After the Fall – Why the Future Looks Bleak

The next decade will have slow income growth and elevated unemployment. This is not only my opinion, but that of Carmen M. Reinhart and Vincent R. Reinhart in their paper entitled After the Fall – an analysis of past financial crises and forecasts how the Great Recession will play out.

This paper was presented to 110 central bankers and economists at Jackson Hole in late August and the primary conclusion was dire for the aftermath of severe financial events such as the Great Recession:

Real per capita GDP growth rates are significantly lower during the decade following severe financial crises and the synchronous world-wide shocks. The median post-financial crisis GDP growth decline in advanced economies is about 1 percent.

I love well executed quantitative analysis of past events, and confess my admiration of Carmen Reinhart for her past work. I believe ignorance of the past causes repeating failures. However, it is difficult impossible to weigh and quantify all the dynamics surrounding historical events – therefore how the future will play out is not predetermined, regardless of my opinion.

One specific dynamic – free trade – was not present in the past crises. How this plays into the forecasts made in After the Fall can only be speculated. My position is free trade will exasperate our bleak future as countermeasures will leak from the USA into the global economy.

Among the important takeaways from this study –

A ubiquitous pattern in policy pitfalls has been to assume negative shocks are temporary, when these were, in fact, subsequently revealed to be permanent (or, at least, very persistent).

After the Fall is saying the biggest mistake is governments believing the effects are temporary. Thinking that – a stimulus would cure the recession and moving to other business – appears to be criticized. The reaction of local and state governments in not assuming lower revenues were permanent stretches out resetting finances to a sustainable level. After the Fall took a swipe at central bankers also.

Misperceptions can be costly when made by fiscal authorities who overestimate revenue prospects and central bankers who attempt to restore employment to an unattainably high level. Many past policy mistakes across the globe and over time can be traced to not recognizing in a timely basis that such changes have taken place.

The Reinharts take a stab at stimulus, without really quantifying the type of stimulus or the appropriate amount of stimulus to minimize the effects of a severe financial shock: One of Carmen Reinhart’s other studies stated in part: “A message from the 1930s is that national authorities must recognize that the openness of the global economy sometimes works to blunt the effectiveness of policy in one country.” Stimulus must be done globally, not by one country

The outcome could materialize as a consequence of the failure of policy makers to provide sufficient stimulus after a wrenching event in an economy where rigidities give ample scope to demand management……… slow growth might be a self-fulfilling prophecy produced by timid authorities who neither supported spending nor dealt with the capital-adequacy problems of key financial institutions.

It appears this study claims the high unemployment and low investment are ordained once they become endemic in the crisis, and it suggests the solution MIGHT be the government employing people to spit at the moon.

Economic contraction and slow recovery might also feed back on the prospects for aggregate supply. A sustained stretch of below-trend investment and depreciation of human capital prompted by elevated and lengthy spells of unemployment could hit the level and growth rate of potential output. The unemployment rate stays high because it has been high, exhibiting hysteresis as described by Blanchard and Summers (1986). The forcing mechanism for a reduction in aggregate supply might be policy itself.

After the Fall warns that there are political moves which will magnify the crisis.

In adverse economic circumstances, political leaders sometimes grasp for quick fixes that impair, not improve, the situation. Included in the list of unfortunate interventions are restrictions on trade (both domestically and internationally), work rules and pay practices, and the flow of credit.

Here is one of my few disputes with this study – I believe “free trade” was one of the elements of the financial crisis which pre-weakened the labor market and set up an exaggerated employment decline. Here, one of the major weakness of economic debate presents, in that I can produce scores of data to support my position while the Reinhart’s can do the same.

The output effects of crises might be persistent because we make them so……..

The above quote from the study is used in many economic theories – is it the facts that define a situation, or people’s perceptions that define the situation? Obviously, it could be either or both. It seems that this was a call for painting lipstick on the pig. Economic leaders must paint rosy economic pictures or there is a danger that a negative economic perception will be self fulfilling.  Further, policy (or lack of policy) which is based on the foundation that there is nothing the government can do is self fulfilling.

Recent discussions about the “new normal” in reference to the post-crisis landscape leave the impression that the pre-crisis environment was “normal.” In fact, there are reasons to believe that the precrisis decade set a high-water mark distorted by a variety of forces. We have presented evidence here that many of those patterns are reversed not only in the immediate vicinity of the crisis, (as Reinhart and Rogoff, 2009 show), but also over longer horizons that span several years.

After the Fall attacks the definition and meaning of “new normal”. Here again, we are faced with a dynamic missing from most of the previous crises – demographics or “baby boomers”. The Great Recession was not triggered by the boomers, but once the recession set in – the boomers hunkered down because of a loss of net worth. Boomers represent a disproportionately sized portion of the American economy. This segment was at nearing retirement This severe financial recession morphed into the perfect storm.

For whatever the initiating change, the real interest rate consistent with full employment of resources presumably falls as a consequence of slower economic growth. The logic is that households need less inducement to defer consumption when future consumption prospects are bleaker. In addition to the fall-out of a lower real interest rate on asset prices, monetary policy makers need to reconsider the benefits of an inflation buffer to protect from the zero lower bound to nominal interest rates.

The inflation buffer is the anticipation that inflation will eventually take hold. My take is that After the Fall is advocating not to worry about inflation. History has demonstrated that excessive capacity after severe financial events literally removes inflation as a possibility.

It is hard to read After the Fall and not be depressed. It offers no real solutions. I hope it is wrong about our future.

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