The Recovery Can Wait
Published in La Repubblica
(Italy) on 24 September 2010
by Luigi Zingales (link to original)
(Italy) on 24 September 2010
by Luigi Zingales (link to original)
Translated from
by Brittany Fowler.
Edited by Heidi Kaufmann.
Before this recession — by now referred to as the Great Recession — the majority of economists believed that the greater the decline was of the GDP at the beginning of a recession, the greater the growth would be at the beginning of the recovery. This empirical regularity has an economic foundation.
In America most post-World War II recessions were created by a contractionary monetary policy, an increase in the cost of currency on the part of the Federal Reserve, which ultimately cools inflationistic pressures. A restrictive monetary policy produces an increase in prices and a reduction of available credit, with immediate effects on the housing market and on the demand of durable goods (cars, washing machines, etc.). The fall in the demand of houses and durable goods encourages producers to reduce their supplies, with more deflative effects. With the objective to reduce inflation achieved, the Fed generally eased the monetary policy, and the demand — which had been artificially repressed during the recession — exploded. Those who postponed changing cars or houses rushed to do so. Because of this, the intensity of the recovery was much stronger than that of the recession.
This regularity has not been respected in the Great Recession. After the collapse of the American GDP by 6.8 percent in the fourth quarter of 2008, the recovery was very modest: an additional 1.6 percent in the last trimester, after a gain of 3.7 percent in the previous one. The reason for this difference can be found in the nature of this crisis. The Great Recession is not a result of a contractionary monetary policy, but rather that of a financial crisis that precipitated a structural crisis, which had been simmering for some time. The Great Recession was unleashed by a bank crisis. The great losses on the subprime mortgages raised doubt as to the solvency of many banks, paralyzing the financial system. Government interventions averted the worst of it, but they didn’t restore the preexisting conditions. The banks, greatly damaged, limited the availability of credit.
Unfortunately an expansive monetary policy isn’t enough to stimulate credit and the economy. After such dangerous turns of events, the banks naturally become more reluctant to lend, even when the cost of money is very low. Because of this, after all the financial crises, the recovery is always slower. The problem is accentuated by the fact that this crisis has revealed a structural problem, previously hidden by an astute but myopic use of monetary policy.
The structural problem is the reallocation of world demand. Today China produces an increasing amount of global production, but it hasn’t bought an equivalent amount in return. To absorb this excess supply on a global level, the Fed in the first decade of this century “drugged” the American economy, pushing it to consume more than it produced. In this way it avoided a recession until the end of the decade, at the cost of burdening American families with massive debt as well as burdening the housing market with enormous unproductive investments. Because of these past abuses, the “weapon” of the monetary policy is now blunted, and the Fed has become impotent.
To stimulate the American economy, there needs to be three conditions: an improvement in the credit sector; a shift of the production of goods and services toward the external market; and an increase in global demand, especially from China and Germany — the countries with the strongest commercial surpluses. All three conditions are hardly guaranteed under the Obama administration. Not having had the courage to intervene more drastically during the crisis, Obama finds it difficult today to accelerate the process of healing the banks. He could do it only with more gifts that would make him extremely unpopular. The fiscal tax breaks proposed recently are perhaps the only tool to facilitate the conversion to a new line of production.
As for China and Germany, the United States no longer has the moral (and military) authority that it had during the ‘80s. When Japan found itself in a similar situation, the Reagan administration was prepared to suggest to its ally, Japan, both a reevaluation of the exchange rate and a greater opening of its borders. It is unlikely that Obama is able to do as much with China. For this, a true recovery has to wait.
In America most post-World War II recessions were created by a contractionary monetary policy, an increase in the cost of currency on the part of the Federal Reserve, which ultimately cools inflationistic pressures. A restrictive monetary policy produces an increase in prices and a reduction of available credit, with immediate effects on the housing market and on the demand of durable goods (cars, washing machines, etc.). The fall in the demand of houses and durable goods encourages producers to reduce their supplies, with more deflative effects. With the objective to reduce inflation achieved, the Fed generally eased the monetary policy, and the demand — which had been artificially repressed during the recession — exploded. Those who postponed changing cars or houses rushed to do so. Because of this, the intensity of the recovery was much stronger than that of the recession.
This regularity has not been respected in the Great Recession. After the collapse of the American GDP by 6.8 percent in the fourth quarter of 2008, the recovery was very modest: an additional 1.6 percent in the last trimester, after a gain of 3.7 percent in the previous one. The reason for this difference can be found in the nature of this crisis. The Great Recession is not a result of a contractionary monetary policy, but rather that of a financial crisis that precipitated a structural crisis, which had been simmering for some time. The Great Recession was unleashed by a bank crisis. The great losses on the subprime mortgages raised doubt as to the solvency of many banks, paralyzing the financial system. Government interventions averted the worst of it, but they didn’t restore the preexisting conditions. The banks, greatly damaged, limited the availability of credit.
Unfortunately an expansive monetary policy isn’t enough to stimulate credit and the economy. After such dangerous turns of events, the banks naturally become more reluctant to lend, even when the cost of money is very low. Because of this, after all the financial crises, the recovery is always slower. The problem is accentuated by the fact that this crisis has revealed a structural problem, previously hidden by an astute but myopic use of monetary policy.
The structural problem is the reallocation of world demand. Today China produces an increasing amount of global production, but it hasn’t bought an equivalent amount in return. To absorb this excess supply on a global level, the Fed in the first decade of this century “drugged” the American economy, pushing it to consume more than it produced. In this way it avoided a recession until the end of the decade, at the cost of burdening American families with massive debt as well as burdening the housing market with enormous unproductive investments. Because of these past abuses, the “weapon” of the monetary policy is now blunted, and the Fed has become impotent.
To stimulate the American economy, there needs to be three conditions: an improvement in the credit sector; a shift of the production of goods and services toward the external market; and an increase in global demand, especially from China and Germany — the countries with the strongest commercial surpluses. All three conditions are hardly guaranteed under the Obama administration. Not having had the courage to intervene more drastically during the crisis, Obama finds it difficult today to accelerate the process of healing the banks. He could do it only with more gifts that would make him extremely unpopular. The fiscal tax breaks proposed recently are perhaps the only tool to facilitate the conversion to a new line of production.
As for China and Germany, the United States no longer has the moral (and military) authority that it had during the ‘80s. When Japan found itself in a similar situation, the Reagan administration was prepared to suggest to its ally, Japan, both a reevaluation of the exchange rate and a greater opening of its borders. It is unlikely that Obama is able to do as much with China. For this, a true recovery has to wait.