around one percentage point of GDP.
America is not alone. Under David Cameron, Britain’s hugely indebted government introduced a harsh programme of fiscal consolidation in 2010 to avert a loss of confidence in its creditworthiness. The rationale was similar to that for chancellor Philip Snowden’s emergency austerity budget of 1931, with its tax rises and spending cuts. On that occasion confidence was not restored, and Britain was forced to devalue the pound and abandon the gold standard. On this occasion the measures have indeed boosted investor confidence, and thus bond yields; that the country still faces a second recession is in large part due to the euro zone’s woes. That said, the possibility of such shocks should always be a counsel for caution when a government embarks on fiscal tightening.
Some say tightening need not hurt. In 2009 Alberto Alesina and Silvia Ardagna of Harvard published a paper claiming that austerity could be expansionary, particularly if focused on spending cuts, not tax increases. Budget cuts that reduce interest rates stimulate private borrowing and investment, and by changing expectations about future tax burdens governments can also boost growth. Others doubt it. An International Monetary Fund (IMF) study in July this year found that Mr Alesina and Ms Ardagna misidentified episodes of austerity and thus overstated the benefits of budget cuts, which typically bring contraction not expansion.
Roberto Perotti of Bocconi University has studied examples of expansion at times of austerity and showed that it is almost always attributable to rising exports associated with currency depreciation. In the 1930s the contractionary impact of America’s fiscal cuts was mitigated to some extent by an improvement in net exports; America’s trade balance swung from a deficit of 0.2% of GDP to a surplus of 1.1% of GDP between 1936 and 1938. Now, most of the world is cutting budgets and not every economy can reduce the pain by boosting exports.
The importance of monetary policy in the 1930s might suggest that central banks could offset the effects of fiscal cuts. In 2010 the IMF wrote that Britain’s expansionary monetary policy should mitigate the contractionary impact of big budget cuts and “establish the basis for sustainable recovery”. Yet Britain is now close to recession and unemployment is rising, suggesting limits to what a central bank can do.
The move to austerity is most dramatic within the euro zone—which can least afford it. Operating without floating currencies or a lender of last resort, its present predicament carries painful echoes of the gold-standard world of the early 1930s.
In the mid-1920s, after an initially untenable schedule of war reparations payments was revised, French and American creditors struck by the possibility of rapid growth in the battered German economy began to pile in. The massive flow of capital helped fund Germany’s sovereign obligations and led to soaring wages. Germany underwent a credit-driven boom like those seen on the European periphery in the mid-2000s.
In 1928 and 1929 the party ended and the flow of capital reversed. First, investors sent their money to America to bet on its soaring market. Then they yanked it out of Germany in response to financial panic. To defend its gold reserves, Germany’s Reichsbank was forced to raise interest rates. Suddenly deprived of foreign money, and unable to rely on exports for growth as the earlier boom generated an unsustainable rise in wages, Germany turned to austerity to meet its obligations, as Ireland, Portugal, Greece and Spain have done. A country with a floating currency could expect a silver lining to capital outflows: the exchange rate would fall, boosting exports. But Germany’s exchange rate was fixed by the gold standard. Competitiveness could only be restored through a slow decline in wages, which occurred even as unemployment rose.
As the screws tightened, banks came under pressure. The Austrian economy faced troubles like those in Germany, and in 1931 the failure of Austria’s largest bank, Credit Anstalt, triggered a loss of confidence in the banks that quickly spread. As pressure built in Germany, the leaders of the largest economies repeatedly met to discuss the possibility of assistance for the flailing economy. But the French, in particular, would brook no reduction in Germany’s debt and reparations payments.
Recognising that the absence of a lender of last resort was fuelling panic, the governor of the Bank of England, Montagu Norman, proposed the creation of an international lender. He recommended a fund be set up and capitalised with $250m, to be leveraged up by an additional $750m and empowered to lend to governments and banks in need of capital. The plan, probably too modest, went nowhere because France and America, owners of the gold needed for the leveraging, didn’t like it.
So the dominoes fell. Just two months after the Credit Anstalt bankruptcy a big German bank, Danatbank, failed. The government was forced to introduce capital controls and suspend gold payments, in effect unpegging its currency. Germany’s economy collapsed, and the horrors of the 1930s began.
It is all dreadfully familiar (though no European country is about to elect another Hitler). Membership in the euro zone, like adherence to the gold standard, means that uncompetitive countries can’t devalue their currencies to reduce trade deficits. Austerity brings with it a vicious circle of decline, squeezing domestic demand and raising unemployment, thereby hurting revenues, sustaining big deficits and draining away confidence in banks and sovereign debt. As residents of the periphery move their money to safer banks in the core, the money supply declines, just as it did in the 1930s (see chart 2). High-level meetings with creditor nations bring no surcease. There is no lender of last resort. Though the European Financial Stability Facility (EFSF) has got further off the ground than Norman’s scheme, which it chillingly resembles, euro-zone leaders have yet to find a way to leverage its €440 billion up to €2 trillion.
Even if they succeed, that may be too little to end the panic. Investors driven by turmoil in Italian markets are pre-emptively reducing their exposure to banks and sovereign bonds elsewhere in the euro zone. Even countries with relatively robust economies such as France and the Netherlands have not been spared. No matter how secure an economy’s fiscal position, a short-term liquidity crunch driven by panic can drive it into insolvency.
History need not repeat itself. Norman’s Bank of England was created in the 17th century to lend to the government when necessary; central banks have always been obliged to lend to governments when others will not. The ECB could take on this role. It is prohibited by its charter from buying debt directly from governments, but it can purchase debt securities on the secondary market. It has been doing so piecemeal and could declare its intention to do so systematically. Its power to create an unlimited amount of money would allow it credibly to announce its willingness to buy any bonds markets want to sell, thus removing the main cause of panic and contagion.
This week France and Germany proposed the adoption of legally binding budgetary “golden rules” by euro-zone members, ahead of a summit of European leaders in Brussels on December 8th-9th. Mario Draghi, the ECB’s new president, has hinted that were a fiscal pact to be agreed, the ECB might buy bonds on a larger scale. What scale he has in mind, though, is unclear. Jens Weidmann, president of Germany’s Bundesbank and an influential member of the ECB’s governing council, has clearly stated that the ECB “must not be” the euro zone’s lender of last resort.
Where this path leads
On the present course, conditions in developed economies look like getting worse before they get better. Growth in America and Britain will probably be less than 2% in 2012 on current policy, and in both recession is quite possible. A euro-zone recession is likely. The ECB could improve the euro zone’s economic outlook by loosening its monetary policy, but widespread austerity and uncertainty will be difficult to overcome. As in 1931 and 2008, a grave financial crisis may cause a large drop in output. That, in turn, would place more pressure on euro-zone economies struggling to avoid default.
As panic built in 1931, country after country faced capital flight. The effort to defend against bank and currency runs prompted rounds of austerity and plummeting money supplies in pressured economies, helping generate the collapse in output and employment that turned a nasty downturn into a Depression. It took the end of the gold standard, which freed central banks to expand the money supply and reflate their economies, to spark recovery. Today the ECB has the tools needed to salvage the situation without breaking up the euro. But the fact that the ECB and euro-zone governments have options does not mean that they will take them.
The collapse of the gold standard led to recovery, but caused terrible economic damage as countries erected trade barriers to stem the flood of imports from those that had devalued their currencies. Governments elected to fight unemployment experimented with wage and price controls, cartelisation of industry and other interventions that often impeded the recovery enabled by expansionary monetary and fiscal policies. In the worst-hit countries long-suffering citizens turned to fascism in the false hope of relief.
The world today is better placed to cope with disaster than it was in the 1930s. Then, most large economies were on the gold standard. Today, the euro zone represents less than 15% of world output. In developed countries unemployment, scourge though it is, does not lead to utter destitution as it did in the 1930s. Then, the world lacked a global leader; today, America is probably still up to the job of co-ordinating disaster response in troubled times. International institutions are much stronger, and democracy is more firmly entrenched.
Even so, prolonged economic weakness is contributing to a broad rethinking of the value of liberal capitalism. Countries scrapping for scarce demand are now intervening in currency markets—the Swiss are fed up with their franc appreciating against the euro. America’s Senate has sought to punish China for currency manipulation with tariffs. Within Europe the turmoil of the euro crisis is encouraging ugly nationalists, some of them racist. Their extremism is mild when compared with the continent-wrecking horrors of Nazism, but that hardly makes it welcome.
The situation is not yet beyond repair. But the task of repairing it grows harder the longer it is delayed. The lessons of the 1930s spared the world a lot of economic pain after the shock of the 2008 financial crisis. It is not too late to recall other critical lessons of the Depression. Ignore them, and history may well repeat itself.
Marc Schulman, “A Golden Future?,” (August 2011)
The eurozone standard is the modern day equivalent of the gold standard. Countries that are in economic trouble are forced to implement austerity measures that have ramifications outside their borders. In the 1930s, a crisis in little Austria spread like wildfire to Germany, Great Britain and, finally, to the United States. In our time, a crisis that began in little Greece has spread like wildfire to Portugal, Spain, Italy, and, perhaps France.
Deutsche Bank, “Is the Euro today the Gold Standard of the 1930s for European Economies?,” (December 2011):
The 1930s in Europe was a slow moving game of falling dominoes with countries one by one leaving the narrow confines of the Gold Standard after chronic growth problems that a fixed currency system intensified. There was a definite trend in the 1930s that saw those countries that left the Gold Standard seeing a much quicker recovery from the Depression than those that stayed on for a number of years into the latter half of the decade. Figure 12 shows a case study of six countries currencies relative to Gold in the 1930s. We’ve rebased them to 100 at the start of the series. In order of leaving the Gold Standard, we had the UK (left September 1931), Sweden (also left September 1931), US (April 1933), Belgium (March 1935), France (September 1936) and Italy (October 1936).
Interestingly, by the middle of 1937 all had devalued by at least 40% to Gold except Belgium who had devalued by around 30% in 1935. France, which held on until September 1936, then saw its currency collapse by nearly 70% in the three years up to WWII. Figure 13 then shows the same six countries nominal (left) and real (right) GDP performance over the same period.
The UK and Sweden, which left the Gold Standard earliest (September 1931) in this sample, saw a ‘relatively’ mild negative growth shock compared to the other four. In contrast, France which stuck to Gold until late 1936 saw growth notably under-perform until they left the standard. Interestingly as discussed above, France later saw a dramatic 3 year 70% devaluation to Gold which helped restore nominal GDP close to that of the UK and Sweden by the end of the 1930s. However, in real terms they were still the laggard at this point. The worst slump of all was that seen in the US between 1929 and 1932 where they lost nearly half the value of their economy in nominal terms and nearly 30% in real terms. However, the bottom pretty much corresponded to the end of the Dollar’s gold convertibility and subsequent devaluation. From this point on, the recovery was fairly dramatic until the 1937 recession we’ll discuss below. Overall, Figure 13 does indicate some fairly strong evidence that growth did seem to respond to currency debasement and that countries which left this later ended up with weaker economies for longer and also, in France’s case, a more dramatic end devaluation.
“. . . in two important—and related—areas, the rich world could still make mistakes that were also made in the 1930s. It risks repeating the fiscal tightening that produced America’s “recession within a depression” of 1937-38. And the crisis in Europe looks eerily similar to the financial turmoil of the late 1920s and early 1930s, in which economies fell like dominoes under pressure from austerity, tight money and the lack of a lender of last resort.”
– The Economist
This quote is from the December 10th issue, which is now available online.
During the summer, I published three posts that made the same points the Economist is now making:
- On financial turmoil: Is Another 1931 in the Offing? (July 11)
- On premature financial tightening: Is Another 1937 in the Offing (July 12)
- On their simultaneous occurrence: 1931 and 1937, At the Same Time (August 4)
Please excuse me for patting myself on the back. I promise it won’t happen very often.
Understanding the Second Great Contraction – The economist and coauthor of This Time Is Different explains what history can teach us about the global downturn and why climbing out of it is still rife with risks.
Continued economic stagnation in Europe and the United States, along with renewed uncertainty about the health of the debt-ridden global financial system, has been raising fresh concerns about the prognosis for economic recovery and even the potential for a relapse into crisis. A big part of the problem, as Harvard economist Kenneth Rogoff pointed out inThis Time Is Different: Eight Centuries of Financial Folly (Princeton University Press, September 2009), the best-selling academic book he coauthored with fellow economist Carmen Reinhart, is that we are working through a recession linked to a deep financial crisis—a powerful amplifying mechanism with long-lasting effects. Reinhart and Rogoff’s work, based on investigations of empirical data from 800 years of financial crises, shows that such downturns are exceptionally deep and long lasting, as well as unprecedented in the United States since World War II. McKinsey’s Bill Javetski and Tim Koller recently visited Rogoff in his Cambridge, Massachusetts, office to ask where we are in the recovery time line and why Rogoff thinks that a bout of moderate inflation may help the world regain economic health. Rogoff’s outlook—that the balance of current economic risks tilts “more to the downside than the upside”—is sobering but essential reading for business leaders and policy makers trying to make sense of today’s uncertain environment.
The Quarterly: What does history tell you about where we are on the time line of the economic contraction we’ve been living through?
Kenneth Rogoff: The historical experience gives a very clear view that the aftermath of a financial crisis brings slow and halting growth, sustained high unemployment, and surging public debt—with the overhang of public and private debt being the most important impediment to a normal recovery from recession. It has been utterly remarkable how the United States has been tracking the averages of postwar deep financial crises across a broad range of indicators. On average, it takes four and a half years to get back to the same per capita GDP where you started out and about the same amount of time for unemployment to stop rising. Indeed, we haven’t yet gotten back to the same per capita GDP where we started. Our perspective is that we have never left the recession; we’re still very much in it. I hope in another two or three years things will be feeling more normal. But there are a lot of difficulties to traverse before we get there.
The Quarterly: You distinguish between normal recessions and those accompanied by a deep financial crisis. Are there many recessions marked by such a crisis?
Kenneth Rogoff: There have been many across the world, but for the United States this is the first one since World War II. A financial-crisis recession is a very different animal from a normal recession. At least quantitatively, it’s not as bad now as it was in the Great Depression. Nevertheless, Reinhart and I argue that the right name for this downturn is the “Second Great Contraction,” building on the title of Milton Friedman and Anna Schwartz’s famous book about the Great Depression.1
The Quarterly: Is there any way to accelerate our pullout from this contraction?
Kenneth Rogoff: It’s not easy, because a postfinancial-crisis recession is characterized by an overhang of private and public debt that is much more severe than it is after a normal recession. There are many mortgages still under water—perhaps 25 percent—and people are more cautious about extending their borrowing than they were before 2007. That leads to slower consumption growth. Businesses in turn invest more slowly. In 2008, policy makers placed too much confidence in the Keynesian idea that you can jump-start the economy with a big temporary stimulus and then step back and watch the private sector take over. Of course, Reinhart and I argued otherwise, based on the results of a seven-year research project, and our results certainly were acknowledged by practitioners, academics, and policy makers. Nevertheless, most policy makers and markets still insisted, “Well, yes, maybe that is how things always were in the past, but this time it’s different because the policy response was so aggressive.” In fact, the policy response is always very aggressive. Every country does everything it can to claw its way back from a deep financial crisis. So, unfortunately, there is no easy out. Perhaps the best chance would be to find a way to get ahead of the mortgage defaults—that is, to have restructurings and debt forgiveness, albeit with some kind of quid pro quo. That is very hard to do. But if there were a way to write down and forgive some of the mortgage debt, that would be money well spent. In ten years, we will probably end up forgiving a big chunk of it. As Carmen has noted, this is a little like Third World debt that was carried on the books forever, even though it was a joke.
The Quarterly: What other policy responses would make sense?
Kenneth Rogoff: Beyond that, we need to think about long-run structural reform. Most financial crises have at their root very, very high leverage. To hit the nail on the head, I think we have to do something about the prevalence of nonindexed debt instruments. I would start with changing our corporate-tax law and any overt incentives that favor debt. Obviously, the US home mortgage tax deduction makes no sense, given the risk that debt entails. I understand the political imperative, but let’s not subsidize debt in an overt way. I think public-finance experts need to methodically go through the system and strip debt subsidies out. And then I’d say governments need to find ways to spark market innovation in indexing debt instruments. If we had housing loans indexed to, say, regional housing prices, as Bob Shiller has advocated, it would have helped a lot and provided better incentives to borrowers and lenders. If in 200 or 300 years, we’re experiencing fewer and milder financial crises, it will be because we figured out how to put some basic indexation clauses into debt that make it a little less vulnerable to systemic risk.
The Quarterly: Financial innovation, in the form of derivatives, credit default swaps, and other instruments, was supposed to make the world a safer place. Did they have a role—good, bad, or neutral—in creating the crisis?
Kenneth Rogoff: Financial innovation is always a piece of financial crises, and financiers are always ahead of the regulators. In This Time Is Different, we discuss how in the 1300s and 1400s the Catholic Church—which was the regulator at the time, of course—had very strict usury laws. The financiers got around them by thinking of very clever devices, including denominating loans to be repaid in a foreign currency. You give the money in a weaker currency and require the repayment in a stronger currency, which, of course, everyone perfectly well understood to be equivalent to paying interest. There are countless examples over the ages. The transatlantic cable led to huge financial innovation. Innovation is always ahead of the regulators.
The Quarterly: Does that mean we should be cautious about the supposed benefits of financial innovation?
Kenneth Rogoff: I think financial innovation has been overly blamed for everything. Financial-sector lobbying is another matter—regulators of the financial sector lost sight of the risks.
The Quarterly: Is the size of the banks an important factor? Can they get too big?
Kenneth Rogoff: I believe that size is overrated as the issue. There is this view that if we can just break up the big banks into smaller ones, we won’t have a problem. But if you look at systemic crises, usually a lot of banks are doing the same thing. So if we take one big bank and break it up into ten smaller banks that act similarly, I’m not sure how much we really would have bought ourselves. The incentives that would make a big bank go whole hog in one direction would probably make ten smaller banks do the same thing.
The Quarterly: You’ve advocated allowing inflation to increase as one kind of remedy. Can you explain?
Kenneth Rogoff: There are no quick fixes. But I do think that this is a period when we shouldn’t be worried about raising inflation slightly. Indeed, moderate inflation, I would say, is exactly the prescription for a Great Depression–type scenario or a Japan-type scenario. It lowers real interest rates, helps facilitate housing price adjustment (the real price still needs to come down in many places), and modestly shortens the typical long post-crisis deleveraging period. I’ve pushed the idea, for some time, that we’re in a Great Contraction, not in a typical recession, and one has to analyze the problem differently. Unfortunately, there is still a risk that this thing could get much, much worse. The biggest problem is the global overhang of debt. After publishing our book, Carmen Reinhart and I did a study that looked at the impact of public debt on growth. When debt gets over a certain level—a good marker is 90 percent of GDP—it is linked to lower growth. If elevated inflation—I’ve suggested 4 to 6 percent for a few years—somewhat reduces real debt levels, that would be welcome. Of course, I do get a knee-jerk reaction from many people saying that even slightly elevated inflation is anathema; we’d be going back to the bad old days of the ’70s. And my answer is that this could still be much worse than the ’70s. I’ve worked my whole career on designing central banks and promoting tools and institutions for containing inflation. But right now, given a once-in-80-years downturn, you have to balance the risks.
The Quarterly: Is that the right approach for Europe as well?
Kenneth Rogoff: Absolutely, though of course they have a political tightrope to walk. Still, how much should they worry about whether inflation is under 2 percent right now when the euro could fall apart in the next year or two? Please understand, the European Central Bank is under tremendous political pressure, and they’re not the main source of the problem. But I don’t see how they would want to be in a situation where they’d go out of business in a year and say, “Well, the euro may have fallen apart, but we never had inflation expectations go above 2 percent.” Inflation is not a panacea, but this is a once in eight or ten decades situation where it would be helpful.
The Quarterly: Is it naive to pretend that some or much of this debt isn’t going to have to be restructured at some point?
Kenneth Rogoff: By any historical benchmark, Greece, Portugal, and probably Ireland are way over the line. Their debts should be dramatically reduced—for Greece by at least 60 percent or 70 percent. Portugal probably 40 to 50 percent. Ireland is more complicated because it’s difficult to disentangle what’s government debt and what’s bank debt. The big problem is Ireland’s bank debt. But the government has guaranteed it. Had the eurozone officials done all this a year ago and, importantly, cast an ironclad safety net over the remainder, perhaps we would be looking at this in the rear window.
The Quarterly: What indicators would you look to for signs that we’re finally starting to get out of this?
Kenneth Rogoff: Job growth and unemployment. I don’t expect unemployment to come down again to 4 or 4.5 percent until the next time the economy overheats. That level was never normal. More likely, when this is all over, unemployment will settle down at around 6.5 or 7 percent. Until we’ve seen unemployment come down to a level like that, things will remain precarious. I should note that the most reliable measure, though, isn’t unemployment; it’s employment. In addition to unemployment rising, the participation rate in the economy has fallen, and that too needs to come back.
The following is the executive summary is from a note by the Staff of the IMF prepared for the October 14-15, 2011 meeting of the Group of Twenty Finance Ministers and Central Bank Governors in Paris. The full text follows this summary.
- The global economy has entered a dangerous phase. Policy makers must act boldly to finish the job they began in 2009, lest the gains from the recovery since then be lost. Collective action can put the global economy on a path to strong, sustainable, and balanced growth.
- Adverse feedback loops between the real economy and the financial sector have intensified, as private and public sector balance sheets have weakened, uncertainty has been exacerbated by policy indecision, and demand rebalancing has stalled. Even assuming that policies prevent downside risks materializing, projections are for an anemic recovery in major advanced economies and a cyclical slowdown in emerging economies. Global growth is expected to fall to about 4 percent in 2011–12.
- Downside risks are severe. The immediate risk is that the global economy tips into a downward spiral of increased uncertainty and risk aversion, dysfunctional financial markets, unsustainable debt dynamics, falling demand, and rising unemployment. Even in a less severe scenario, key advanced economies could suffer from a protracted period of low growth.
- Policy action along three key fronts will help break the adverse feedback loop between weaker growth and confidence, fiscal tensions, and financial fragilities. This includes well calibrated fiscal adjustment to reassure markets; liquidity provision in the euro area to avoid deeper dislocation and relieve funding strains; and building banks’ capital buffers in Europe.
- In advanced G-20 economies, fiscal sustainability must be restored through credible medium-term consolidation plans. Countries with high debt and facing market pressure must press ahead with “growth-friendly” consolidation now. In others, fiscal policy should navigate between the perils of undermining credibility and undercutting recovery, and facilitate a pickup in private demand. To alleviate prevailing market pressures in the euro area, the ECB should continue its extended liquidity operations and sustain the Securities Market Program (SMP) alongside the support provided by the European Financial Stability Facility (EFSF) for as long as necessary to stabilize issuance costs for banks and sovereigns. At the same time, banks should be urged to build capital buffers in a coordinated fashion, using national public and euro area resources, including the EFSF, if necessary.
- In emerging G-20 economies, near-term policy should focus on responding to spillovers from moderating growth in advanced economies and heightened global risk aversion in financial markets, subject to available policy space. In key surplus economies, fostering sustained, inclusive medium-term growth requires removing distortions, implementing structural and financial reforms, and moving to a more market-based exchange rate.
This paper, published by the New America Foundation and authored by Daniel Alpert, Robert Hockett and Nouriel Roubini, is the best analysis of the economic crisis than I’ve read. Policymakers here and abroad should study it carefully. I hope that readers of this blog will do the same.
Bill Clinton on paying more taxes:
. . . from the end of the Second World War to about 1980, we had enough inequality to reward hard work and raw talent and creativity, and enough equality to build the world’s greatest middle class and allow poor people a reasonable chance to work their way into it. And the distribution was the bottom 90% had 65% of the income; the top 10% had 35% of the income; the top 1% had about 9% of the income.
And those numbers have changed in the last 30 years. The 90% share has dropped from 65 to 52. The 10% share has gone from 35 to 48. The 1% share has gone from 9 to 21.
That’s a breathtaking increase in inequality, and I don’t think it’s good for our long-term stability.
The highlighted portion of this quote is the most cogent statement of what we should be aiming to restore that I’ve seen. And I agree with him that the current degree of inequality carries with it the risk of future social unrest, especially if, as seems to be increasingly likely, we’re in for a long spell of elevated unemployment. A society saddled with large numbers of educated young adults who can’t find work is an explosion waiting to happen.