The second draft of history

Economic historians and others interested in the Great Depression still turn to the economic publications of the League of Nations as a basic source for understanding the economic catastrophe of the 1930s. While I don’t want to give anyone in Washington DC stage fright, the publications of today’s international organisations, such as the IMF’s World Economic Outlook which was published in full last week, will also serve as a first port of call for the historians of decades hence. So: how are they shaping up?

Extremely well, is my reaction after having finally given the April WEO the attention it deserves. This is essential reading for people seeking a global overview of the crisis,  and advice as to how to get out of it.

The first thing to be said about this report is that the first two chapters, which summarize where we are today at both the global and the regional levels, are a masterpiece of synthesis. Getting the right mix of generalization and detail right is hard when writing global history, and the authors have pulled it off splendidly. A key theme throughout is the negative feedback loops which exist between financial sector stress and the real economy; and it is these links which are largely responsible for the severe downside risks to the already gloomy baseline forecast which are discussed in great detail (pp. 17-26). From an Irish perspective, we are already seeing the impact of financial sector stress on small businesses around the country, and it is predictable that a reverse chain of causation, from rising unemployment to difficulties with mortgage repayments, putting further stress on banks, will start to operate in the near future. (One hopes that the Government understands this, and that the exclusion from NAMA of residential mortgages does not imply excessive official optimism regarding this component of banks’ assets.)

Another contribution of these chapters is to show how the initial shock has been transmitted across the globe through trade and financial linkages, with the precise nature of the transmission mechanism varying across regions. The collapse of exports and industrial production in Asia is something that was entirely absent 80 years ago, but the combination of sudden stops of capital inflows, and falling prices for commodity exports, experienced in other regions is in many respects a familiar one to historians.

It is Chapter 3, however, which has the best chance of becoming a classic statement of our current situation that will be read and debated and fought about in years to come. The broad message is well known at this stage, so I can be brief. First, recessions originating in financial crises are deeper and last longer than other recessions. Second, global recessions are also deeper, and last longer, than other recessions. The obvious implication is that this recession, or depression, can be expected to be long and deep.

The policy implications are stark, and spelled out sufficiently clearly and often that readers can be left in no doubt about them. Because of the interactions between the real and financial sectors, we need aggressive policies both to clean up the financial system, and to support aggregate demand. Achieving the former requires inter alia “credible loss recognition of impaired assets”, adequate recapitalisation “taking into account both write-downs to date and a realistic assessment of prospects for further write-downs”, transparency, and possibly nationalisation. Achieving the latter requires both aggressive monetary policy and aggressive fiscal policy: “Governments have acted to provide substantial stimulus in 2009, but it is now apparent that the effort will need to be at least sustained, if not increased, in 2010,and countries with fiscal room should stand ready to introduce new stimulus measures as needed to support the recovery”. This emphasis on fiscal policy stems from the finding that when recessions are due to financial crises, this lowers the effectiveness of monetary policy, but increases the effectiveness of fiscal policy. (One can see ambitious grad students around the world reaching for their laptops at this stage.)

Because of the global nature of the crisis, countries can’t assume they will be able to export their way to recovery. Because of the move to higher savings rates in countries like the US, “it is unlikely that overleveraged economies will be able to bounce back quickly via strong growth in domestic private demand” either — hence the importance of government policy to support demand. As the report says, “governments can break the negative feedback between the real economy and financial conditions by acting as a ‘spender of last resort'”. Because of the trade and financial linkages between countries, policy coordination is essential: “fiscal stimulus should be provided by a broad range of countries with fiscal room to do so.”

The key in all of this is that the negative feedback loops between the real and financial sectors will continue to drive the world economy downwards if they are left unchecked — hence there is an overwhelming case for acting decisively, immediately, and globally.

Because this is the IMF, and not some bunch of wild-eyed radicals, the WEO worries in an appropriate manner about fiscal sustainability going forward, especially in the light of pensions problems coming down the line. It is this very orthodoxy that should give any demand-deficiency-deniers who may still be out there pause.

9 thoughts on “The second draft of history”

  1. There is alas no agency to coordinate a global response. Even the eurozone has failed to develop a coordinated response. For Ireland monetary policy is set in Frankfurt, fiscal policy is contracting the govt’s contribution to aggregate demand, and the zombie banks await the NAMA solution. We just have to sit back and await, in cargo cult fashion, the international upturn.

  2. This recession has been coming for 30 years and is the culmination of the unraveling of the US Reserve currency system. Unfortunately this will be bad for Ireland which has neither the means or the ability to ride the storm ahead.

  3. As someone with an ongoing need for comprehensive comparable and up-to-date statistics on economic growth for work, I think Kevin’s post is spot on. The openness and accessibility of both the IMF and the WEO reports are extremely helpful.

    (And hopefully warm fuzzy feelings of gratitude now will help them overcome any stage fright as they consider the economic historians of the 2080s.)

  4. I’m one of those holocaust, I mean, “demand-deficiency” deniers out there. Call me crazy, but I simply don’t beleive that massive misallocations of productive factors during the boom can be corrected by engaging in printing and spending on an unimaginary scale.

    Of course, the IMF take the stance that no matter how much governments spend or how big the deficits are, the long slump will always be blamed on governments not spending enough!:

    “Governments have acted to provide substantial stimulus in 2009, but it is now apparent that the effort will need to be at least sustained, if not increased, in 2010,and countries with fiscal room should stand ready to introduce new stimulus measures as needed to support the recovery”.

  5. Great post. I think feedback is the right language here, both positive and negative feedback are main drivers. This problem is one of not only a culture of risk-taking or individual foolishness, but of long term market failures operating on multiple levels, and which have the tendency to re-enforce one another.

    The great fear right now is that governments continue to react as though this was somehow an unpredictable and impersonal problem, and do not examine their ability to shape the long term factors, either for fear of culpability, through ignorance or out of ideology.

  6. @Matt: you are absolutely right, there was a lot of misallocation: too many people working in finance everywhere, too much construction in places like Ireland, probably too many people producing the wrong sorts of cars, and so on. Reallocating those resources will be costly in the short run, even if it will be beneficial in the long run. In addition, since some of those resources were being paid artificially inflated prices (hence the misallocation), there was a bunch of income that was fictive, and that isn’t coming back. That seems clearly to be the case in Ireland, for example. So, let’s say global incomes will fall x% as a result of all this. The fear is that, at the global level, incomes will end up falling by several multiples of x, as a result of the pernicious feedbacks identified by the IMF. Perfectly viable businesses will go bust. And what you lose quickly you only regain slowly: it is easier to close a company than to build one up again to the same size, easier to fire workers in their 50s than to rehire them, easier to erect trade barriers in the face of a storm than to reduce them later, and so on.

  7. Since we are facing a classic debt deflation (balance sheet recession), is it not clear to anyone that especially the American and UK central banks want to inflate the problems away? How else should we interpret the suggestions of the Fed that an interest rate of -5% would be ideal for the USA? Though I do not believe that the Fed wants to have hyperinflation I still think it would tolerate a rate of around 5%. Coupled with 3% long-term growth for GDP this would be the best way to lower the overall debt levels. Also, with such a high inflation rate the dollar must depreciate or remain weak against the other three major currencies euro, yen and yuan. Not only would this help American exporters, but also effectively reduce the dollar debts of the USA. This seems to be to be the most powerful and effective tool for the Americans to get out of the crisis.

  8. Whenever I read a Kevin O’Rourke post, I find references selected to illustrated the need for yet more pump priming.

    Yet even the latest message from the IMF sounds more nuanced IMF says existing stimulus could suffice headlines the FT, 26 April, a day before this post.
    It reads: The head of the International Monetary Fund said on Saturday that if countries are successful in cleansing their financial systems, the fiscal stimulus already implemented for 2009 “may be enough”. Dominique Strauss Kahn, the Fund’s managing director, said that all the IMF’s main members agreed on the need for fiscal stimulus in 2009 and had stopped worrying about small differences in the degree of stimulus. He called the transatlantic arguments that raged earlier this year “a little bit childish”.

    Effectively this is all rather removed from the history of globalisation. And there is no bee in the bonnet of DSK on this issue.

    A day later, the FT writes another IMF-related article on budget deficits, “the biggest deterioration will come in Germany, the IMF forecasts, with the deficit jumping from 4.7 per cent of GDP to 6.1 per cent”.

    Indeed such forecasts are looking more timid by the day, with even the German Federal government now predicting that German GDP will fall some 6% this year.

    I have by the way great respect for the analysis of the IMF. The GFSR is a must-read for all financial professionals. However I wouldn’t recommend blithely quoting – the context is important, and the Staff are constrained in what they can get write (so no countries, not least Germany, are named as deserving to increase public spending).

    The IMF also produces some great country research. I believe Ireland is shortly going to get an Article IV. And that will doubtless have a non-jaundiced eye. Little hope it will proffer support for pump priming in Ireland though!

    And be careful what you wish for. There are growing signs of crowding out of the weak by the strong. The next rendez-vous with markets may be in early 2010. The prevailing truce is not an indication that all is henceforth on the mend.

    Finally Kevin O’Rourke’s repeated calls for Germany to step up to the plate appear rather at odds with the debate in the German press. A taste of it here, from an Irish Times article in March. “Irish race from bust to boom and back again leaves Germans feeling confused and resentful”

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