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The Great Contraction

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A popular view among economic forecasters and market bulls is that "the deeper the recession, the quicker the recovery". They are right — up to a point: immediately after a normal recession, economies do, indeed, often grow much faster than usual over the ensuing 12 months. Unfortunately, the Great Recession of 2008-09 is far from being a normal global recession.

The Great Recession was turbo-charged by a financial crisis, making it a far more insidious affair that typically has far more long-lasting effects.

As Carmen Reinhart and I argue in our new book This Time is Different: Eight Centuries of Financial Folly, the Great Recession is better described as "The Great Contraction", given the massive and simultaneous contraction of global credit, trade and growth that the world has experienced.

Fortunately, despite a hobbled recovery in the developed world, emerging markets in Asia, Latin America and the Middle-East have enormous latent growth potential. Most should be able to grow strongly, despite the challenging global environment.

Nevertheless, the legacy of the huge contraction in credit will not go away soon. Yes, if you are a bank — a big one— you can raise money through sweeping explicit and implicit government guarantees. For others the credit environment is still tough. 

The optimists say not to worry. Credit will soon come to everyone else as easily as it has to the banks. After all, credit also dried up during the 1991 global recession, and yet funds were flowing briskly within 18 months.

But this parallel fails to recognise the fact that balance sheets remain far more impaired this time. Housing prices are being propped up temporarily by myriad subsidies, while a commercial real-estate tsunami looms. 

Indeed, G-20 governments now face the daunting prospect of trying to rein in the monster they have created. It is now clear that the taxpayer will always be there to guarantee that bondholders get paid. Unchecked, large financial firms will be able to tap bond markets for decades to come at rates just above what the government pays, regardless of the risk of their asset positions. Lenders to banks will not worry about what kinds of gambles and investments financial institutions are making, or whether regulation is effective.

The good news is that most governments see the need for new regulation on financial firms. But here's the rub: financial regulation is very complicated, all the more so given that there must be some degree of consistency. 

On the other hand, if regulators take their time to "get it right", there will be a big shadow of uncertainty hanging over the financial system. Banks know that they face higher capital requirements, which will force them to scale back lending relative to their resources. But how much higher? There is much discussion of breaking up banks that are too big to fail. But what will actually happen?

Given this environment, no wonder credit is still contracting in the US, UK and elsewhere. If banks don't know what the rules of the game will be, they have to be cautious about over-extending their balance sheets.

So government regulators — and ultimately all of us — are caught between a rock and a hard place. Regulate in haste, repent at leisure. Overly strict regulation could seriously impair global growth for decades. But if regulation is too soft, the next monster global financial crisis could come within a decade. And even if regulators take their time to try to get it right, the world may have to live with weak credit expansion as banks hold back, awaiting a clearer verdict on their future.

And here is another painful thought that Harvard historian Niall Ferguson often emphasises: many of the leaders and legislators, who are passing judgement on new rules for banks, are the same leaders and legislators who oversaw the regulation in the run-up to the global crisis.

I am often asked why economies get into such a bind repeatedly. As Reinhart and I document empirically for hundreds of financial crises, covering 66 countries and eight centuries, the answer is all too simple: arrogance and ignorance. Investors and policymakers are often ignorant of the myriad historical experiences with financial crises. And those who are too often say, "Don't worry, this time is different."

Perhaps the Great Contraction of 2008-09 will be different from other deep financial crises, and we will see a sustained sharp recovery worldwide. But G-20 policymakers are best advised not to bet on it, and to counsel patience, particularly in epicentre countries.

The author is Professor of Economics and Public Policy at Harvard University, and was chief economist at the IMF.
Copyright: Project Syndicate, 2009.

(This story was published in Businessworld Issue Dated 23-11-2009)