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.

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Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.


  1. Loviatar says:

    I prefer Paul Krugman’s term The Lesser Depression.

  2. hey norm says:

    What you left out was his example of how to catalyze debt reduction: “…For example, governments could facilitate the write-down of mortgages in exchange for a share of any future home-price appreciation….”
    Why Steve ya ol’ lefty…you want to nationalize the home industry!!!

  3. legion says:

    Yup, this is another thing I’ve been ranting about for (literally, now) years – since wages have been essentially flat for the last couple of decades, all increases in consumer purchasing/quality of life have come through increased access to credit. Since wages haven’t gone up (and aren’t going to go up) the only possible end for all this excess consumer debt is for it to be written off. We have to go through a period of significant deflation – without credit, you can’t sell things to people with no money.

  4. Dave Schuler says:

    @hey norm:

    Just for the record I’ve tossed that idea out a couple of times at my place over the last year or so. That’s part of the context of my remark quoted in Steve’s post.

  5. JohnMcC says:

    Ahh, Mr Legion, you bring up the specter of ‘a significant period of deflation’ as if it were a remedy easily applied. Don’t we all wish that were true; deflation after all means ‘stuff is cheaper’, eh? Sadly, there is this thing called a ‘positive feedback loop’ that is very difficult to turn up, turn down and eventually to turn off. Deflation leads to deflationary spirals with result that instead of remaining flat, wages actually decline. It is when this happens that demand shrinks which shrinks manufacturing/service providing which shrinks needs for labor and further decreases wages.

    Controlling inflation is much easier for central bankers and their success at doing that led to the lengthy ‘Great Moderation’ which was a period of fabulous increases in productivity that was foolishly diverted to great wealth for a few while middle-class income was stagnant. Central bankers have tried to stimulate deflation (setting interest rates @ ZERO!!) without success. How could that be? If money is essentially free, wouldn’t everyone rush out and borrow it? Turns out the answer to that question is NO. The reason is that if deflation occurs, the money we pay back will be worth more than the money we borrowed, a ‘hidden’ interest rate if you will.

    Thus the need for actual gov’t programs to force ‘deleveraging’ on the banks and corporations that are holding liquidity in what amounts to huge safety deposit boxes.

  6. legion says:

    @JohnMcC: I think you misunderstand my rant – I don’t think deflation is something we should seek to implement, I think it may be an unavoidable consequence of the complete and total refusal by all parties to stimulate job and/or wage growth.

    Believe me, I would much rather the current crop of oligarchs and plutocrats who rule us (officially and unofficially) suddenly recall the old business mantra: “You gotta spend money to make money,” but I don’t see that happening. I also completely agree with your suggestion on gov’t programs to discourage liquidity… but I don’t see that happening either.

  7. PD Shaw says:

    The benefit of the inflationary cure is that I don’t think the government can withstand the politics of orchestrating debt relief for individuals without severe political blowback. I’m talking naked jealousy — I saved and was responsible and the government is going to help out that idiot that bought more house than I can ever dream of owning? I’m a sucker.

    Tax cuts/rebates make sense to the extent that the over-extended use them to fix their balance sheets. (The argument against tax cuts has been different — people won’t spend them and this is an aggregate demand problem) But I don’t know if people have or will. Need data.

    The other approach was to orchestrate state by state plans. The feds have the unique power to engage in deficit spending, but how to deal with the problems of Detroit and Las Vegas within the context of a single program? Probably wasn’t going to happen for a similar reason.

    The downside to the inflationary cure is that you can’t admit that is what you’re doing, can you? Otherwise you risk uncontrollable inflation.

  8. A voice from another precinct says:

    @hey norm: No, he wanted to preserve assets. In the end, we gave the money to the banks instead and neither preserved the assets nor restarted the recovery.

  9. JohnMcC says:

    Mr Legion, Thanx for correcting my misunderstanding. I see you and I are in agreement. Ages ago, when dinosaurs roamed the earth, a teacher in my high school civics class told us, ‘Money is like manure. When it’s kept piled up it’s poisonous and combustible. When it’s spread all around it’s fertilizer.’ The past 50 years have proved to me that he was a wise man.