Rogoff: The Great Contraction

Markets in a badly overleveraged economy.

August 4, 2011

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story_images_popped_balloonOne of the chroniclers of global economic catastrophe, Kenneth Rogoff has warned us that what we were calling the “Great Recession” was not that at all. It was a “Great Contraction.”

“[T]oo 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 normal recession takes about a year for the numbers to get back to where they were. With a contraction, he says, “it typically takes an economy more than four years just to reach the same per capita income level that it had attained at its pre-crisis peak. So far, across a broad range of macroeconomic variables, including output, employment, debt, housing prices, and even equity, our quantitative benchmarks based on previous deep post-war financial crises have proved far more accurate than conventional recession logic. “

Curiously, the global economy is not deleveraging, commentator Paul Kedrosky notes. Instead, citing a McKinsey study, he shows that the total stock of financial assets has now surpassed pre-crisis levels. Perhaps ominously, it is public bonds that are leading the way.

McKinsey reports that most of the rebound in tradable financial assets came from equity issues in emerging markets, and all together stock markets accounted for $6 trillion of the $10 trillion bump. But government debt accounted for $4 trillion. Public debt is growing as fast as stock market capitalization.

Is that wise? For Rogoff, it depends what it’s used for. He would prefer to see a rapid writedown of private debt – which means a transfer of wealth from creditors to debtors.

“For example, 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.”

Global lending has been tepid, mostly because, in the McKinsey report, banks in developed countries have curtailed their activities. The real boost has come from emerging economies.

“Since 2007, outstanding loan volumes in both Western Europe and the United States have been broadly flat with a decline in 2009 followed by a modest increase in 2010. In Japan, the stock of loans outstanding has been declining since 2000, reflecting deleveraging by the corporate sector. Lending in emerging markets has grown at 16 percent annually since 2000—and by 17.5 percent a year in China. Mainland China has added $1.2 trillion of net new lending in 2010 and other emerging markets $800 billion.”

Before asking what’s next., perhaps we should take a clue from Rogoff: what’s past. Mark Buchanan, a physicist and science writer, has dug up some salutary pre-crisis quotes from “R. Glenn Hubbard of Columbia University (formerly an economic advisor to the president) and William Dudley, then at Goldman Sachs and now, post-crisis, acting head (wouldn’t you know!) of the Federal Reserve Bank of New York.”  This is from a 2004 paper, with Buchanan’s bolding:

“The development of the capital markets has provided significant benefits to the average citizen. Most importantly, it has led to more jobs and higher wages.

“The capital markets have also acted to reduce the volatility of the economy. Recessions are less frequent and milder when they occur. As a result, upward spikes in the unemployment rate have occurred less frequently and have become less severe.
“The development of the capital markets has also facilitated a revolution in housing finance. As a result, the proportion of households in the US that own their homes has risen substantially over the past decade.”

Okay, managed leverage – a revolution in housing finance. Does it work? In theory,

“With the development of a secondary mortgage market and the elimination of interest rate ceilings on bank deposits, ‘credit crunches’ of the sort that periodically shut off the supply of funds to home buyers, and crushed the homebuilding industry between 1966 and 1982, are a thing of the past. Today, the supply of credit to qualified home buyers is virtually assured. The result has been to cut the volatility of activity in the economy’s most interest-sensitive sector virtually in half. This change is a truly significant improvement, because it means that the economy’s most credit-sensitive sector is now more stable.”

That was then. But then physicists do look for recurring phenomenon.

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