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.

One reply on “After the Fall – Why the Future Looks Bleak”

  1. GREAT points Steven in this article that are being minimized by policy makers such as the Boomers draw-down effect, globalization weakening labor (declining wages) and the Taylor Rule.

    Here is a contribution from a retired Central Banker, Thomas O’Connor. This was a letter to a friend of his and he gave me consent to have it published. This letter is about a year old and is very salient regarding the calculations of debt repayment and the headwinds on growth. It quantifies your general analysis of a sluggish coming decade:

    “Dear *******

    It looks like things are finally turning around,” said a friend “Not at all…” I replied.

    Paul Krugman says the world “avoided a second Great Depression.” He’s wrong too. I know he won the Nobel Prize for Economics in 2008. So What ?

    The stock market crashed in ’29. The market then bounced. After a few months almost everyone was persuaded that the “worst was over.” But the worst was just beginning. It wasn’t until 1932 that the stock market finally hit bottom. By then, it was beginning to seem like a depression…and only years later did economic historians tag it as a ‘great’ depression.

    This depression is still wet behind the ears… We’re still in the bounce phase. On Friday, the Dow went 113 points higher. And as the bounce continues, more and more investors will come to believe that stocks are in a new bull market and that the economy is back in growth mode.

    Neither will be true.

    The stock market is in a bear market rally, not a genuine bull market. The economy is entering a long depression…possibly a ‘great’ one.

    How can we be so sure? Well, we’re not sure of anything. But all the signs point in that direction. Household debt as a percentage of disposable income hit a low of about 2% just at the end of WWII. It’s been going up ever since. By 2005 it nudged against 15% – seven times higher than it had been 60 years earlier. Household debt represents spending that has been taken from the future. But you can’t take an infinite amount from future earnings. You reach a point when the future can’t handle it. As more and more future earnings are absorbed by past consumption, pretty soon there’s not enough left to live on. At some point, so much of earnings are devoted to paying the interest and principle on past borrowings that the poor householder cannot to pay his expenses. And imagine what happens if his disposable income goes down.

    Guess how many jobs the US private sector has added over the last 10 years? Almost none. Private sector employment is back to levels of 1999. There are more jobs in restaurants and health care…but many fewer in manufacturing. Net gain: zero.

    The only job gains have been in the parasite sector – government. On the evidence, this trend is going to continue. Now, the feds have a new post called “pay czar.” As near as we can tell this is a busybody who undertakes to control salaries in the industries that the feds have bailed out. There will be a lot more jobs running the regulatory/bailout apparatus. Then, too, there are all the make-work jobs of the shovel ready boondoggles the feds began in an effort to replace private spending.

    Back in the private sector, 72 banks have failed so far this year. And a record 34 million Americans are getting food stamps.

    Naturally, incomes are falling. Now, imagine the consumer…he’s already paying 15% of his disposable income to debt service…and then his income is cut in half! This means that 30% of his remaining income must be used just to service the debt. Impossible to do without big cuts in spending…

    The poor consumer hit the wall in 2007. He was spending all he earned…and paying more of his income in debt service than at any time in the last 60 years. He couldn’t continue to living on future earnings – there just weren’t enough of them. That is why the finance industry has topped out. It loaded Americans up with enough debt already.

    And it’s why the credit cycle has turned. All of a sudden savings rates are back up to 7%. Consumers are cutting back…raising chickens in their back yards…driving less…planting gardens and squeezing their nickels. The private sector is de-leveraging. And there won’t be any durable economic boom or lasting bull market on Wall Street until this process is finished.

    Harvard professor Ken Rogoff says it will take 6-8 years for households to reduce their debts to a more sustainable level. Let’s see. It was reported on Friday that the big upswing in credit over the last 60 years added about $35 trillion in excess debt to the system. But not all of that is private debt.

    Taking the period of the bubble years, in 2000 total debt in the United States came to $26 trillion. Now, it’s twice that amount – $52 trillion, of which $38 trillion is private…or more than two and-a-half times GDP. At this level, the private debt absorbs roughly one out of every seven dollars in consumer earnings – in interest and principal payments.

    If the private sector undertook to reduce debt back to 2000 levels, it would mean eliminating all the debt accumulated during the bubble years – or about $19 trillion. How long will it take to pay down, write off, inflate away and otherwise shuck $19 trillion? Well, inflation is running below zero – so that is not now a source of debt reduction. Between write-offs and pay-downs, about $2 trillion has already been cut – over, very roughly, the last 2 years. At least the math is easy. At that rate, it will take 19 years.

    Now, let’s go back and look at the Japanese. How long have they been deleveraging? Gosh all mighty…19 years. From 1990 to 2009.

    Are we looking at a 20-year period of on-again, off-again deflation…of bear market rallies followed by real bear markets…of weak employment and weak or no growth? That’s what I’ve argued, . Then, the stock market took off…and the bubble years came. It looked like we were dead wrong. Maybe I was just early. Or maybe those bubble years were just a feint…a fake-out that convinced the entire world to invest in stocks and property, just before the biggest crash in history.
    I guessed that the crash in the tech sector marked the beginning of the end. By 2005, it didn’t seem at all as though we were in a down-cycle. But adjusted for inflation, stocks never beat their January 2000 high. And outside of government, the economy has no more jobs than it did in 1999. We’ve had wars against terror, bubbles in practically every sector, trillion-dollar boondoggles, bailouts, bamboozles and Michael Jackson’s tragic cooling…but what is the only durable thing to come out of the last 10 years?
    Just Google and debt.

    But do not believe me. I am a ‘simple player’ and what would I know ?

    Kindest regards,


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