The Path of True Recovery Is Never Smooth
Submitted to Financial World
© Peterson Institute for International Economics.
Adam Posen is a Senior Fellow at the Peterson Institute for International Economics and a member of the Monetary Policy Committee of the Bank of England. The views expressed here are solely his own and not those of the Bank, the MPC, or any of its staff.
It takes a lot of repeated policy errors to keep a market economy down. For all the talk about Japan in the 1990s being a lost decade, or tracing an "L-shape" (i.e., down and then flat in terms of growth), the actual pattern was that of a sawtooth. Economic recoveries after the initial shock from the bubble bursting were recurrently cut off by macro policy tightening or financial system neglect. Looking at the US and other economies in the Great Depression shows much the same pattern-notably the recovery in the United States once stimulative policy kicked in and the banking panic ended, and a sharp reversal in 1937-38 when policy was prematurely tightened. Absent those kinds of policy mistakes, if you are not Zimbabwe or North Korea-in other words, if you're an economy with rule of law, property rights, basic market structures, and price stability-the nature of things is that the economy tends to bounce back.
You still need to stimulate with macroeconomic policy upfront after a major financial crisis, because if you let a bad downturn of this kind take hold, the deflation and financial fragility can get a momentum of their own. This is primarily about stopping financial panic, which emerged a year ago and which did take aggressive action by economic policymakers to forestall. You also should stimulate upfront so that the cost of this downturn is spread out over our future income and generations to come, rather than imposing all of it on those who happen to become unemployed or bankrupt today. But there is a limit to how far and how long macro stimulus can go, and the good news is that usually the private sector can pick up growth again before too long.
That applies today. On the monetary and fiscal side, the G-20 economies have all pretty much done the right thing in terms of aggressive stimulus policies. The policies are having the desired effect, moving consumption and even some investment from the future to today, and from the private to the public sector, when households are rapidly increasing saving. Unemployment will continue to rise, but that is a lagging indicator in forecasting terms (even though a huge indicator of human and political stress). The financial panic, and with it the potentially self-fulfilling fear of disastrous outcomes, has been largely ruled out. As Milton Friedman said and more recently Michael Mussa has reminded us [pdf], one dependable regularity about business cycles in market economies is the steeper the decline, the sharper the rebound. That is already being seen in residential construction and in stock building to some degree, having been long below replacement levels, and will likely increase over the coming months.
Yet, the path to true recovery is never smooth. Absent major policy mistakes, the sawtooth pattern should not have as many teeth, or teeth as sharp, as those seen in a plot of Japan's GDP-but it will still look a lot more like a string of W's than any other letter or a prolonged upward trend line. We will experience a bumpy ride at best, though thankfully on an average upward trend, for the major economies in the next few years. There are four basic reasons for this:
- The handoff of the growth baton from the public sector back to the private sector is rarely well synchronized. Thankfully, we are only rarely confronted with the need for such explicit transitions, but that means there is no practiced coordination, let alone institution for arranging such. Similarly, discretionary fiscal policy beyond automatic stabilizers is, as Paul Krugman puts it, the prescription medicine given for serious conditions; I would characterize the experimental treatment of quantitative easing the same way, something you only give a patient who is really sick. Getting off that treatment has side effects. Apt analogies aside, the point is that there is likely to be over- and undershooting of demand from various sources over the coming years versus potential, coming at various points in the upswing.
- More fundamentally, there is reason to think that potential output growth-the sustainable trend rate of productivity and labor force growth-has declined for most of the advanced economies as a result of the crisis. Human and capital investment foregone, disruption of credit markets and likely misallocation of financing as a result, and reallocation of labor and capital across sectors (say from finance and real estate to export industries) will require adjustment and thus time. The actual impact on potential growth will be difficult to accurately discern, and in part will evolve with developments in real-time. So long as potential is not vastly over- or undershot by growth on a sustained basis, we will adjust, but it will not be smooth.
- The banking systems in most of the major economies still retain a lot of bad assets on their books, and still have to rebuild capital and liquidity. This will likely be a drag on growth over the near-term, but that is not the aspect that will lead to bumps in the road. What policymakers have done so far in most economies has been very good about preventing outright panic and, to a lesser degree, kicking the banking problems down the road for a few years. Yet, in many countries the supervisors have gone soft on the banks in some ways, provided a lot of guarantees, and made it so the current management and shareholders feel too secure. That means that there are some underlying problems there, and it is a question whether the economy just grows out of those problems without incident. It remains possible that in some countries, we will have a recurrence of overt financial fragility a year or two down the road. At least the threat will arise.
- Internationally, there is a limit on how many countries can be net exporters at once. The US and a number of other trade deficit economies are raising their savings rate (household net of government borrowing) and seeing their currencies decline. Their governments are also giving policy signals of varying credibility that they expect the world to allow for adjustment to greater domestic demand in, and thus exports from, these economies. In the short-term, Asian net imports have picked up, even though some other surplus countries in Europe and the Mideast have continued to reply on external demand. Yet these surplus economies' governments have also said that they are unwilling to see a sustained decline in their net exports. Something has to give. While such adjustment will take place through a combination of give and take, exchange rate and real sectoral changes, it will likely be accompanied by bursts of trade frictions and exchange rate volatility. That is another reason the global recovery will not be smooth.
Compared to where we were a year-ago, the world economy is in much better shape. Macroeconomic policy stimulus has prevented the worst outcomes, and financial panic has receded. The trick will be to sustain that positive overall environment while major adjustments take place within and between economies: from public spending to private demand; from extraordinary policy measures to normal automatic stabilizers and interest rate setting; from booms to lower sustainable growth rates; from previously favorable but now bloated sectors to new sources of employment and growth; from guaranteed banks to boring banking; and from net exporters to net importers (and vice versa). Our market economies and our macroeconomic policies, supported by needed social safety nets, can deliver that outcome. But fasten your seatbelts, it is going to be a bumpy ride for the next few years.