Recession? The U.S. Economy Should Be So Lucky

Last Updated Aug 12, 2011 5:26 PM EDT

If you're worrying that the U.S. economy is in danger of a "double-dip, " don't bother. Our problems are much, much worse.

So suggests Harvard University economist Ken Rogoff, who says it's a mistake to think of the economic crunch that has followed the 2008 financial crisis as a recession. Rather, we face what he calls the "Second Great Contraction" (with the Depression in the 1930s marking the first big contraction).

That might seem like semantics, but in fact the distinction is critical. Recessions are common. Since World War II, there have been 10 such slumps in the U.S. and scores more worldwide. More important, growth following these episodes rebounds fairly quickly. In the States, post-war recessions have lasted an average of roughly 10.5 months, compared with an official figure of 18 months for the 2007-09 decline.

No ordinary rabbit
The current economic mess is a different beast altogether, Rogoff argues. Like other severe financial crises, such as the 1992 meltdown in Japan, it slammed asset prices, economic output and the labor market. Indeed, it is now emerging that the U.S. economy was more badly hurt than previously believed. Growth in the fourth quarter of 2009 fell by a whopping 8.9 percent, for instance, not 3.8 percent as forecasters thought at the time.

Following such a cataclysm, history shows that housing prices slide for years, and the jobless rate remains high well beyond what is normal after a typical recession. Given these differences, applying the usual fiscal and monetary fixes will merely prolong the crisis, Rogoff writes:
The phrase "Great Recession" creates the impression that the economy is following the contours of a typical recession, only more severe â€"- something like a really bad cold. That is why, throughout this downturn, forecasters and analysts who have tried to make analogies to past post-war US recessions have gotten it so wrong. Moreover, too 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.
Japan's "lost decade," now going on 20 years, is perhaps the most direct and recent illustration of what can happen after a major financial crisis. After a real estate bubble burst, the Japanese responded by shielding their financial firms and other large corporations from potentially crippling losses. Bailouts and credit lines were arranged (and seven banks nationalized, it's worth remembering). The government slashed interest rates and injected various forms of stimulus, to no avail. Prices and wages fell. Facing heavy household debt, Japanese consumers stopped spending. Economic growth slowed to a crawl.

Wealth transfer
Sound familiar? The difference now, both for the U.S. and other nations, is that the financial crisis was global. All the advanced economies (save Australia, for a variety of reasons) are dealing to different degrees with the impact of slowing demand, rising unemployment and growing debt. It's difficult to predict how long it will take for the world to recover, but here's a sobering thought -- in countries around the world affected by the Depression, on average it took a decade for real per capital GDP to return to pre-crisis levels.

Rogoff's innocuous-sounding solution -- transferring "wealth from creditors to debtors" -- is, in fact, profound and bold. For instance, the government would write down the value of distressed mortgages in return for a share of the upside when home prices rebound. Extending that approach to Europe's sovereign debt crises, Rogoff proposes that richer eurozone countries offer Greece a much bigger rescue package in exchange for higher payments in future years if the country's economy grows faster than expected.

Rogoff also favors helping U.S. consumers and businesses shed debt by allowing inflation to rise. That would penalize savers and other Americans who have, to borrow the phrase of the moment, lived within their means. But such "deleveraging" is not only the fastest way to revive the economy, he notes -- it is inevitable. He concludes:
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.
In view of the financial and political forces determined to keep wealth in the hand of our creditors, from Wall Street banks to Beijing, such prescriptions may for now be impossible. If so, the threat of recession may be the least of our concerns.

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  • Alain Sherter On Twitter»

    Alain Sherter is an award-winning business journalist who has written for The Deal, MarketWatch and Thomson Financial Media.

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