Beware those who think the worst is past – Reinhart and Reinhart – The landscape of Jackson Hole, Wyoming, where central bankers gathered at their annual conference last week, is spectacular and forbidding. Ben Bernanke, chairman of the Federal Reserve, painted a sober but reassuring picture of US prospects. The basis for sustained recovery is in place, and canny Fed officials are now alive to the dangers of both deflation and inflation. Similarly Jean Claude Trichet, head of the European Central Bank, spoke about how the dust had begun to settle on the crisis. Policymakers and financial markets seem to be looking at what comes next. Such optimism, however, may be premature. We have analysed data on numerous severe economic dislocations over the past three-quarters of a century; a record of misfortune including 15 severe post-second world war crises, the Great Depression and the 1973-74 oil shock. The result is a bracing warning that the future is likely to bring only hard choices.
Our research found real per capita gross domestic product growth tends to be much lower during the decade following crises. Unemployment rates are higher, with the most extreme increases in the most advanced economies that experienced a crisis. In 10 of the 15 episodes we studied, unemployment never fell back to its pre-crisis level, not in the following decade nor right up to the end of 2009.
It gets worse. Where house price data are available, 90 per cent of the observations over the decade after a crisis are below their level the year before the crisis. Median prices are 15 to 20 per cent lower too, with cumulative declines as large as 55 per cent. Credit is also a problem. It expands rapidly before crises, but post-crash the ratio of credit to GDP declines by an amount comparable to the pre-crisis surge. However, this deleveraging is often delayed and protracted.
Our review of the historical record, therefore, strongly supports the view that large destabilising economic events produce big changes in long-term indicators, well after the upheaval of the crisis. Up to now we have been traversing the tracks of prior crises. But if we continue as others have before, the need to deleverage will dampen employment and growth for some time to come.
Part of these changed prospects after a crisis simply reflects the correction of expectations. During episodes of financial euphoria – from the diving bell, through the steam engine and thereafter – the old rules seem not to apply. Lenders provide easy credit, investors bid up asset prices, and businesses invest unwisely. Spending advances rapidly, and debt builds up. Yet recent discussions about the “new normal” leave the misleading impression that the pre-crisis environment was “normal”.
Perceptions aside, at Jackson Hole, policymakers debated whether further measures to stimulate demand were needed. History shows that today’s problems could certainly materialise as a consequence of the failure to provide sufficient economic stimulus. In particular, a collapse in financial intermediation can reduce the availability of loans. This lack of access to credit, in turn, makes households and business less able to spend, lengthening and deepening the downturn. In such circumstances slow growth often becomes a self-fulfilling prophecy produced by timid authorities, who neither supported spending nor dealt with the capital-adequacy problems at large banks.
However, it is also possible that economic contraction and a slow recovery can dent aggregate supply, otherwise known as an economy’s ability to produce efficiently. In this scenario, much less discussed in current debates, a sustained stretch of below-trend investment, alongside the depreciation of human capital that comes from high unemployment, hits the level and growth rate of potential output. That is, the unemployment rate stays high because it has been high.
Importantly, this reduction in supply can also be caused by policy. In adverse economic circumstances, political leaders grasp for quick fixes that impair, not improve, the situation. The list of unfortunate interventions includes not recognising bank losses, as well as restricting trade (both domestically and internationally) and credit. In these cases the effects of crises might be persistent because we make them so.
A prudent post-crisis policy, therefore, must be alert to threats both to supply and demand, not demand alone. But the bigger worry remains the assumption that dust has begun to settle; that the shock from the crisis is temporary, when it is likely to be deep and persistent. Today, as in the past, over-optimistic fiscal authorities are over-estimating tax revenues. Financial supervisors want to believe that troubled banks are temporarily illiquid, not permanently insolvent. And central bankers like Mr Bernanke may soon attempt to restore employment to unattainably high levels. If they do so, the road to recovery will be long, and the lessons of history will have been ignored once more.