- The nature of the 2008/9 crisis was different from previous crisis, and the nature of the recovery also differed.
- Apart from explaining the tepid nature of the recovery itself, it also shows the difficulties in interpreting the economy.
- These difficulties complicate the timing of policy changes by the Fed and significantly increase the risk that the Fed is falling behind the curve.
This recovery has been different from other recoveries, simply because the recession was of an entirely different nature. The nature of the recovery complicates an assessment of the state of the economy, more especially how close it is to full capacity and how large effective labor supply really is.
This situation makes it very hard for the Fed to determine the timing of monetary tightening, it's no wonder that there is so much discussion, even within the Fed, and opinions vary rather widely.
In order to understand this situation, we'll have to describe rather extensively how the present recovery differs from others.
How bad is the recovery?
Actually, the US recovery compares favorably to the economic recoveries in almost all other developed nations:
Compared to other recoveries:
But still, it feels pretty bad and there are some figures to back that up. Wages are stagnant, growth is hardly exuberant, productivity growth is disappointing and perhaps most disappointing of all is the state of the labor market. Job creation as such hasn't been all that bad, although we'll have a bit more to say about that below:
Unemployment is still fairly high above 6% and job creation is tepid at best, but perhaps the most alarming aspect is the large fall in labor participation rates. It isn't yet clear how much of that is demographics (retiring baby-boomers) and how much can be ascribed to the discouraged worker effect.
The nature of the crisis
A first and perhaps most important reason why the US recovery has been tepid is provided by the fact that this was no ordinary crisis which comes out of the business cycle.
A garden variety business cycle downturn is normally produced by the Fed, as the economy runs on full capacity and the Fed raises interest rates in order to temper the accompanying inflationary pressures.
At times, the inflationary pressures that result from tight capacity can be compounded by supply shocks, which happened in the 1970s by a shift in productivity growth (early 1970s) and a big increase in the oil price (early 1970s, late 1970s) as a result of some geo-political crisis.
That's why the Fed under Paul Volcker drastically increased interest rates at the end of the 1970s, interest rates reached an unprecedented height of over 20%. One doesn't need a lot of imagination to realize what 20% interest rates do to an economy, they caused a deep recession in the early 1980s.
But once inflationary expectations were slain and inflation came down, interest rates could be lowered rapidly, this produced a vigorous recovery. It is noteworthy that inflation has never really been a serious problem in the US since so perhaps the steep Volcker recession was a price worth paying for that achievement, although it's difficult to know with any degree of certainty.
The crisis in 2008/9 was of an entirely different nature. No Fed rising rates because inflationary pressures were building up as a result of the economy producing at full capacity. The main reason the US economy slumped (an unprecedented 9% in the first quarter of 2009) is simply that $9 trillion was wiped off of household balance sheets.
Which is why it is often called a balance sheet recession. These are usually deeper (compared to a business cycle downturn), and, more importantly, recovery has a habit of taking much more time.
The mechanics of a balance sheet recession
Household debt levels increased as they treated their ever increasing house prices as a sort of ATM, but when house prices collapsed, the debts remained and a whopping $9 trillion was wiped of household balance sheets.
While Lehman caused panic, and threatened to freeze the whole credit system, the Fed saved the day and in reality, the housing crash and $9T crater in household balance sheets is the 800 pound gorilla of the economic crisis.
Here is how this tends to cause a sharp and long lingering recession:
Household credit demand and spending is sharply reduced as households try to improve their balance sheets, this process is known as deleveraging.
Not only credit demand falls, credit supply as well because bank balance sheets are also affected as many cannot service their debt.
The reduction of spending is what produces the crisis, which is simply companies responding to lower demand by lowering production, laying off people, and slashing investment in new capacity.
All of this has second round effects, people made redundant will slash their spending and/or cannot service their debt. Companies slashing investment in new capacity reduce demand for other companies producing capital goods, etc. More lay-offs, more households unable to service their debt, more forced selling of assets, lowering asset prices (in this case, mostly houses) even further.
We have experienced such balance sheet recessions earlier as such crisis are usually the result of the bursting of a credit infused asset bubble. The most notable examples are the Great Depression of the 1930s, and Japan's epic bubbles bursting in the early 1990s.
It is instructive to read Irving Fisher about the dangers of a debt-deflationary spiral, which will bring home the point that these kind of crisis are full of self-reinforcing mechanisms. For instance, falling asset prices forces more households into default, producing more forced asset sales (in this case, foreclosures), which produces further asset price declines. It also further reduces spending, which could lead to deflation (this happened in the 1930s and in Japan), which rises the real value of debts, further worsening balance sheets.
The depth and durability of balance sheet recessions
It is important to note that these self-reinforcing feedback loops (spending cuts reducing income, which reduces spending further, forces asset sales depressing asset prices further, producing more forced sales) have a habit of producing particularly deep recessions.
Balance sheet recessions also usually take rather a long time to heal, simply because balance sheets (of banks, households, or, like the Japanese example, firms) take a long time to repair. Deleveraging balance sheets is usually a lengthy and protracted process.
Below you see how this recovery is different from previous ones, as unlike any other recent recovery, the private sector is reducing, not increasing debt.
So, one factor making this recovery tepid is the fact that households are deleveraging, saving more and paying off debt, rather than taking on new debt, which reduces spending.
How policy reacts makes a rather crucial difference. In the 1930s, policy reaction was pro-cyclical, worsening rather than improving things, hence we speak of the Great Depression.
Japan did somewhat better in the 1990s avoiding a big fall in production and double digit unemployment, but it let the process fester for too long and deflation crept into the Japanese economy as a result.
US policy makers reacted speedily to the onset of the crisis. The Fed slashed interest rates instantly, the Federal government embarked on a big fiscal stimulus program, and banks and other financial institutions were saved and required to recapitalize themselves.
This quick policy reaction has almost certainly prevented the Great Recession to turn into the 1930s style Great Depression
So after the initial policy response saved the day, opinions differ more on the effectiveness of the subsequent policy reaction, which left all the heavy lifting upon monetary policy while fiscal policy went into reverse. So a little note on policy under a balance sheet is warranted.
A garden variety business cycle downturn is usually produced by rising interest rates, to improve the economy lowering them again once inflationary threats have subsided is enough.
However, in a balance sheet recession, interest rates are already at rock bottom levels as credit demand dries up. With asset prices crashing, debts have become such an overriding problem that no matter how low interest rates are, people prefer to pay-off debt rather than to embark on new borrowing.
This makes spending particularly unresponsive to the interest rate, which even at zero isn't able to generate much uptick in economic activity. The main channel by which lower interest rates stimulate economic activity is by stimulating borrowing, just what households won't or can't do because of balance sheet constraints.
The Fed and other central banks resorted to more unconventional monetary policy measures instead, like QE, quantitative easing. One might also notice that the widely predicted take-off in inflation never materialized for the same reason, credit demand remained tepid.
In fact, and it might surprise a few people, but whilst monetary policy efficiency suffers a great deal fiscal policy becomes much more effective under balance sheet recession conditions, for several reasons:
The core problem is that spending is well below what the economy can produce (see graph below), leaving a large output gap, as people cut back borrowing and spending to repair balance sheets. That is, there are enough idle resources to absorb by direct public spending, for instance employing laid-off construction workers in building infrastructure, without risking an overheating of the economy or crowding out private production.
Interest rates are low the result of the Fed and the existence of ample savings from people trying to reduce their debt. Low interest rates makes public borrowing much cheaper and the ample supply of savings virtually eliminate the risk that increased public sector borrowing crowds out private sector credit demand.
And indeed, most macro-economic research shows that the stimulus was effective (see here, here and here) and there is a near consensus amongst academic economist that it was. Research by the IMF (for instance here and here) has also shown that the multiplier is significantly larger under these circumstances than previously thought (this even led to a mea-culpa from the IMF and it's chief economist).
Indeed, research by Summers and DeLong has shown that increasing public spending might actually reduce, rather than increase the public deficit, which suggests a very big multiplier.
For graphs, see my article full of US graphs
Consensus of academic research, as well as academic economist about the value of the stimulus
Blackrock, there has been no deleveraging
Yet, policy shifted, most notably at the state and local level (and even more dramatically in Europe, but that's another story).
The recovery following the 2008 crisis is the odd one out as public employment actually fell, rather than rose as it did in all of the last recoveries. This is one thing that has made the labor market so tepid, private sector job creation has actually been comparable to these other recoveries.
Another way of looking at this is that the private sector moved sharply into financial surplus (savings exceeding investments), in order to keep demand anywhere near stable, the public sector has to move into deficit (and note how unemployment correlates with the private sector financial surplus in the graph below).
So a second reason why the recovery is tepid is that fiscal policy went into reverse from stimulus to austerity.
Most of the spoils of the recovery have gone to a tiny fraction of the population at the top of the income and wealth scales (93%, in 2010 according to one study). Since these people tend to save much more than median wage earners, such income shift contributes further to a lack of demand.
There has also been a shift from wages to profits. That wouldn't normally be bad for the economy, but in a situation of excess capacity this sucks more demand out of the economy.
(click to enlarge)
- So a third reason why the recovery has been tepid is because of a rise in inequality shifting income from people with a low propensity to save to people with a high propensity to save.
Lower growth in production capacity and productivity
We hope that by now you understand why the Fed embarked on rather aggressive and unconventional monetary policy.
However, we're now well into the fifth year of recovery. We've identified why the recovery has been tepid, but these same forces also create some structural problems, and these create awkward dilemma's for the Fed.
The most important structural problem is that production capacity is growing slower than it's trend, and this is the direct result of the existence of a large output gap.
The output gap is simply the difference between what an economy can produce at full capacity and what it does produce. If that persists, business has little incentive to build new production capacity. Why should they, if they cannot fully use existing capacity?
This means that production capacity itself grows more slowly, which you see in the graph below as a growing wedge between the trend growth in production capacity and actual capacity growth.
So tepid business investment, caused by tepid demand, leads to tepid expansion of production capacity and tepid introduction of new productive technologies, hence tepid productivity growth.
The large output gap also leads to an increase in long-term unemployment and workers retreating from the labor market altogether (the discouraged worker effect), effectively reducing labor supply as long-term unemployed have a tendency to lose skills, motivation and are discriminated against.
- So a forth reason for the tepidness of the recovery is the structural damage that has been done to the economy by a large and persistent output gap.
Inflationary risk and the Fed policy dilemma
And here is where the Fed dilemma is situated. The nature of the recession and recovery produce a situation in which it is difficult to assess how close we are to full capacity:
Unemployment is still high, but how much is the result of long-term unemployed losing skills, motivation and/or discriminated against, that is, how large is effective labor supply really? And how big has the discouraged worker effect been?
How close are we to capacity constraints? this is difficult to assess from the difference between trend growth and actual output, as trend growth has been affected by lower investment and lower productivity growth.
Even the speed of the growth is likely to be lower due to lower investments, less spare capacity, lower effective labor supply and lower productivity growth, all the result of years of big output gaps persisting.
While the recovery is, well, tepid, it's somewhat difficult to know how close we actually are to supply constraints. We cannot simply fly on trend output growth, because capacity is growing slower than that, and the difference has accumulated over time. We cannot simply navigate on unemployment either as the state of the labor market has been changed and effective labor supply is likely to be considerably smaller than 6%+ unemployment figure suggests.
One way would simply be to wait for inflation and/or wage pressures to build up, but the Fed would run the risk of falling significantly behind the curve and start rising rates too late.
We could actually be pretty close to reaching some capacity constraints already. If and when that happens you'll see inflation creeping up. So we think it's right that the Fed is tapering the asset buying (QE), scheduled to finish by October.
We're also not surprised that there is a bit of a discussion about the timing of interest rate hikes. Some argue that these should be raised because of Wall Street exuberance, but if we're still have a large output gap, that doesn't make much sense (it essentially comes down to letting the economy suffer because Wall Street can't contain itself).
However, if the economy is already reasonably close to full capacity, rising interest rates make much more sense (at least to us). The point is, we're getting close to that.
You see that we're almost back to the more immediate pre-crisis years, but not quite back to earlier periods of growth, in which capacity utilization used to be well over 80%. So this remains a difficult dilemma for the Fed, and they could well be behind the curve here.
So we think there is a considerable risk that the Fed is falling behind the curve, but as so often, the risks have to be weighed against alternatives.
If the US economy isn't close to capacity constraints tightening too soon risks torpedoing the recovery itself, which is something the Fed will be at pains to avoid. One has to set that against the cost of the Fed falling behind the curve.
A Fed falling behind the curve risks inflation creeping up, but if that happens, the Fed could still tighten and one could even argue that with still high debt levels, some inflation also has its upside (eating away the real burden of debt levels).
We also strongly disagree with those who argue that there is a risk of accelerating inflation. Inflation hasn't really been a problem since Volcker killed it, and one could argue that before the crisis, inflation was low despite a rather epic housing and construction boom, conditions which are unlikely to return anytime soon.
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