Economists can’t seem to help themselves.
One might think that after they failed to anticipate the greatest financial crisis since the Great Depression, they learned to step back and look at the big picture. Instead, we’re seeing the same blind spot: a pre-crisis dependence on the wrong data set of post-World War II recessions, which led to the biggest blunder in economic history.
Many failed to even recognize the crisis for what it was as it was happening. Much of the economic profession was in deep denial until Lehman, AIG and Citi were in freefall – or worse. I was reminded of this courtesy of a bleak front-page article last weekend in the Wall Street Journal:
“Economic growth is now tracking at a 1 percent rate in 2016 – the weakest start to a year since 2011 – when combined with a downwardly revised reading for the first quarter. That makes for an annual average rate of 2.1 percent growth since the end of the recession, the weakest pace of any expansion since at least 1949.”
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The piece did note that “the output figures are in some ways discordant with other gauges of the economy. The unemployment rate stands at 4.9 percent after a streak of strong job gains, wages have begun to pick up, and home sales hit a post-recession high” in June. It also pointed out that consumer spending has been strong as of late.
Why are so many economists, journalists and asset managers using the wrong history for their analysis? In a word: context. Most are looking at the wrong data set to analyze and compare this recovery to prior ones, using post-World War II recession recoveries as their frame of reference. The proper frame of reference, as Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University explained in 2008, are debt-induced financial crises.
Why? As Reinhart and Rogoff demonstrated in their book “This Time Is Different: Eight Centuries of Financial Folly,” debt-driven crashes – government defaults, banking panics, credit bubbles – all bear a striking similarity to prior disasters. Looking at any debt or credit crisis as part of an ordinary economic cycle is destined to be wrong.
Economists who use run-of-the-mill recessions as a reference point for their analyses are implying two things: first, that there is nothing qualitatively different between debt crises and ordinary business-cycle recessions, and second, that the usual policy measures that are effective after ordinary recessions should be similarly effective now. Both are wrong. Look no further than the results of zero interest-rate policy, which has at best a modest impact on the overall economy. It is not without effects – just see the impact on corporate profits, stock valuations and borrowing costs.
Why is there such a difference between economic recoveries? The defining characteristic of any recovery from a credit crisis is ongoing debt deleveraging, meaning that households, companies and governments are primarily using any economic gains in income or borrowing costs to reduce their debt. Low rates are not being used to buy homes, but rather to refinance existing obligations. Hence, the entire current post-crisis period has seen only mediocre retail sales gains and slow GDP growth.
Reinhart and Rogoff observed that, while rarer, post-credit-crisis recoveries are weaker, more protracted and much more painful. The reason is straightforward: Asset-market collapses tend to be prolonged and deep. In their 2008 paper, they observed that historically, credit crises also saw average equity crashes of about 55 percent and declines in real housing prices of about 35 percent. That’s pretty close to what happened in the U.S. following the crisis of 2007-2009.
Eventually, we will slog our way back to “normal” – whatever that is. In the meantime, we should expect the ongoing recovery to look like that of Japan’s in 1992, Finland’s in 1991, Sweden’s in 1991, Norway’s in 1987 and Spain’s in 1977 – all of which were slower, weaker and less comfortable than the usual post-war recessions.