Slumping for How Long


Carmen Reinhardt and Ken Rogoff call for a renewed spirit of pessimism:

In particular, when one compares the U.S. crisis to serious financial crises in developed countries (e.g., Spain 1977, Norway 1987, Finland 1991, Sweden 1991, and Japan 1992), or even to banking crises in major emerging-market economies, the parallels are nothing short of stunning. […] On other fronts the news is similarly grim, although perhaps not out of bounds of market expectations. In the typical severe financial crisis, the real (inflation-adjusted) price of housing tends to decline 36%, with the duration of peak to trough lasting five to six years. Given that U.S. housing prices peaked at the end of 2005, this means that the bottom won’t come before the end of 2010, with real housing prices falling perhaps another 8%-10% from current levels. […] Turning to unemployment, where the new administration is concentrating its focus, pain seems likely to worsen for a minimum of two more years. Over past crises, the duration of the period of rising unemployment averaged nearly five years, with a mean increase in the unemployment rate of seven percentage points, which would bring the U.S. to double digits.


For far too long, official estimates of the likely trajectory of U.S. growth have been absurdly rosy and always behind the curve, leading to a distinctly underpowered response, particularly in terms of forcing the necessary restructuring of the financial system. Instead, authorities should be prepared to allow financial institutions to be restructured through accelerated bankruptcy, if necessary placing them under temporary receivership, and only then recapitalizing and reprivatizing them. This is not the time for the U.S. to avoid painful but necessary restructuring by telling ourselves we are different from everyone else.

The striking thing, to me, is that in some ways this is too optimistic. If there’s anything the past four months’ worth of talking about black swans ought to have taught us is that just because the past five developed world financial panics led to severe recessions that were followed by recoveries doesn’t mean that recovery is inevitable. Things could be much worse this time around. Indeed, one of the really scary things about this kind of problem—especially when you consider its global spread and the enormous size of the epicenter country—is that there are decent theoretically reasons to believe that we could semi-permanently settle on a new low-output, high-unemployment equilibrium.