Saturday, July 3, 2010

The historical perspective on austerity

Even as the debate rages on whether the time has come for exiting from expansionary fiscal and accommodative monetary policies, it may be instructive to revisit the two instances in history - Great Depression and Japan's recession of the nineties - that have strong similarities with the events of the past two years.

It is by now widely acknowledged that the aftermath of the Great Depression was a classic example of the perils of premature exit from expansionary policies. David Leonhardt writes about the fiscal policy exit mistake,

"The parallels to 1937 are not reassuring. From 1933 to 1937, the United States economy expanded more than 40 percent, even surpassing its 1929 high... From 1936 to 1938, when the Roosevelt administration believed that the Great Depression was largely over, tax increases and spending declines combined to equal 5 percent of gross domestic product... the recovery was still not durable enough to survive Roosevelt’s spending cuts and new Social Security tax. In 1938, the economy shrank 3.4 percent, and unemployment spiked."

And David Beckworth (via MR) has this to write about the premature withdrawal from the monetary accommodation,

"Is the Federal Reserve (Fed) making a similar mistake to the one it made in 1936-1937? If you recall, the Fed during this time doubled the required reserve ratio under the mistaken belief that it would reign in what appeared to be an inordinate buildup of excess reserves. The Fed was concerned these funds could lead to excessive credit growth in the future and decided to act preemptively. What the Fed failed to consider was that the unusually large buildup of excess reserves was the result of banks insuring themselves against a replay of the 1930-1933 banking panics. So when the Fed increased the reserve requirements, the banks responded by cutting down on loans to maintain their precautionary level of excess reserves. As a result, the money multiplier dropped and the money supply growth stalled."

The graphic below clearly shows how the money supply got squeezed as the required reserve ratios doubled in the 1936-37 period.

Japan is the other historical precedent of relevance. There are striking similarities in the situation of the major economies today with Japan's experience in the nineties. The aftermath of the bursting of its twin equity market and real-estate bubbles devastated household and corporate balance sheets, created a massive banking crisis, and plunged the economy into a decade long period of deflation and recession. Further, the near zero nominal interest rates rendered conventional monetary policy responses meaningless.

Adam Posen of the Peterson Institute has written that Japan’s Great Recession was the result of a series of avoidable macroeconomic and financial policy mistakes (as evidenced by the under-appreciated strength of Japan’s recovery once policies were reversed in 2002-03),

"The aberration in Japan’s recession was... the persistent steadiness of limited deflation, even after recovery took place... there were severe recessions in 1997-1999 and 2001-2002, following the recession upon the initial impact of Japanese bubbles bursting in 1992. But, in between, the Japanese economy recovered, growing steadily for two or three years at a time... these were recoveries which could have been sustainable, but were cut off by macroeconomic policy mistakes...

It was then withdrawal of public investment and zeroing out of public consumption, along with banking problems, which provided the negative shock in 1997 leading to the renewed recession of 1998-1999. Insufficiently loosened monetary policy contributed... continuing the GDP breakdown through the 2000s, the Japanese economy recovered strongly in 2000-2001, a period of withdrawal of public investment (again) and limited public consumption (driven by automatic stabilizers)...

At this point, it was mounting financial fragility in the core of Japan’s banking system, exacerbated by fears of monetary tightening, that provided the negative shock leading to a sharp collapse in private investment, driving the economy back into recession. Again, the picture is that of a market economy showing some natural tendencies to recovery being stymied by policy mistakes."

The cut back in public investments in the 1997-98 period led to an immediate impact on the economic growth

And when the right mixture of policies are administered at the appropriate time, as happened with Japan in the 2002-08 period, the results followed

"What was necessary was the clean-up and recapitalization of the banking system, the further loosening of monetary policy (to the extent possible given that interest rates were at zero), and the avoidance of any further premature fiscal tightening... it emphasized demand side factors... Japan’s new economic leadership in the early 2000s... turned matters around. They reversed monetary policies that contributed to deflation, turned the fiscal impulse to average net zero, and forced bad loan write-offs and recapitalization by the Japanese banks. What few seem to appreciate, either inside or outside of Japan, is just how strong the resulting Japanese recovery from 2002-2008 was. It was the longest unbroken recovery of Japan’s postwar history, and, while not as strong as pre-bubble Japanese performance, was in fact stronger than the growth in comparable economies even when fuelled by their own bubbles."

If these two examples are relevant precedents, as they appear to be, then the drive towards fiscal austerity is clearly a mistake.

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