By Samuel Brittan
Published: October 29 2009 23:15
There is a pleasing myth about the business cycle. This is that it is just a fluctuation around an underlying trend. Output in a boom is above a sustainable level. In a recession it is below it. Budget deficits in the recession phase can be and should be offset by surplus in boom years. Whether you are optimistic or pessimistic about stabilisation policies they exist in a sphere of their own, and economic policy can concentrate on so called “supply side” measures.
Unfortunately, this pretty symmetrical picture is belied by the facts. There is widespread agreement that the damage done in a recession associated with a financial crisis tends to be twice as a severe as one that is not. More important is the finding that much of the loss of output in a severe recession is permanent and that the economy never gets back to its old trend line. This was demonstrated in some detail by the late Christopher Dow in his study, “Major Recessions”, published in 1998. Although that study was rigorous and quantitative it was not in the right key for today’s macroeconomists. The latest IMF World Economic Outlook returns, however, to the charge in its fourth chapter, which unfortunately is only obtainable online.
The IMF authors estimate that after a financial crisis output remains 10 per cent below its previous trend in the medium term, which it defines as seven years. This is, of course, an average with wide variations on either side. In Chile after 1981 and Mexico after 1994, output soon rose well above its previous trend while in Japan after 1997 it stagnated for many years. The average estimate may give an exaggerated impression of the enduring loss of productive capacity. It may be influenced by lingering recession effects, which may take more than seven years to disappear. The UK Treasury for example puts the permanent loss of output at 5 per cent of gross domestic product.
Countries currently in the midst of a banking crisis account for close to one-half of real GDP for the advanced economies. This is equivalent to a combined GDP total of about $40,000bn (€27,050bn, £24,440bn) per annum. Applying the 5 per cent figure for the enduring output loss, the ensuing hole in the world economy amounts to $2,000bn. It is only limited consolation that, according to the IMF, “economies that apply countercyclical fiscal and monetary stimulus in the short run to cushion the downturn after a crisis tend to have smaller output losses over the medium term”.
Interestingly enough these studies show an eventual return to the pre-crisis rate of growth from this lower level. I cannot help remarking that this is a convenient result for policymakers. For, however much they are blamed for the recession itself, output in the recovery phase appears to be back on a new if lower trend line and they cannot too obviously be faulted for inadequate growth.
The IMF’s detailed analysis suggests that higher structural unemployment, slower capital accumulation and lower productivity growth play an important role in explaining the lasting loss of output after a financial crisis. The UK National Institute highlights a higher price for risk, which would increase the effective cost of capital, involving a higher equity premium in the stock market.
Yet I am not altogether convinced. According to Keynes’s vision, outlined in the last few chapters of his General Theory, there is a chronic tendency for savings to exceed genuine investment opportunities and therefore full employment is achieved only on rare occasions, such as wartime and at the peak of a boom. On this analysis it is not the output loss after a crash that has to be explained, but the unsustainable high levels that preceded it. He therefore advocated permanently low interest rates to mitigate stagnationary tendencies. This picture did not seem plausible in the postwar decades but may now come into its own with the emergence of chronic Asian savings surpluses.
If China and other countries are chronic oversavers, who are to be the overborrowers? For a number of years it was consumers in the “Anglo-Saxon” type economies. But even if there had been no banking crisis they would sooner or later have come up against prudential limits to their debt ratios. This leaves only governmental authorities to do the borrowing. Sound money types may complain that they are doing this with gusto. But the right attitude may be St Augustine’s “Make me virtuous but not yet”, with the “not yet” stretching ahead quite a long while.
Copyright The Financial Times Limited 2009.
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