The Second Great Contraction
Harvard economist Kenneth Rogoff says we're undergoing much more than a mere recession.
Harvard economist Kenneth Rogoff is calling the current recession the second great contraction and explains why the difference is not just mere semantics.
CAMBRIDGE – Why is everyone still referring to the recent financial crisis as the “Great Recession”? The term, after all, is predicated on a dangerous misdiagnosis of the problems that confront the United States and other countries, leading to bad forecasts and bad policy.
The phrase “Great Recession” creates the impression that the economy is following the contours of a typical recession, only more severe – something like a really bad cold. That is why, throughout this downturn, forecasters and analysts who have tried to make analogies to past post-war US recessions have gotten it so wrong. Moreover, too many policymakers have relied on the belief that, at the end of the day, this is just a deep recession that can be subdued by a generous helping of conventional policy tools, whether fiscal policy or massive bailouts.
But the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation.
A more accurate, if less reassuring, term for the ongoing crisis is the “Second Great Contraction.” Carmen Reinhart and I proposed this moniker in our 2009 book This Time is Different, based on our diagnosis of the crisis as a typical deep financial crisis, not a typical deep recession. The first “Great Contraction” of course, was the Great Depression, as emphasized by Anna Schwarz and the late Milton Friedman. The contraction applies not only to output and employment, as in a normal recession, but to debt and credit, and the deleveraging that typically takes many years to complete.
Why argue about semantics? Well, imagine you have pneumonia, but you think it is only a bad cold. You could easily fail to take the right medicine, and you would certainly expect your life to return to normal much faster than is realistic.
With most recessions we see a quick rebound in economic activity often above the historical norm. We also see a quick rebound in employment as well with the exception of the recessions in 1991 and 2001. We aren’t seeing that here. While the unemployment/employment situation has improved slightly the improvements have been weak and appear to have stopped.
Some have argued that part of the problem is that fiscal stimulus was not large enough. However, Rogoff has a response to that as well,
Many commentators have argued that fiscal stimulus has largely failed not because it was misguided, but because it was not large enough to fight a “Great Recession.” But, in a “Great Contraction,” problem number one is too much debt. If governments that retain strong credit ratings are to spend scarce resources effectively, the most effective approach is to catalyze debt workouts and reductions.
There is also this part as well,
In my December 2008 column, I argued that the only practical way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years. Of course, inflation is an unfair and arbitrary transfer of income from savers to debtors. But, at the end of the day, such a transfer is the most direct approach to faster recovery. Eventually, it will take place one way or another, anyway, as Europe is painfully learning.
Interestingly this fits well with how the Great Depression ended. Once the U.S. went off the gold standard and the money supply expanded and the inflation rate increased the economy started growing again. Inflation is one way of reducing debt, and as Rogoff points out it is arbitrary in that is transfers wealth from savers to debtors.
Dave Schuler also has a post on this article and notes,
As I see it our key problem is that we’re mollycoddling the banks, just as the Japanese did. The big banks are insolvent. They were insolvent in 2008. They’re still insolvent. Propping them up just prolongs the agony.
Indeed. I think this is one of the elephants in the room that nobody wants to mention.