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.