Fed Chair Ben Bernanke recently testified before the House of Representatives Committee on Financial Services and acknowledged the troubling employment conditions. Unemployment rate at 7.6% remains well above its longer-run normal level, and rates of underemployment and long-term unemployment are still much too high. Bernanke indicated that he would continue quantitative easing because of the unemployment figures but this method doesn’t seem to be working when you consider the lack of job growth – see graph. The U.S. Federal Reserve is currently purchasing US$85 billion of agency mortgage-backed securities and Treasury securities each month as part of its quantitative easing programme. This programme places downward pressure on long-term interest rates, and is intended to promote economic activity. However the S&P* earnings per share (eps) has grown above 70% since the bottom of the last cycle but job growth has been under 5%.
*The S&P 500® is widely regarded as the best single gauge of large cap U.S. equities. There is over USD 5.58 trillion benchmarked to the index, with index assets comprising approximately USD 1.3 trillion of this total. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalisation.
“The long run is a misleading guide to current affairs. In the long run we are all dead.”
Should investors focus on the short run or long run? The majority are looking at short run gains rather than a long term focus as they are most likely driven by instant financial rewards after the GFC.
Investors are also looking to see if the significant monetary expansion over the last 5 years will lead to inflationary pressures. Niels Jensen of Credit Writedowns has been writing on this for awhile and has come up with a couple of reasons why we shouldn’t be worried about it. Firstly many investors don’t seem to have grasped the difference between the monetary base and the money supply.
The monetary base is the total amount of a currency that is either circulated in the hands of the public or in the commercial bank deposits held in the central bank’s reserves.
The money supply is the entire stock of currency and other liquid instruments in a country’s economy as of a particular time. The money supply can include cash, coins and balances held in checking and savings accounts.
See above for some figures from Neils Jensen
As he points out it is the money supply, not the monetary base, which influences inflation. The chart below shows that there is no growth in bank lending despite the QE measures of printing money.
“As so aptly demonstrated in a recent IMF paper, the interaction between inflation and the economic cycle is very different today when compared to the 1975-1994 period. Whereas inflation back then was pro-cyclical, it is largely non-cyclical today with inflation well anchored around 2% regardless of the underlying economic conditions – see chart below. The obvious implication of this is that inflation should behave relatively well even as (if) economic fundamentals improve.” Source: Credit Writedowns
Lately there has been a lot of media coverage about an Excel error by academics Ken Rogoff and Carmen Reinhart – co-authors of ‘This Time is Different’ – 2009. A student from University of Massachusetts tried to replicate one their models regarding growth rates when a country has a public debt of greater than 90% of GDP. Rogoff and Carmen stated that with this level of public debt growth in a country falls to a mean of -0.1%. However using the same data the student found that a figure of 2.2% was applicable in this context.
However Rogoff and Reinhart have been cautious about saying that high debt causes slower growth rates but it does highlight the validity of analysis connecting debt and austerity to growth rates. Adam Posen in the FT stated that the claim of a clear tipping point for the ratio of Government Debt to GDP past which an economy starts to collapse doesn’t hold. Following the second world war the US, UK, Belgium, Italy and Japan had public debt greater than 90% of GDP but there was not much of an effect on their economies. In Italy and of late in Japan stagnation in economies led to slowly rising debt levels. In the UK and US in the 1950’s growth returned and debt levels declined. What this is suggesting is
Slow growth is at least as much the cause of high debt as high debt causes growth to slow.
But a certain amount public debt is necessary for future development of any economy especially when you think about the construction of infrastructure and government spending on education. Both of which contribute to future growth and in theoretical terms move the production possibility curve outwards. This in turn creates growth and subsequently income for a government.
USA – Mad Spending v EU – Nervous Austerity
With one side of the Atlantic – USA – involved in quantitive easing (printing money) and the other – EU – with severe austerity, maybe somewhere in between would be a logical way to go about things. But is moderation a choice for policy makers when they have already gone so far down the track of their respective plans?
What can be concluded is that too much debt has costs for growth but the degree of those costs is dependent on the reasons for debt accumulated and what path the economy is actually taking.
Nouriel Roubini wrote a piece on the Project Syndicate site focusing on the costs of QE. After three rounds of QE one wonders about its effectiveness. Roubini came up with 10 potential costs.
1. QE policies just postpones the necessary private and public sector deleveraging and if this is left too long it can create a zombie economy – institutions, firms, governments etc lose their ability to function.
2. Economic activity in the circular flow may become clogged with bond yields being so low and banks hoarding liquidity. Therefore the velocity of money circulation grinds to a halt.
3. With more money in the economy this implies a weakening of the currency but this is ineffective if other economies use QE at the same time. QE becomes a zero-sum game as not all currencies can fall simultaneously. QE = Currency Wars
4. QE leads to excessive capital to emerging markets. This can lead to a lot of extra liquidity and feed into domestic inflation creating asset bubbles. Furthermore an appreciation of the domestic currency in emerging markets makes their exports less competitive.
5. QE can lead to asset bubbles in an economy where it is implemented. It is especially prevalent when you’ve had an aggressive expansionary monetary policy (1% in USA after 9/11) already present in the economy for many years prior.
6. QE encourages Moral Hazard – governments put off major economic reforms and resort to a band aid policy. May delay fiscal austerity and ill discipline in the market.
7. Exiting QE is important – too slow an exit could mean higher inflation and assets and credit bubbles are created.
8. Long periods of negative real interest rates implies a redistribution of income and wealth – creditors and savers to debtors and borrowers. QE damages pensioners and pension funds.
9. With QE excessive inflation accompanied by slow credit growth, banks are faced with very low net interest-rate margins. Therefore, they might put money into riskier investments – remember the sub-prime crisis, oil prices up $147/barrel
10. QE might mean the end of conventional monetary policy. Some countries have discarded inflationary targets and there is no cornerstone for price expectations.
Japan’s Prime Minister Shinzo Abe recently addressed parliament stating that he plans to reverse the trend of issuing bonds to raise money but raise more in taxes. Japan cannot beat deflation and a strong currency (yen) if it adheres to the same policy of the past decade.
However his speech comes after the announcement of a $226.5bn stimulus package earlier in the year and this when Japan already has some serious debt issues – public debt that is almost three times the size of the Japanese economy.. He also wants the Bank of Japan to maintain an open-ended policy of quantitative easing (QE) and a doubling of the inflation target – 2%. Hopefully the fiscal stimulus package accompanied by more QE will drive down the price of the yen which will make Japanese exports more competitive. He stated his three arrows of economic policy:
1. Aggressive Monetary Easing
2. Flexible fiscal spending
3. A growth strategy that would induce private investment
Who knows if it will work but Shinzo Abe stated that it is worth the gamble.
The race for countries to devalue their currency (make their exports more competitive) has led to massive increase in monetary stimulus into the global financial system. We are all aware of the three rounds of Quantitative Easing from the US Fed and the indication that they would keep the Fed Funds Rate at virtually zero until 2015. To add fuel to the ‘dim embers’, in 2013 the US is going to inject US$1 trillion into the circular floe. However in China they have also embarked on some serious stimulus:
* More infrastructure development – US$60bn
* Additional credit – US$14 trillion in extra credit since 2009 (equal to entire US banking system)
Nevertheless even with all this artificial stimulus there might be some short-term growth but I can’t see it being sustainable when you consider the extent of global deleveraging. Also IMF figures show that the world saving rates are on the increase (* forecast):
With increased saving rates accompanied by significant austerity measures in many parts of Europe where is the consumer demand going to come from? Unemployment in Spain is 26% and predicted to hit 30% this year- more worrying is 50% of those under 25 are unemployed. Spanish protesters chanted “We don’t owe, we won’t pay” in a march against austerity. So in the US we have massive fiscal stimulus but across the water in Europe it’s all about “tightening the belt” and cutting government spending. Neither seems to be working and are we just putting off a significant downturn for a later date?
Here is a very funny video from Paddy Cullivan who first performed this at Kilkenomics 2011. Worth a look.
It is important that you are aware of current issues to do with the New Zealand and the World Economy. Examiners always like students to relate current issues to the economic theory as it gives a good impression of being well read in the subject. Only use these indicators if it is applicable to the question.
Indicators that you might want to mention are as follows:
The New Zealand Economy
The New Zealand economy expanded by 0.6 percent in the June 2012 quarter, while economic growth in the March quarter was revised down slightly to one percent. Favourable weather conditions leading to an increase in milk production was a significant driver of economic growth over the June quarter. The current account deficit rose to $10,087 million in the year ended June 2012, equivalent to 4.9 percent of GDP. Higher profits by foreign-owned New Zealand-operated banks and higher international fuel prices were factors behind the increase in the deficit during the year. Unemployment is currently at 6.8% but is expected to fall below 6% with the predicted increase in GDP. Annual inflation is approaching its trough. It is of the opinion that it will head towards the top end of the Reserve Bank’s target band (3%) by late next year.
The Global Economy
After the Global Financial Crisis (GFC) the debt-burdened economies are still struggling to reduce household debt to pre-crisis levels and monetary and fiscal policies have failed to overcome “liquidity traps”. Rising budget deficits and government debt levels have become more unsustainable. The US have employed the third round of quantitative easing and are buying US$40bn of mortgage backed securities each month as well as indicating that interest rates will remain at near zero levels until 2015. Meanwhile in the eurozone governments have implemented policies of austerity and are taking money out of the circular flow. However in the emerging economies there has been increasing inflation arising from capacity constraints as well as excess credit creation. Overall the deleveraging process can take years as the excesses of the previous credit booms are unwound. The price to be paid is a period of sub-trend economic growth which in Japan’s case ends up in lost decades of growth and diminished productive potential. The main economies are essentially pursuing their own policies especially as the election cycle demands a more domestic focus for government policy – voter concerns are low incomes and rising unemployment. Next month see the US elections and the changing of the guard in China. In early 2013 there is elections in Germany. The International Monetary Fund released their World Economic Outlook in which they downgraded their formal growth outlook. They also described the risk of a global recession as “alarmingly high”.
Here is a great graphic from the BNZ showing how the NZ dollar performed in September. You could say that it strengthened on the back of notably QE3 from the US Fed and the improving global growth sentiment. Furthermore the NZ economy has performed well under trying circumstances.
June quarter GDP accounts revealed the NZ economy finished Q2 1.6% bigger than where it began the year. That is solid economic growth under ordinary circumstances. But given the ongoing challenging and uncertain global economic environment we should not under sell this achievement. It is the strongest six month expansion we have seen in the past five years. Source: BNZ
It is the US Fed’s intention to buy volumes of mortgage backed securities and keep borrowing rates at near zero (0-0.25%) until the job market and broader economy pick up. Basically they are going to print money until there is some improvement in unemployment figures. Unemployment is at 8.1% and the Fed estimate that it will fall no lower than 7.6% in 2013 and 6.7 in 2014. Inflation is forecast to remain at or below 2% until 2015.
How does it work?
The Fed will buy $40 billion a month in mortgages and will keep doing this until unemployment starts to fall. This will have a couple of effects:
1. It might lower mortgages rates by another 0.25% (already quite low). The 30-year mortgage rate is 3.5% and could go down to 3.25%
2. When mortgage rates go down, the price of houses tends to go up which is beneficial even if you are not refinancing a mortgage
3. Investors tend to move out of low interest earning investments and put their money into stocks. The DJIA closed up more than 200 points and was 625 points off its all-time high.
Impact on NZ$
With the flood of US$ into the market this has put downward pressure on the US$ which will make its export market more competitive and imports more expensive. However risk currencies like the NZ$ and AUS$ have rallied. Looking at the NZ$, this has appreciated considerably against the US$ and will make NZ exports more expensive and NZ imports cheaper. This will not only hurt the export industry as the price of goods become more expensive but the domestic sector have now got to compete with cheaper imports. The NZ$ reached US$0.84 yesterday.
Below is one of many really good presentations on macro and micro economics from the Khan Academy. They are particularly useful for the more theoretical parts of the course and include just about every topic in the AS/A2 syllabus as well as other presentations on current economic issues like the one below. Here they are looking at the difference between quantitative easing in the US and in Japan. Well worth a look.
Bernard Hickey wrote a very valid piece in the New Zealand Herald yesterday. The gist of his writing focuses on the RBNZ and the fact that it should be following other central banks in printing money – quantitative easing. In the 1930’s the RBNZ did inject money into the economy and this helped pull NZ out of the Great Depression.
Most people see the dangers of quantitive easing in the hyperinflation that may follow such an expansion of the money supply. However, if you look at Japan in the 1990’s (the lost decade) interest rates remained at near 0% and the printing of more money didn’t create inflation. Furthermore if you look at more recent examples you see the following:
US Federal Reserve, Bank of Japan, Bank of England, Peoples’ Bank of China, and the European Central Bank have printed a combined US10 trillion in the last 4 years and spent it on bonds, cash injections into banking systems. This normally happens when central banks run out of ammunition to stimulate growth – i.e. low interest rates and they enter a liquidity trap scenario. The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have reached the floor. All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Hence, monetary policy in this situation is ineffective.
Bernard Hickey suggests that it would be much better if the government borrowed from the RBNZ rather than foreign banks and pension funds. Also to print money to fund the deficit which in turn will reduce the value of the NZ$ and therefore make exports more competitive. Click here to view the full article.
1. Inflation would shrink the value of the debts both the government and borrowers have to pay, improving our collective balance sheets. Higher salaries would also make it easier for borrowers to pay back their loans helping banks.
2. This might be the more important reason now, inflation pushes people and companies to spend money. If you know prices are going to drop or stay flat, then you will delay a purchase. That’s why most of us are late adopters when it comes to technology. But if you know prices are going to rise, then you will spend your money now. So increasing inflation could stimulate the economy, as well as lower our debts.
Also, according to Paul Krugman, in the long run, it’s very difficult to cut nominal wages. However when you have very low inflation, getting relative wages right would require that a significant number of workers take wage cuts. So having a somewhat higher inflation rate would lead to lower unemployment, not just temporarily, but on a sustained basis. Or to put it a bit differently, the long-run Phillips curve isn’t vertical at very low inflation rates.
The fortunate aspect of all this is that creating inflation is not a difficult task. The central banks just have to keep rointing money and buying up government debt. The issue is to do with the long-run and that inflation could get out of control like that in the 1970′s – 20% instead of being below 10%. However it is all to do with inflationary expectations – behavioural economics.
A recent article in the New Zealand Herald by Mark Lister (Craigs Investment Partners) suggested that the best way for an investor to beat inflation is to have an allocation of precious metals in a portfolio. Inflation affects the holders of monetary assets, e.g. bank deposits, savings, loans,government securities – as money loses value, so do these assets. Therefore, savings in real assets such as property are also advisable to beat the inflation monster. However what was interesting about the article was the history of global inflation and money over the last 100 years. Over that time period inflation has averaged 4.5% but it has been the last 10 years that has seen it accelerate significantly.
The table shows inflation rates of industrialised countries since 1900. Switzerland is the only country to have maintained an average inflation rate below 3% over the time period. One has to ask why other countries have found it so hard to keep inflation under the 3% level. Up until the mid 1970’s most major currencies were backed by precious metals. What it bascially meant was that a country could only print more money if it increased its stock of gold or other precious metals – the currency was backed by these precious metals. The rationale here was that the notes and coins could be exchanged for precious metals which meant that you couldn’t just print more money (quantitative easing) like they have been doing over the last couple of years. It was in 1971 when President Nixon suspended the convertibiity of US dollars into gold and by 1975 most other developed countries had followed suit. This led to a new era of just prinitng more money and currencies become known as fiat currencies – no inherent value. The term derives from the Latin fiat, meaning “let it be done” or “it shall be (money)”, as such money is established by government law. The key aspect about fiat money is the fact that its value relies entirely on the confidence the public have in it.
Up to 2000 Switzerland still kept linking its currency to gold and it was only after a referendum that authoriites loosened the requirement to hold a certain amount of gold as a back-up to paper money. Today, it’s as easy as a few extra numbers entered on a computer keypad. Printing money doesn’t achieve much other than inflation. There is still the same amount of goods and services to go around, but now there is more money chasing the same amount of goods, so the price simply goes up in reaction, which in turn makes your money worth less in terms of its purchasing power.
US Fed Chairman Ben Bernanke could really take a leaf out of former US Fed Chairman Paul Volcker’s book. In the 1970‘s the US economy was going through a period of stagflation – high unemployment and high inflation (both over 10%). Volcker believed that inflation was one of the worst of all economic evils and that it hinged on the growth of the money supply. He therefore began to target inflation which in turn would break people’s inflationary expectations. With this in mind he tightened the money supply and the prime interest rate reached 21.5% – the economy went into a nosedive. However the policy worked and inflation fell from 11% in 1979 to 3% in 1983 and subsequently with this lower inflation rate unemployment fell to 5.3% by 1989.
Today the US economy has 2.6% inflation and 9.6% unemployment and the current Fed policy, like that used in the pre-Volcker era, doesn’t seem to be working. According to Professor Christina Romer in the New York Times, Bernanke needs to be like Volcker and set a new policy framework which, this time, targets nominal gross domestic product which in turn would favour job creation. In the US normal output growth is around 2.5% and the inflation around the 2% so a target of 4.5% GDP would seem appropriate. How Professor Romer would see it operate would be like this:
The Fed would start from some normal year — like 2007 — and say that nominal G.D.P. should have grown at 4 1/2 percent annually since then, and should keep growing at that pace. Because of the recession and the unusually low inflation in 2009 and 2010, nominal G.D.P. today is about 10 percent below that path. Adopting nominal G.D.P. targeting commits the Fed to eliminating this gap.
How would this help to heal the economy? Like the Volcker money target, it would be a powerful communication tool. By pledging to do whatever it takes to return nominal G.D.P. to its pre-crisis trajectory, the Fed could improve confidence and expectations of future growth.
The expected increase in inflation would effect inflationary expectations but a small increase in inflation would be beneficial as it would lower borrowing costs and encourage spending a large budgetary items.
Even if we went through a time of slightly elevated inflation, the Fed shouldn’t lose credibility as a guardian of price stability. That’s because once the economy returned to the target path, Fed policy — a commitment to ensuring nominal G.D.P. growth of 4 1/2 percent — would restrain inflation. Assuming normal real growth, the implied inflation target would be 2 percent — just what it is today.
Other policies within the framework include:
Quantitative Easing – printing more money
Lower the US$ – makes exports more competitive
Would this work today to reduce unemployment? I suppose the US Fed are currently running out of policy options and like Volcker in the 1980’s there needs to be a quiet revolution in the Fed’s thinking. I don’t mean the shock therapy used in Latin American countries but a realigning of the objectives of ecoomic policy. It seems that the bold measures of Volcker in 1980’s and Roosevelt in the 1930’s actaully brought the US economy out of its depressed state but in both periods of time the process involved a lot hardship and protest. I just wonder if the US Fed is prepared to go through this pain again? As President Reagan said about the recession the US economy was about to go through in the 1980’s -
“If not now, when? If not us, who?”
However The Economist has a different point of view with regard to targeting nominal gross domestic product – NGDP.
Asking central banks to ditch inflation targeting and to pursue another goal could do more harm than good particularly if it left people less certain about the central bank’s ultimate commitment to prudence and stability. That is why a switch to NGDP targeting, whatever its virtues, should not be undertaken lightly.
Another amusing piece from Clarke and Dawe of the ABC in Australia. This time they look into what Quantitative Easing actually is.
In explaining the differences between internal and external balances I came across an old textbook that I used at University – Economics by David Begg. It was described as ‘The Student’s Bible” by BBC Radio 4 and I certainly do refer back to it quite regularly. Part 4 on macroeconomics has an informative diagram that shows the impact of booms and recessions on the internal and external balances.
Internal Balance – when Aggregate Demand equals Aggregate Supply (potential output). And there is full employment in the labour market. With sluggish wage and price adjustment, lower AD causes a recession. Only when AD returns to potential output is internal balance restored.
External Balance – this refers to the Current Account balance. The country is neither underspending nor overspending its foreign income. For a floating exchange rate, the total balance of payments is always zero. Since the balance of payments is the sum of the current, capital, and financial accounts, saying the current account is in balance then also implies that the sum of the capital and financial accounts are in balance.
The top left-hand quadrant shows a combination of a domestic slump and a current account surplus. This can be caused by a rise in desired savings or by an adoption of a tight fiscal policy and monetary policy. These reduce AD which cause both a domestic slump and a reduction in imports.
The bottom left-hand corner shows a higher real exchange rate, which makes exports less competitive, reduces export demand and raises import demand. The fall in net exports induces both a current account deficit and lower AD, leading to a domestic slump.
In a downturn a more expansionary fiscal and monetary policy can hasten the return to full employment eg. Quantitative easing, tax cuts, lower interest rates. However one could say that today it doesn’t seem to be that effective.
With the CIE and NCEA exam fast approaching there is usually a question that refers to economic policy in economies. Monetary and Fiscal Policy are two that are covered in significant detail and you will be aware of the following:
Monetary Policy - the way in which interest rates and money supply are used to manage the overall level of economic activity and achieve government targets for inflation, unemployment, economic growth and balance of payments.
Fiscal Policy – the use taxes and spending by the government to manipulate aggregate demand and influence the overall economic activity in the economy.
It is puzzling to observe the implementation of monetary policy by the European Central Bank when you consider the correlation between the interest rates movements and the economic environment in the euro area. I have put together a flow diagram below that shows the steps taken by the ECB since 9th July 2008.
* 9th July 2008 ECB IR↑= 3.75% – Just before finaincial crisis – ECB concerned about inflation
* 21st Jan 2009 ECB IR↓ = 2% – Sept 2008 – global economy collapses and inflation not an issue
* 13th April 2011 ECB IR↑ = 1.25% – Europe – high unemployment, low growth, debt crisis. ECB raises interest rates?
* 13th July 2011 ECB IR↑ = 1.50% – Debt crisis worsens and no growth. ECB raises interest rates again?
* Austerity measures – slash gov’t spending and raise taxes = little or no growth.
The euro zone’s concerns are that debts levels are too high and economic growth is too low. But are the debt levels this large because of too slow growth or the fact that some countries don’t have an efficient tax collection system – eg. Greece? When you relate the ECB policy with that of the US Federal Reserve there are differing opinions on how to use monetary and fiscal policy.
US Fed Model
Expansionary Fiscal Policy – extension in unemployment benefits and temporary tax breaks for low and middle-income households.
Expansionary Monetary Policy – low interest rates and quantitive easing.
Contractionary Fiscal Policy- strong austerity measures
Contractionary Monetary Policy – higher interest rates
The ECB might be concerned with dampening inflation but with the CPI at 2.5% prices are not really unstable. Are they repeating the mistakes of the early 1930′s? Then the tight monetary policy and austerity measures led to the Depression. Furthermore it appears that neither the policies of the US Federal Reserve nor the ECB are actually working.
The Swiss National Bank (SNB) has brought a new interpretation of quantitative easing. We have all heard of QE1 and QE2 (maybe QE3 is arond the corner) where US Fed Chairman Ben Bernanke has been printing money to try and stimulate demand in the US economy, but in Switzerland it has taken on a new meaning. Officials see the Swiss Franc as being massively overvalued and this threatens the development of the economy.
Nervous investors have sought safety in the traditional safe haven asset. Since the start of the year, the Swiss franc has surged nearly 20% against the euro due to growing global economic uncertainty. Just last month, the franc strengthened enough to trade close to parity against the euro. Swiss exporters have blamed the overvalued exchange rate for poor performances – companies like Swatch and Clariant have recorded significant reductions on export revenues – Swatch has warned that the franc’s appreciation could cost it Sfr1bn (NZ$1460m) this year. The SNB announced a ceiling against the euro of SFr1.20 and said it would interevene in foreign currency markets by buying foreign reserves with Swiss Francs in order to depreciate their currency. Remember that it is a lot easier for a country to reduce the value of their currency as they can print as much of it as they wish in order to intervene – this is another form of QE. This does have it’s risks in that the economy may experience inflationary pressures with the increase in supply of Swiss Francs.
Kenneth Rogoff – Professor of Economics at Harvard and former Chief Economist at the IMF – wrote an interesting piece suggesting that policy makers have got it wrong in describing the recent financial crisis as the ‘The Great Recession’. At the bottom of the post there is a very good interview with Rogoff criticising the present policy decisions in the US. Some good references to behavioural economics.
Great recession suggests that the economy is following the contours of typical recession but that it is more severe. Subsequently forecasters who have tried to make resemblance to post-war US recessions are “barking up the wrong tree” and are of the belief that conventional tools like expansionary fiscal policy, quantitative easing and bailouts are way to go. The real problem is that the global economy is badly leveraged and there is no quick fix without a transfer of wealth from creditors to debtors. Rogoff suggests that the “Second Great Contraction’ is a more realistic description of the current crisis in the global economy. The “First Great Contraction” was the Great Depression of 1929 but the contraction applies not only to output and employment, as in a normal recession, but to debt and credit, and the deleveraging that typically takes many years to complete.
In a typical recession the economy returns to pre-recession growth within a year and in most cases catches up to its rising long-run trend. The repercussions of the financial crisis typically can take 4 years just to reach the same per capita income level that it had attained at its pre-crisis peak.
Rogoff argues that the only practical way to shorten this coming period of painful deleverging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years. Although inflation is unfair as it is the transfer of income from savers to debtors, such a transfer is the most direct approach to faster recovery. Eventually, it will take place one way or another, anyway, as Europe is painfully learning.
History suggests that recessions are often renamed when the smoke clears. Perhaps today the smoke will clear a bit faster if we dump the “Great Recession” label immediately and replace it with something more apt, like “Great Contraction.” It is too late to undo the bad forecasts and mistaken policies that have marked the aftermath of the financial crisis, but it is not too late to do better.