Kenneth Rogoff: We Need a Recession (Well, at Least a Slowdown)

Readers may know I am a big fan of Kenneth Rogoff and Carmen Reinhart, his frequent research partner and co-author. One of my reasons is that he is much more empirically-oriented than most Serious Economists.

One recent bit of Reinhart/Rogoff research that has gotten some attention (but in my mind, still not enough) is their in-depth study of financial crises. They went back 900 years, and studied the more recent ones (as in post 1800) more intensely. They’ve had several end products from this effort, one of which everyone should read, a comparison of our current mess with the major financial crises in developed countries after World War II.

Another reason for my fondness for Rogoff is that he does not hew to conventional wisdom. For instance, most liberal economists, and Rogoff falls in that camp, are recession-averse and are thus keen (way too keen, in our opinion) to break glass and administer stimulus at the first sign of economic weakness (Larry Summers exemplifies this posture).

Even though we agree that recessions are Bad Things, we also think there are things worse than letting recessions occur. For instance, we are now seeing that keeping the party going way too long leads to more brutal adjustments in the end. And there is some evidence that there is no free lunch, that forestalling a recession leads to lower than potential output in the good times.

Rogoff, in a Financial Times comment, contends we need a slowdown for different reasons: he views the efforts at stimulus as a dangerous, misguided way to try to evade the need to restructure the financial system. Even though his forecast of oil falling as low as $75 a barrel may strike some readers as extreme. note that the famous Goldman research that called for a “super spike” of $150 to $200 a barrel this year also called for prices a few years out at $75. He also says, mirable dictu, that financial firms need to fail because the industry is unsustainably large.

Update: Brad Sester corrects me, saying Rogoff is not a liberal. I had mistakenly assumed he was at least somewhat to the left of center because a) he has written for Project Syndicate and the Guardian and b) I’ve no doubt missed it somewhere, but for the life of me, I can’t recall him having used the expression “free market”.

From the Financial Times:

As the global economic crisis hits its one year anniversary, it is time to re-examine not just the strategies for dealing with it, but also the diagnosis underlying those strategies. Is it not now clear that the main macroeconomic challenges facing the world today are an excess demand for commodities and an excess supply of financial services? If so, then it is time to stop pump-priming aggregate demand while blocking consolidation and restructuring of the financial system.

The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast. There is nothing sinister in this. The world has just experienced perhaps the most remarkable growth boom in modern history. Given the huge cumulative rise in global growth during the 2000s it is little wonder that commodity suppliers have found it increasingly difficult to keep up, even with sharply rising prices.

For many commodities, particularly energy and metals, new supply requires long lead times of five to 10 years. In principle, the demand response is more nimble, but it has been greatly dulled by a wide variety of subsidies and distortions in fast-growing emerging markets.

Absent a significant global recession (which will almost certainly lead to a commodity price crash), it will probably take a couple of years of sub-trend growth to rebalance commodity supply and demand at trend price levels (perhaps $75 per barrel in the case of oil, down from the current $124.) In the meantime, if all regions attempt to maintain high growth through macroeconomic stimulus, the main result is going to be higher commodity prices and ultimately a bigger crash in the not-too-distant future.

In the light of the experience of the 1970s, it is surprising how many leading policymakers and economic pundits believe that policy should aim to keep pushing demand up. In the US, the growth imperative has rationalised aggressive tax rebates, steep interest rate cuts and an ever-widening bail-out net for financial institutions. The Chinese leadership, after having briefly flirted with prioritising inflation (expressed mainly through a temporary acceleration in renminbi appreciation), has resumed putting growth as the clear number one priority. Most other emerging markets have followed a broadly similar approach.

Dollar bloc countries have slavishly mimicked expansionary US monetary policy, even in regions such as the Middle East, where rapid growth is putting huge upward pressure on inflation. Of the major regions, only Europe, led by the European Central Bank, has resisted joining the stimulus party so far. But even the ECB is coming under increasing domestic and international political pressure as Europe’s growth decelerates.

Individual countries may see some short-term growth benefit to US-style macroeconomic stimulus, albeit at the expense of loosening inflation expectations and possibly paying a steep price to re-anchor them later on. But if all regions try expanding demand, even the short-term benefit will be minimal. Commodity constraints will limit the real output response globally, and most of the excess demand will spill over into higher inflation.

Some central bankers argue that there is nothing to worry about as long as wage growth remains tame. True, globalisation continues to shrink unskilled labour’s share of global income. But as goods prices rise, wage pressures will eventually follow. As Carmen Reinhart and I have shown in our research on the history of international financial crises, governments in every corner of the world showed themselves perfectly capable of achieving very high rates of inflation long before they had the assistance of modern unions*.

What of the ever deepening financial crisis as a rationale for expansionary global macroeconomic policy? It is hard to see the argument in emerging markets where inflation is raging, but even in epicentre countries it is becoming increasingly dubious. Inflation stabilisation cannot be indefinitely compromised to support bail-out activities. However convenient it may be to have several years of elevated inflation to help bail out homeowners and financial institutions, the gain has to be weighed against the long-run cost of re-anchoring inflation expectations later on. Nor is it obvious that the taxpayer should absorb continually rising contingent liabilities (such as increased backing for Fannie Mae and Freddie Mac, the giant US mortgage agencies).

Indeed, if financial firms are not going to be allowed to go out of business, how exactly do central banks and regulators intend to effect the shrinkage of the financial industry commensurate with the sharp fall in key lines of business related to mortgage securitisation and derivatives? Perhaps regulators hope firms will shrink 10-15 per cent across the board. But this is seldom how consolidation works in any industry. Rather, the weakest firms go out of business, with their healthy parts being taken over, or pushed aside by better run institutions. Is every failure evidence of a crisis?

The airline industry often goes through periods of excess capacity, with giant companies going out of business or merging. Yet, we have grown accustomed to these traumas and learned to live with them, as in many other industries. Is it right to let the banking industry hold nations hostage each time they experience consolidation? As major central banks extend their discount windows to complex investment banks whose business lines are evolving and churning constantly, “crises” of consolidation are surely going to become more frequent.

For a myriad reasons, both technical and political, financial market regulation is never going to be stringent enough in booms. That is why it is important to be tougher in busts, so that investors and company executives have cause to pay serious attention to risks. If poorly run financial institutions are not allowed to close their doors during recessions, when exactly are they going to be allowed to fail?

Of course, today’s mess was many years in the making and there is no easy, painless exit strategy. But the need to introduce more banking discipline is yet another reason why the policymakers must refrain from excessively expansionary macroeconomic policy at this juncture and accept the slowdown that must inevitably come at the end of such an incredible boom. For most central banks, this means significantly raising interest rates to combat inflation. For Treasuries, this means maintaining fiscal discipline rather than giving in to the temptation of tax rebates and fuel subsidies. In policymaker’s zealous attempts to avoid a plain vanilla supply shock recession, they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater and more protracted downturn.

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  1. peterthepainter

    yves. thanx for this post. over on my blog we are Dorktrekkin : Lost In Space. Me and the crew are trapped in the ‘Flation Nebula and are seeing the forces of INflation and DEflation pulling the Starship Turnerprize apart.
    Down in the cargo bay our ‘vestments is shrinkin…

    In a desperate effort to save, not only our selves, but also our ‘vestments Spider is out here onna web lookin fo stuff just like this.

    We are lookin at apparently conflictin views on ‘Flation and what to do to get the ‘ship out of the nebula. I will refer to this post and me n the crew will try an gets our heads around these differing views.

    My main concern is “is there is or is there aint”(inflation/deflation).

    I have your blog linked in to the bridge on the starship along with the ninja and BP an krug and alice and of course mish.

    I have referred to rogof before and I am interested in his take verses mish. If any of you or your readers got a view on this including whether we on the Turnerprize(not the art prize)are dumb and indeed lost in space.

  2. S

    The problem with suggesting somehow inflation will help homeowners with debt is simply not true on the gov’t side or the household side. Households are not seeing any benefit on the wage side and thus being pinched from the perverse consequences of gov’t policy. Gov’t on the other hand is increasing debt faster than inflation and thus seeing no benefit. Also, while the article focuses on everyone trying to stimulate demand it is simply not the case. Everyone it seems is racing to devalue to stimulate supply, as in exports. The US has a dual mandate, fancy that, stimulate both, so the charade can continue. It would be refreshing for once to see some call this whole inflate debt away thing what it is: a myth.

  3. Richard Kline

    I concur with nearly everything stated by Rogoff, in just about the same number and sequence of phonemes. ” . . . [I]f all regions attempt to maintain high growth through macroeconomic stimulus, the main result is going to be higher commodity prices and ultimately a bigger crash . . . .” Amen: look this is so basic, it comes _before_ Econ 101. Our central bankers aren’t planners, or producers, they’re pushers in a world with no cops.

    If we get major demand destruction in a global re/depression, we could tumble down to $75 a barrel, but into the mid-term it’s hard to see the fee staying under three digits. —But that’s a good thing. The world needs to get serious, like S-E-R-I-O-U-S, about finding energy alternatives including using less and smarter what we produce by whatever means. And _this_ global energy pinch unlike the last one may finally get the brains of Necessity’s Little Mother juiced. So it just isn’t in the world’s interest for oil to stay low, or humanity’s, either.

  4. a

    I agree with Rogoff (in these parts, he is preaching to the choir), but would just like to insist of the need to shrink the financial sector. The sector is adding minimal added value yet taking an enormous part of national income; this is hugely inefficient and makes everyone else much poorer.

  5. Anonymous

    yves — I am pretty sure that Rogoff doesn’t consider himself a liberal in the US sense of the term. He is rather conservative in a lot of ways. I share your view of the caliber of his work (I would also note that unlike many economists of his caliber, he doesn’t just do theory — but looks at actual crises and the like), but his world view isn’t liberal. he generally thinks government intervention makes things worse —

    all that said, he also has been a critic of Bush administration policy – notably its initial macro policy (the 03 recovery was the “best recovery money could buy”) — on similar grounds, namely that it was overly stimulative. Rogoff isn’t a good republican, but i don’t think that makes him a liberal either.


  6. S

    To Rogoff’s point! The Fed is out of control and even more so the quiet malignancy that is the NY Fed. How is it possible that the Fuld remains on the Board? Simply mystifying

    Per Fed Reserve…
    The Federal Reserve today announced several steps to enhance the effectiveness of its existing liquidity facilities, including the introduction of longer terms to maturity in its Term Auction Facility. In association with this change, the European Central Bank and the Swiss National Bank are adapting the maturity of their operations.

    Federal Reserve Actions
    Actions taken by the Federal Reserve include:

    Extension of the Primary Dealer Credit Facility (PDCF) and the Term Securities Lending Facility (TSLF) through January 30, 2009.
    The introduction of auctions of options on $50 billion of draws on the TSLF.
    The introduction of 84-day Term Auction Facility (TAF) loans as a complement to 28-day TAF loans.
    An increase in the Federal Reserve’s swap line with the European Central Bank to $55 billion from $50 billion.”

  7. jm

    But due to previous attempts to paper over the problems, they have now grown so large that we couldn’t possibly allow a recession. Everything possible must be done to try to reverse the decline.

    And since this is just kicking the can down the road and will lead to an even more dire situation in a few years, the Fed and all other economists, and legislators, should begin thinking now about what measures will be needed to deal with that crisis.

    Since we can be sure the next recession to be avoided will be even worse than the one we absolutely musts avoid now, and the one after that will be worse again, and the one after that …, we need to create institutions that will anticipate future need for ever-more-creative financial recession-fighting legerdemain.

    Since we can’t possibly allow this recession, we certainly won’t be able to allow any future recession.

    Therefore, there is really no need to worry about recessions any more.

  8. Peripheral Visionary

    Totally agreed that the financial sector is far too large. Its value add to society is in directing resources toward the most productive uses, but it doesn’t need the enormous numbers of workers it now has to do that, particularly with computer automation taking over much of the back office. Reduction in the size of the financial sector will be, for all of the nation outside of New York, Chicago, and San Francisco, a good thing.

  9. Anonymous

    So some central bankers are happy with inflationary growth as long as wages don’t rise. Why is growth desirable if it lowers workers’ standard of living?

  10. Anonymous

    Relax, there was never a chance of a recession with Bush; that guy is smart and America is on track with great opportunities. Never before has so much money been lost and then recovered. Let the good times keep rolling!

    “Though July’s figures showed a slight employment gain, the ADP Report’s recent three-month average of negative 14,000 suggests that the weakened employment situation continues,” ADP said in a press release.

    The ADP employment report provides a snapshot of the private sector job market just ahead of the official payrolls report on Friday. ADP’s report doesn’t include government jobs, which in June rose by 29,000.

    According to the report, gains were driven by growth in the services sector, where jobs rose by 74,000 in July. Jobs in the goods-producing sector declined 65,000 and by 49,000 in the manufacturing sector.

    ADP’s reading indicates that the labor market outlook remains weak even as overall economic growth has held up despite severe headwinds from the bursting of the housing market bubble and sharp rises in food and energy prices.

  11. S

    sort of ironic that when you look at all the credit card issuers the small bsuiness portoflio is the space showing the greatest strain. Also look at the loans for banks and it toois showing strain. So it makes perfect sense that the segment would be expanding. Sureal.

  12. Anonymous

    Krugman takes sharp aim at these Rogoff comments. Yves, I think your post would be even more interesting with the Krugman rejoinder as an update.

    It seems to me that Rogoff is implying that the onus of global rebalancing needs to fall on the USA in the form of higher interest rates. Heaven forbid the dollar peggers should abandon their peg. I think we need low interest rates, and that does not imply we keep our bloated financial sector: let it shrink. I am I confess a tad suspicious of the conservative bent Rogoff is bringing into these areas, as it seems to be correlated to a desire to punish & cleanse after market excesses. That is not the lesson we learned from the Great Depression. Interested in other views.

    Here are the Krugman comments:

    Ken Rogoff is one of the world’s best macroeconomists, so I take whatever he says seriously. But — you know that’s the kind of statement that is followed by a “but” — I’m having a hard time understanding his demands for a world slowdown.

    Ken tells us that

    "The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast."

    And then he calls for

    "a couple of years of sub-trend growth to rebalance commodity supply and demand at trend price levels"

    Um, why? Basically, the world is employing rapidly growing amounts of labor and capital, but faces limited supplies of oil and other resources. Naturally enough, the relative prices of those resources have risen — which is the way markets are supposed to work. Since when does economic analysis say that the way to deal with limited supplies of one resource is to reduce employment of other resources, so that the relative price of the limited resource returns to “trend”?

    Presumably there’s some implicit argument in the background about why a sharp rise in the relative price of oil is more damaging than leaving labor and capital underemployed. But that argument isn’t there in Ken’s recent pieces. Model, please?

    I agree that

    "Dollar bloc countries have slavishly mimicked expansionary US monetary policy"

    and that’s a real issue: the Fed is pursuing very loose policy to deal with a US financial crisis, and that’s inflationary in countries that are pegged to the dollar without facing our problems. But that’s an argument for breaking up Bretton Woods II; it’s not an argument for tighter Fed policy.

    Since this is coming from Ken Rogoff, I assume that there’s some deeper analysis here. But I can’t infer it from the articles I’ve read. Please, sir, can I have some more?

  13. S

    Krugman goes in circle’s here.

    “But that’s an argument for breaking up Bretton Woods II; it’s not an argument for tighter Fed policy.”

    breaking bretton woods II would have the asame effect (i.e. higher rates) as what Rogoff is saying, just said differently. Once the system of pegging breaks the implicit subsidy it provides the US on the funding side goees away.

  14. Anonymous

    Recessions are not allowed, debt is unimportant, regulation unimportant, and the economy will grow and reward people even if we have to have a war that is unfunded and under-funded; we need more wars!!

  15. James

    A perfectly well thought out piece, but rest assured no one is listening. My guess is this global mess is going to be around for a very longtime

  16. Anonymous


    Yes they have their ears covered and are chanting, “I’m not listening, I’m not listening, I’m not listening…..” Waaahhh!!!

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