Nearly four years after the start of the global financial crisis, many are wondering why economic recovery is taking so long. Indeed, its sluggishness has confounded even the experts. According to the International Monetary Fund, the world economy should have grown by 4.4% in 2011, and should grow by 4.5% in 2012. In fact, the latest figures from the World Bank indicate that growth reached just 2.7% in 2011, and will slow this year to 2.5% – a figure that may well need to be revised downwards.
There are two possible reasons for the discrepancy between forecast and outcome. Either the damage caused by the financial crisis was more serious than people realized, or the economic medicine prescribed was less efficacious than policymakers believed.
In fact, the gravity of the banking crisis was quickly grasped. Huge stimulus packages were implemented in 2008-9, led by the United States and China, coordinated by Britain, and with the reluctant support of Germany. Interest rates were slashed, insolvent banks were bailed out, the printing presses were turned on, taxes were cut, and public spending was boosted. Some countries devalued their currencies.
As a result, the slide was halted, and the rebound was faster than forecasters expected. But the stimulus measures transformed a banking crisis into a fiscal and sovereign-debt crisis. From 2010 onwards, governments started to raise taxes and cut spending in response to growing fears of sovereign default. At that point, the recovery went into reverse.1
As Carmen Reinhart and Kenneth Rogoff tell it in their masterly book This Time is Different, there is no secure way of short-circuiting a deep banking crisis. The crisis originates with “excessive debt accumulation,” which makes economies “vulnerable to crises of confidence.” Commercial banks have to be bailed out by governments; then governments have to be bailed out by commercial banks. In the end, both have to be bailed out by central banks.
All of this, according to Reinhart and Rogoff, involves a “protracted and pronounced contraction in economic activity.” They reckon that the average length of post-war crises has been 4.4 years – the time it takes for the necessary “de-leveraging” to occur – after which the crisis of confidence is over and economic growth revives.1
However, there is something missing in the story. Recovery from the Great Depression took about 10 years, more than twice the post-war average. Reinhart and Rogoff offer a couple of reasons for the difference in recovery rates: the slow policy response to the Great Depression and the gold standard, which meant that individual countries could not export their way out of depression. In other words, fiscal policy and the monetary-policy regime have a decisive influence both on the depth of the collapse and how long before the economy recovers.
It is also significant that big financial collapses occurred again in the 1970’s, after being virtually absent in the 1950’s and 1960’s, when the Keynesian system of managed economies and the Bretton Woods system of managed exchange rates was in place. The major post-war crises that Reinhart and Rogoff consider run from 1977 to 2001. They occurred because regulation of banks and controls on capital movements were lifted; they were shorter than in the 1930’s because the policy responses were not idiotic.
Indonesian president Susilo Bambang Yudhoyono emphasized that point earlier this month, boasting to British Prime Minister David Cameron that Indonesia’s successful recovery plan after the 1998 collapse was inspired by John Maynard Keynes. “We must ensure that the people can buy; we must ensure that industries can produce…”
Today, many governments, especially in the eurozone, seem to have run out of policy options. With fiscal austerity all the rage, they have given up ensuring that “people can buy” and “industries can produce.” Central banks have been handed the job of keeping economies afloat, but most of the money that they print remains stuck in the banking system, unable to arrest stagnating consumption and falling investment.
Moreover, the eurozone itself is a mini-gold standard, with heavily indebted members unable to devalue their currencies, because they have no currencies to devalue. So, given that Chinese growth, too, is slowing, the world economy seems destined to crawl along the bottom for some time yet, with unemployment rising in some countries to 20% or more.
With fiscal, monetary, and exchange-rate policies blocked, is there a way out of prolonged recession? John Geanakoplos of Yale University has been arguing for big debt write-offs. Rather than waiting to get rid of debt through bankruptcies, governments should “mandate debt forgiveness.” They could buy bad loans from lenders and forgive part of the principal payable by borrowers, simultaneously reducing lenders’ collateral requirements and borrowers’ debt overhang. In the US, the Term Asset-Backed Securities Loan Facility (TALF) program and the Public-Private Investment Program (PPIP) were in effect debt-forgiveness schemes aimed at sub-prime mortgage holders, but on too small a scale.
But the principle of debt forgiveness clearly has applications for public debt as well, especially in the eurozone. Those who fear excessive public debt are the banks that hold it. Junk public bonds are no safer for them than junk private bonds. Both lenders and borrowers would be better off from a comprehensive debt cancelation. So would citizens whose livelihoods are being destroyed by governments’ desperate attempts to de-leverage.
Philosophically, the debt-forgiveness approach rests on the belief that creditors share culpability for defaults with debtors, since they made the bad loans in the first place. As long as the borrower has not misled the lender at the time of taking the loan, the lender bears at least some responsibility for the transaction.1
In 1918, Keynes urged the cancelation of inter-Allied debts arising from World War I. “We shall never be able to move again, unless we can free our limbs from these paper shackles,” he wrote. And, in 1923, his call became a warning that today’s policymakers would do well to heed: “The absolutists of contract…are the real parents of revolution.”