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With the Federal Reserve Bank of Kansas City’s Jackson Hole Symposium this weekend, the bitter message of “After the Fall”–a paper I presented with Carmen M. Reinhart at Jackson Hole last year–is coming true in the downward projections to economic forecasts by public- and private-sector economists. Our examination of the fifteen worst financial crises in the second half of the twentieth century showed that economies persistently perform poorly after a financial crisis, with real gross domestic product (GDP) growth 1.5 percentage points slower in the decade after the crisis than in the one before. In ten of the fifteen cases, the unemployment rate did not return to its precrisis low for the entire decade after the fall. The United States is contending with an expected painful deleveraging cycle and excessive regulation that slows growth, but we may not have laid the foundation for sustained expansion. Real per-capita output is still 2.2 percent off its 2006 level, and effective fiscal consolidation and true tax reform are unlikely to come out of Congress in the run-up to the 2012 elections. I would put the chance that the economy slips into another recession within a year at about four in ten.
Key points in this Outlook:
In a famous academic paper written in 1965, the pioneering economist Paul A. Samuelson proved that an optimal forecast varies less than what is being forecast. This mathematical property is hard to square with events of late, as forecasters race to mark down their projections of US economic growth more furiously than they had marked them up one year ago. The bad news to users of economic projections is that the downward direction of revisions seems right in light of the disappointing data on spending, employment, and confidence and the downdraft in equity markets. The even worse news is that such a glum outlook for economic activity should not have been a surprise.
In a paper called “After the Fall” presented at the Federal Reserve Bank of Kansas City’s Jackson Hole Symposium last year, my wife Carmen and I looked at the experience surrounding the fifteen worst financial crises in the second half of the twentieth century. The bitter message is that economies persistently perform poorly after a wrenching crash in financial markets and shock to banks.
“In any event, two years after the low point in the business cycle, dated as June 2009 by the National Bureau of Economic Research, the United States is still in recovery.” — Vincent Reinhardt
This Outlook will review that territory to provide perspective about the current position and the likely trajectory of the US economy. Precedent predicts that economic activity will expand at a pace insufficient to make much progress in reducing the unemployment rate. This sizable resource slack should help hold inflation steady in the face of depreciation of the exchange value of the dollar.
An economy not generating much momentum is less resilient to adverse shocks. And with the current backdrop of multiple European governments teetering on the brink of default, investors still backpedalling from risk, and US politicians itching for the next fight, adverse shocks loom especially ominous. That said, firms have liquid balance sheets and equity markets are providing remarkably high earnings relative to their prices. Economic expansion could be rejuvenated, but it will likely have to come from within, as US policymakers are unlikely to provide a spark from outside. Netting across the various risks and factoring in this policy inertia, the chance that the economy slips into another recession within a year is about four in ten.
Surprised Each Winter by the Snow
Economic forecasts rely importantly on an intuitive statistical regularity. With the passage of time, many key magnitudes, such as output, consumption, and the unemployment rate, tend to home in to their long-term trends. Moreover, when they are far from home, they hurry back faster. This was the engine underlying many projections of rapid recovery and expansion following the recession spanning late 2007 to mid-2009. Forecasters were confident of a “V-shaped” recovery and expansion because a sharp recession that pulls activity well below its mean should be followed by an equally sharp rebound as activity moves back to its mean.
In any event, two years after the low point in the business cycle, dated as June 2009 by the National Bureau of Economic Research, the United States is still in recovery. That is, as shown in figure 1, real gross domestic product (GDP) has not yet regained its mid-2008 peak. Over that period, economic forecasts have been marked lower and lower. A case in point comes from the survey of participants of the Federal Open Market Committee (FOMC). The Fed surveys all its governors and bank presidents four times per year about the outlook and summarizes the range of views expressed. Figure 2 plots the central tendency and midpoint of the forecasts of real GDP growth for this year from the eleven different surveys since the start of 2009. Early on, when the economy was still shrinking, Fed officials believed that real GDP would expand about 4.5 percent in 2011. For just about each quarter since, the projection has been marked down, most recently to 2.75 percent. To put matters in perspective, the current high end of the range is below the low end of the range for the prior ten surveys. Still, the Fed survey of June seems outdated, at least as judged by recent revisions from private-sector forecasters.
Everything Old Seems New Again
Mean reversion is a pretty good bet to describe typical post-World War II recoveries. But we are not living through a typical cycle. Rather, the United States experienced a wrenching financial crisis, and recoveries from those are lengthy and the subsequent economic expansions are tepid. The paper “After the Fall” looked at the fifteen worst financial crises of the second half of the twentieth century, a sample that includes advanced and emerging-market economies, and focused on economic outcomes in the decade before and after the crises. The median experience of real GDP growth in these countries is plotted as the solid line in figure 3a. (To read the chart, note that the time series for each country has been shifted so year zero marks the onset of the financial crisis.) As is evident, a financial crisis is followed by a severe recession and initially subpar recovery. On average, as indicated by the dashed lines, real GDP growth slows about 1.5 percentage points in the decade after the crisis relative to the one before. With output first contracting and then recovering only hesitantly, the unemployment rate rises and stays stubbornly high. Indeed, in ten out of fifteen cases studied, the unemployment rate does not return to its precrisis low for the entire decade after the fall.
Three features appear to shape the two decades bracketing a crisis, writing a script that the United States now appears to be following. First, there is a pronounced leverage cycle. Increases in debt relative to income allow an economy to spend more than it produces and fuel an asset price boom that sets the stage for a bust. After the bust, households and firms struggle to reduce their balance-sheet exposure, exerting a drag on spending. Since 2007, US households have reduced their total liabilities to disposable income about 20 percentage points, but default has been important in lowering the numerator of that ratio. Moreover, the overall debt-to-disposable-income ratio still stands at about 120 percent. Nonfinancial firms, in contrast, have done a better job in bolstering their balance sheets, including by accumulating sizable liquid assets.
Second, a country usually leaves unfinished business after a banking crisis. Problematic financial contracts litter bank balance sheets in the form of bad mortgage loans. They also impede the ability to make commitments of the one out of five mortgage-holding households that have debts valued more than their homes. This unfinished business has also prevented the clearing of the housing market in the United States, seen in the five-year run of declining home prices.
Third, policymakers typically respond to a financial crisis by raising the cost of finance, imposing an edifice of new regulation, and making appropriate business practices more uncertain. An efficient regulatory response to financial excesses is understandable and probably generates longer-term benefits. But in the imposition phase, it penalizes intermediation and innovation. In the US case, the Dodd-Frank financial reform legislation is exhibit A for regulatory backlash.
“The chance that the economy slips into another recession within a year is about four in ten.”
For Every Time There Is a Season
The risk to the US outlook is not that it will repeat the precedent in “After the Fall” of a deep recession and hesitant recovery. That has already happened. Rather, the risk is that the foundation for sustained expansion after that pain has not been set. Figure 3b identifies the key drivers of economic expansion in the fifteen episodes we studied. As plotted by the solid blue line, real equity prices rebound sharply in the median performance. House prices (the dashed green line) continue to sag in real terms, but their rate of decline slows. Four years after the fall (which is five years after the asset market peak), capital gains on equities are driving wealth creation.
But this is not so, yet, in the United States. The table tracks the median performance of the fifteen crisis countries and the United States five years after the asset market peak. In the median case, a country has recovered its previous peak in production, with real GDP per capita up 3.7 percent, on net. The US recovery is yet incomplete, with real per-capita output 2.2 percent off its 2006 level. The two rows below give the associated asset market performance, showing that the real values of equities and homes track well below the median experience.
Not shown because it was not part of our study, significant depreciation of the national currency on foreign exchange markets often accompanies financial crises. In our case, the US dollar’s role as a reserve currency has blunted that force. As a consequence, overall financial conditions have been much less supportive of spending and the private sector has been a less reliable engine of recovery than in the historical norm.
An economy expanding at a subpar rate is less resilient in the face of adverse shocks. That is, the country’s economy is a plane flying slowly and close to the ground. This combination makes wind shear and pilot error more consequential. Indeed, in seven of the fifteen cases studied in “After the Fall,” economies suffered what could reasonably be called two recessions in the decade after the crisis.
The US economy is flying over a landscape with a high risk of wind shear. Among the sources of concern is the uncertain status of several European governments that may hit the wall of a sudden stop of external credit. Such an event, or official action to informally restructure outstanding debt, could call into question the viability of some large European banks. A replay, if only fainter, of the events of the 2008 fall would lead investors to withdraw even more from risk taking, taking another dent out of wealth.
“Quantitative easing is all about taking riskless Treasury securities off the hands of investors in the hope that they will reinvest the proceeds into riskier assets.”
Closer to home, domestic financial institutions remain hindered by prior lending mistakes. If the unemployment rate tracks high, as seems likely, other problems on their loan books may emerge. In addition, the debate on the debt ceiling was startling proof of deep dysfunction in the political process. There are more fights to come, including on the budget. Indeed, if the economy performs poorly, it may well be the case that Congress has to revisit the debt ceiling sooner than currently anticipated. Taken together, additional fiscal restraint may be in the cards. If it comes in the run-up to national elections, such a congressional debate will focus on low-hanging budgetary fruit of a one-off nature, rather than being woven into a longer-term strategy that reassures the private sector. For these reasons, the near-term chance of a second recession is high, consistent with the experience of seven out of fifteen countries in “After the Fall.”
Prospects for Policy
Discussions of the conduct of US monetary and fiscal policies in the aftermath of the crisis have mostly emphasized a one-sided comparison: quick and forceful action by the regulators stopped a cascading contraction, thereby preventing a replay of the Great Depression. That might well be the case, but such a verdict has to weigh all the evidence. There is another side to the comparison: policy did not prevent the US economy from placing in the lower tier of recoveries in the “After the Fall” sample.
Perhaps this reflects the severity of the US shock. However, the fifteen case studies in “After the Fall” were selected precisely because they were severe. Perhaps the global synchronicity of crises compounded the challenge. Or, perhaps, more can be done. Unfortunately, most of the policies pursued in those fifteen cases to reinvigorate expansion seem out of the realm of possibility over the next year in a gridlocked Washington. By default, attention focuses on the independent entity with policy levers remaining–the Federal Reserve–even though such action is probably less desirable.
The bad news for Fed chairman Ben Bernanke is that the scope for any monetary policy offset is limited if the net driver of financial market prices has been a downward revision to fundamentals. Interest rates are already at rock-bottom levels. Promises to keep the policy interest rate lower for longer will probably not subtract much from them. Indeed, at its last meeting, the Fed tried to work that fallow field a bit more intensively by defining its extended period of accommodation to encompass at least the middle of 2013. Unfortunately, in the process, the statement also signaled to investors that the Fed’s outlook was sufficiently glum to make it hold its policy rate at zero for that long, reinforcing their sense of angst. In such an environment, large-scale asset purchases by the Fed might send Treasury yields even lower, but the extent that private rates would follow is suspect.
If, in contrast, the main meme in markets is avoidance of risk, then monetary policy might get more traction. Quantitative easing is all about taking riskless Treasury securities off the hands of investors in the hope that they will reinvest the proceeds into riskier assets. Such a nudge to risk taking would move prices significantly if they were not anchored by firm conviction. But it is not about rates, which are already low and expected to stay so, but rather about quantities.
The best path hedges against both possibilities. The Fed should explain that it will keep policy accommodative as long as its forecast falls short of its objectives. Both elements of that determination–its assessment of the near-term forecast and longer-term trends–are released four times per year in the Fed’s summary economic projection. Importantly, linking the stance of policy to the outlook allows investors to read a path for future policy contingent on their own economic views. This is a better outcome than investors making an uncertain inference about the Fed’s forecast based on an unconditional promise to keep rates low. Accommodation should be read generously to include the Fed’s balance sheet as well as its policy rate. Purchases of Treasury securities could nudge investors toward accepting more risk and so encourage economic growth.
Vincent R. Reinhart ([email protected]), a former director of the Federal Reserve Board’s Division of Monetary Affairs, is a resident scholar at AEI.
1. Paul A. Samuelson, “Proof That Properly Anticipated Prices Fluctuate Randomly,” Industrial Management Review 62, no. 2 (Spring 1965).
2. Carmen M. Reinhart and Vincent R. Reinhart, “After the Fall,” in Macroeconomic Challenges: The Decade Ahead (Jackson Hole, WY: Federal Reserve Bank of Kansas City, 2010).
3. Carmen M. Reinhart and Kenneth Rogoff point out this feature of the aftermath of financial crises in chapter 14 of their book, This Time Is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press, 2009).
4. Most countries do not have a generally recognized arbiter that calls turning points. And for some fast-growing emerging-market economies, a sharp slowing in growth to a low, but not negative, rate feels like a recession. See the discussion in Carmen M. Reinhart and Vincent R. Reinhart, “Diminished Expectations, Double Dips, and External Shocks: The Decade after the Fall,” VoxEU, September 13, 2010.
5. See the concerns I expressed in “A Year of Living Dangerously: The Management of the Financial Crisis in 2008,” Journal of Economic Perspectives 25, no. 1 (Winter 2011): 71-90.
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