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Contraction, Not Recession

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Why is everyone still referring to the recent financial crisis as the ‘Great Recession'? The term, after all, is predicated on a dangerous misdiagnosis of the problems that confront the US and other countries, leading to bad forecasts and bad policy.

The phrase Great Recession creates the impression that the economy is following the contours of a typical recession, only more severe — something like a really bad cold. That is why, throughout this downturn, forecasters and analysts who have tried to make analogies to past post-war US recessions have gotten it so wrong. Moreover, too many policymakers have relied on the belief that, at the end of the day, this is just a deep recession that can be subdued by a generous helping of conventional policy tools, whether fiscal policy or massive bailouts.

But the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors through defaults, financial repression, or inflation.

A more accurate, if less reassuring, term for the ongoing crisis is the ‘Second Great Contraction'. Carmen Reinhart and I proposed this moniker in our 2009 book This Time Is Different, based on our diagnosis of the crisis as a typical deep financial crisis, not a typical deep recession. The first ‘Great Contraction' of course, was the Great Depression, as emphasised by Anna Schwarz and the late Milton Friedman. The contraction applies not only to output and employment, as in a normal recession, but to debt and credit, and the deleveraging that typically takes many years to complete.

Why argue about semantics? Well, imagine you have pneumonia, but you think it is only a bad cold.

In a conventional recession, the resumption of growth implies a reasonably brisk return to normalcy. The economy not only regains its lost ground, but, within a year, it typically catches up to its rising long-run trend.

The aftermath of a typical deep financial crisis is something completely different. It typically takes an economy more than four years just to reach the same per capita income level it had attained at its pre-crisis peak. So far, across a broad range of macroeconomic variables, including output, employment, debt, housing prices, and even equity, our quantitative benchmarks based on previous deep post-war financial crises have proved far more accurate than conventional recession logic.

Many commentators have argued that fiscal stimulus has largely failed not because it was misguided, but because it was not large enough to fight a ‘Great Recession'. But, in a ‘Great Contraction', the main problem is too much debt. If governments that retain strong credit ratings are to spend scarce resources effectively, the most effective approach is to catalyse debt workouts and reductions.

For example, governments could facilitate the write-down of mortgages in exchange for a share of any future home-price appreciation. An analogous approach can be done for countries. For example, rich countries' voters in Europe could perhaps be persuaded to engage in a much larger bailout for Greece (one that is actually big enough to work), in exchange for higher payments in ten to 15 years if Greek growth outperforms.

In an earlier column, I had argued the only way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4-6 per cent for several years. Of course, inflation is an unfair and arbitrary transfer of income from savers to debtors. But, at the end of the day, such a transfer is the most direct approach to faster recovery. Eventually, it will take place one way or another, anyway, as Europe is painfully learning.

Some observers regard any suggestion of even modestly elevated inflation as heresy. But Great Contractions, as opposed to recessions, are very infrequent events.

The big rush to jump on the ‘Great Recession' bandwagon happened because most analysts and policymakers simply had the wrong framework in mind. Unfortunately, by now it is far too clear how wrong they were.

Acknowledging that we have been using the wrong framework is the first step toward finding a solution. Perhaps the smoke will clear a bit faster if we dump the ‘Great Recession' label immediately and replace it with something more apt, like ‘Great Contraction'. It is too late to undo the bad forecasts and mistaken policies that have marked the aftermath of the financial crisis, but it is not too late to do better.

The author is Professor of Economics and Public Policy at Harvard University, and was chief economist at the IMF.

Copyright: Project Syndicate, 2011

(This story was published in Businessworld Issue Dated 15-08-2011)