In a recent article “Stimulus Package Rebuilding Same Myth of Debt Fueled Economic Growth” I suggested sustained economic growth could only be achieved if excess money supply over and above the real economic worth of society was applied to new investment, rather than consumption or financial transactions.
I also suggested in a following article “Two Asset Classes in Times of Turmoil: Risky and Risk-Free” that the incorrect allocation of excess money supply to financial transactions and consumption created at best a zero-sum scenario for the global economy with the increase in demand for goods and assets leading to inflation and price bubbles, not sustained real economic growth. The article concluded that investors, in the current environment of increased global economic synchronization, had little opportunity to protect the nominal value of their risky asset portfolios as the correlation between most risky assets, gold a notable exception, increased sharply in times of economic and financial turmoil.
In the third and final article of the series, I will draw on extensive International Monetary Fund research which clarifies the reasons why systematic failure in the financial sector causes recessions to be longer, more severe and more contagious across international borders.
The IMF analysed 122 country specific recessions since 1960 across a sample of 21 advanced economies. Some countries, Ireland, Sweden, Norway, Japan and Canada entered only three recessions during the 50 year period. Switzerland and Italy suffered nine each. New Zealand led the sample with 12 instances of at least two consecutive quarters of economic contraction (the official definition of a recession). The US and UK suffered six and five recessions respectively.* Not surprisingly when the US was in recession the contraction had significantly more impact globally and during five of the six US recessions, more than ten of the 21 sampled countries also fell into recession.
Also provided by the IMF were details of the average duration of recessions, recoveries and expansionary periods since 1960. A recovery is defined as the length of time the economy takes to re-capture the GDP output level of the previous peak. Including contractions prompted by a financial crisis the average recession lasted 3.64 quarters. The average recovery period was 3.22 quarters and the average expansionary period lasted 21.75 quarters. Analysing only the contractions caused by systematic financial failure, the average length of recessions increased to 5.67 quarters. The recovery period also lengthened to 5.64 quarters on average. Interestingly the period of economic expansion following a financial crisis recession also increased to 26.40 quarters, possibly due to the introduction of much needed economic reform which inevitably follows systematic failures.
My wording clearly implies a financial crisis causes a recession to be deeper and longer. But could it be the case that deeper recessions cause a financial crisis? The IMF kill off this suggestion.
The fund researched credit availability, consumption, employment levels, nominal wages, house prices and equity prices in the expansionary periods leading to recessions and a clear and disturbing pattern emerged. Prior to a financial crisis recession (relative to other recessions); credit was more freely available, consumption was higher, the employment rate was higher, nominal wages were higher and house and equity prices were at more inflated levels. Unfortunately, unemployment levels took longer to improve as well following a financial crisis. The IMF went further and highlighted a strong relationship between country specific deregulation of credit markets and the depth and severity of the following recession. To put it simply, if you unleash cheap money and easily available credit you will get a very nasty recession when the bubble bursts.
The above findings support my more simplistic analysis which suggested debt, and its misallocation, above all other reasons is the cause of both the boom and bust economic cycle and the severity of the current global recession.
The IMF concluded its research with a discussion relating to the effectiveness of monetary and fiscal stimulus. Non-financial recessions responded better to monetary intervention. Financial crisis recessions responded better to fiscal stimulus. In all instances the recovery was accelerated when both fiscal and monetary action was taken, rather than just one of the two. There was no evidence that monetary easing or fiscal stimulus delayed or damaged a demand led recovery.
The solution is clear, fundamental reform of credit markets is urgently required including the introduction of legislation limiting the availability of debt for speculative financial transactions and consumption in periods of economic expansion. My conclusion would be vulnerable in isolation, but combined with the IMF research it’s increasingly hard to argue against massive reform of credit markets.
*The US actually suffered seven occasions of at least two consecutive quarters of economic contraction but two separate instances in the early 1980’s were so close, I have defined them as being part of the same prolonged recessionary period.
Data source: International Monetary Fund