It's Worse Than You Think: Halftime Between Two Lost Decades

The recovery feels extraordinarily slow because we face an extraordinary three-part crisis: a financial shock compounded by a global slowdown and a demographic time bomb. Time to think big.

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Reuters

The global economy is in a synchronized swoon. Brazil's economy practically stalled out in the first quarter, all of China's manufacturing figures indicate much lower growth than last year, Britain remains in recession, Spain's banking system needs a rescue and may collapse, and the U.S. -- which had been the last remaining bright spot in the global economy -- suddenly has started sputtering. The number of jobs created in May was not just half as many as expected; the figures for the previous two months were sharply revised lower as well. And for good measure, GDP growth for the first quarter was revised downward too.

Many observers were surprised or disappointed, because they still do not understand the nature of this recession, which is neither exclusively cyclical, nor exclusively structural, but rather a rare collision of crises -- a financial recession, in the middle of a global slow-down, at the edge of a demographic time bomb.

THE FIRST HALF

First, this is not a normal demand-damp cyclical recession. In such a recession, demand has been driven upward by rising population and rising wages, faster than production can keep pace, and the result is inflation. To rein in that inflation, monetary authorities raise interest rates and/or governments reduce spending to reduce demand. The result is a dampening of demand that usually drops unemployment and spending and ends inflation. However, as soon as inflation is under control, interest rates can be lowered and government spending can resume; hiring then usually picks up as does overall demand and the economy again grows. The whole process is a bit like hitting the pause button, then the forward button, for the economy as a whole. In such a cycle, the basic relationship between economic growth and job and wage growth remains unchanged, hence the recession is only cyclical, not structural.

However, the current slump is a different kind of cyclical recession; it is a financial overleveraging recession brought on by an excess of debt rather than just demand. In such recessions, deregulation and unusually easy credit lead to enormous borrowing to invest in 'sure things' -- in this case, private residential housing (in other cases it has been sovereign debt, or property, or new technologies). People view this asset as so safe that they develop all kinds of ways to boost their leverage (e.g. debt to asset ratios) or get out risky loans to purchase those assets. This huge influx of buying power raises the price of the 'safe' asset to unsustainable, unrealistic levels; then when people start to realize that the risky loans will fail and the underlying asset is losing value, you get a collapse of the market and a financial bust. Both borrowers and firms that managed the debt are critically hit.

In the current recession, demand is not being intentionally damped to reduce inflation. Demand collapsed of its own accord as people recognized that they do not, in fact, have the asset wealth they believed they had. Worse, they were left holding large debts that now are much larger than they want given the value of their assets. They then have no choice but to deleverage -- that is, to reduce spending, pay down debts and increase their savings until they return to their desired debt/asset ratio. With this economy-wide collapse of private spending (banks too have to rebuild their debt/asset ratio by recapitalizing and reducing their loan books), deflation and depression follows - unless (as Keynes first showed) government spending moves higher to take the place of the reduced private spending.

THE EMPTY PLAYBOOK

Carmen Reinhart and Kenneth Rogoff have clearly pointed out this difference, but their guidance -- that financial crisis-based recessions tend to last 7-10 years and usually involve sovereign debt crises as well -- has often been disregarded. This is why you often hear President Obama being blamed for the recovery being "weak" or "pathetic" compared to the recovery from other recessions. It is of course true that the recovery (or non-recovery as we are likely in this for years to come) has been very weak compared to recoveries from ordinary demand-dampening cyclical recessions. But that is to be expected. This is a different beast. One cannot simply push the "forward" button and restart the economy. The underlying mechanism is broken and has to be repaired by reducing debts, which takes time.

It is true that the solution to a financial-crisis based recession is reduction of debt to acceptable levels. Those calling for an austerity program in response have on their side that they are calling for a reduction in debt, namely government debt. But they have only seen a fraction of the problem. The economy has slowed to a crawl because private firms and households took on too much debt, and have to save and reduce spending and debt. In doing so, they put a lot of people out of work. That in turn raises government spending. Yet at the same time, the recession sharply reduces government revenues, so the result -- a symptom of the underlying crisis -- is much more government debt.

Austerity policies target that symptom. Yet cutting government spending and raising taxes in an economy where both consumers and private firms are seeking to reduce their debts and increase their savings simply redoubles the overall reduction in spending throughout the economy, making the recession even deeper. That is why austerity policies have not pulled any countries out of this economic crisis.

Presented by

Jack A. Goldstone is the Virginia E. and John T. Hazel, Jr. Professor of Public Policy at George Mason University, a non-resident senior fellow at the Brookings Institution, and the author of Political Demography.

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