Thursday, August 4, 2011

"Great Contraction", not "Great Recession"?

Carmen Reinhart and Ken Rogoff, the foremost historians of financial market crises, have consistently cautioned against any misplaced optimism for a quick recovery from the depths of the sub-prime crisis. They have pointed to historical evidence to argue that it takes typically more than four years for an economy hit by a deep financial crisis to just recover to the same pre-crisis per capita income level. The evidence so far, for most macroeconomic indicators, has pretty much squared up with their findings.

Though they have opposed contractionary policies to reduce public debts in the US, they have also questioned the effectiveness of large fiscal stimulus. They reject the arguments of those advocating expansionary policies who blame the current state of the US economy to inadequate fiscal stimulus spending. They argue that this policy approach can be useful in combating a "recession", but not a debt-driven "contraction". In such financial meltdown induced contractions, the major problem is debt-laden consumers and businesses.

As to possible prescriptions, Kenneth Rogoff advocates policies that "catalyze debt workouts and reductions" and "moderate inflation". He writes,

"Governments could facilitate the write-down of mortgages in exchange for a share of any future home-price appreciation. An analogous approach can be done for countries. For example, rich countries’ voters in Europe could perhaps be persuaded to engage in a much larger bailout for Greece (one that is actually big enough to work), in exchange for higher payments in ten to fifteen years if Greek growth outperforms....

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... inflation is an unfair and arbitrary transfer of income from savers to debtors. But... such a transfer is the most direct approach to faster recovery. Eventually, it will take place one way or another, anyway..."

This line of analysis, with its focus on reducing the debt exposure, is similar to the "balance sheet recession" analysis of Richard Koo. He argues that the sub-prime meltdown had left the balance sheets of households and financial institutions in tatters. The financial market bailout program, TARP, and the extraordinary quantitative easing measures have effectively backstopped the losses of financial institutions.

However, there have been nothing similar to bailout households, especially those facing foreclosures and negative equity with their housing mortgages. The result is that consumers, whose consumption forms 70% of the US GDP, remains subdued, even deepressed. The knock-on effect on business investments and the labour market is there to see. As Ken Rogoff suggests, some form of partial and conditional write-downs of certain mortgages, and tax cuts that could be used to pay-off debts, would be the most appropriate fiscal expansion measures for such times.

Update 1 (5/8/2011)

Larry Summers makes the point that tax receipts over the next decade would be about $1 trillion lower — and debt that much larger — if economic growth were shaved by half a percentage point a year. This is about the same amount that the debt deal bill passed by the US Congress claims it will save.

Update 2 (15/8/2011)

The biggest restraint on consumer spending in the US has been the debt hangover. Since August 2008, when household debt peaked at $12.41 trillion, it has declined by about $1.2 trillion, according to an analysis by Moody’s Analytics of data from the Federal Reserve and Equifax, the credit agency. A large portion of that, though, was simply written off by lenders as borrowers defaulted on loans. However, the proportion of after-tax income that households spend to remain current on loan payments has fallen, from close to 14 percent in early 2007 to 11.5 percent now.

Still, household debt as a percentage of GDP remains high, far higher than its pre-nineties rate. It is reasonable to argue that the economy cannot achieve true health until debt levels decline, even with the ultra-low rates and the commitment to keep them low till atleast mid-2013.

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