Yesterday, at the Peterson Institute for International Economics, Mike Mussa and I discussed – and debated – the likely shape of the US and global economic recovery. Mike has great experience and an outstanding track record as an economic forecaster. His view is that the entire post-war experience of the US indicates there will be a sharp rebound. Victor Zarnowitz apparently stressed to Mike, a long time ago, “deep recessions are almost always followed by steep recoveries.”
I completely accept the idea that a slow or L-shaped recovery for the US and at the global level would be something outside the realm of experience over the past 50 years. I would also suggest that the financial crisis in fall 2008, the speed of decline in the US, and the synchronicity of the slowndown around the world over the past 6 months has also surprised everyone (including most officials) who think that we are always destined to re-run some version of the post-1945 data.
I argued that the nature of our economy has changed profoundly over the past 30 years, and we are only now beginning to understand the consequences. There has been some pushback against the main argument of our Atlantic piece, which is that a (very modern) financial oligarchy has taken disproportionate economic and political power in the US (aside: “we’re just stupid” is not much of a defense; the people involved are very smart, so how exactly did they get to create stupid organizations with the power to blow up the entire economy?) But no one is seriously disputing (1) the financial sector has become very large, (2) it was able to take on risks that were massive relative to the system, (3) these risks were not well managed, to say the least. We have experienced the financial equivalent of Three Mile Island; you will never look at finance again in the same way.
What does this imply for shorter-run macroeconomic dynamics? Do conventional US-based macro models still apply in the same way? Can finance drive growth in the same way as it has over the past 20+ years? How easy is it to switch people and capital into new sectors, for example so growth can be more driven by non-financial technology development? To the extent that banking survives the waves of contagion that are apparently still with us (look at the CDS spreads for major US banks over the past few weeks; during the rally!), won’t bankers hunker down for a while and refuse to take risk – until the next bubble, of course?
I agree with Mike that fixing the financial system is often not necessary (or actually sufficient) for a rapid economic recovery, although in today’s situation I worry about the disruptive effects of current bank bailout plans in many countries. A fast recovery, particularly if combined with moderate inflation, would probably improve the banks’ balance sheets considerably. To me, fixing the banks – i.e., greatly reducing their economic and political power – is essential for all our futures, irrespective of when and how the economy recovers. We cannot allow the same kind of potentially system-breaking risks to be taken again, and we cannot assume that the solutions that failed in the past (e.g., tweaking regulatory powers) will work in the future. Next time, the banks won’t just be Too Big To Fail, they’ll be Too Big To Rescue – the fiscal costs if we let this happen again would likely be huge; where is it written that the U.S. will for all time have fiscal credibility and provide the world’s leading reserve currency?
The main short-term issue for the shape of our recovery is surely that balance sheets are perceived as damaged all around the world. Plenty of creditworthy consumers think they need to be more careful. Firms with sensible investment projects are worried about the future availability of credit. Governments have only a limited ability to engage in fiscal stimulus; almost no one ran a sufficiently counter-cyclical surplus during the boom. And policy responses in most of the G20 remain inadequate.
If we have created a more unstable financial structure, perhaps we have stepped back in time to the US in the 19th century, when downswings could take considerably longer (or recoveries were more likely to be L-shaped; look at the NBER’s data) than in the post-1945 period? Or have we become more like an emerging market not just in terms of the excessive power of finance and the ability of one overexpanded sector to bring us down, but also in terms of our broader macroeconomic dynamics?
Emerging markets do, it is true, often recover quickly from steep declines. But they usually achieve this through managing a large real exchange rate depreciation (i.e., the nominal exchange rate falls by more than prices increase), which produces an export boom. At the level of world economy, we cannot export our way out of this recession.
By Simon Johnson
The PIIE event audio is available already. It was also recorded by C-SPAN; when I learn the broadcast details, I’ll add them here and also put on Twitter.