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: Bench Memos - National Review Online

'A Period of Subpar Growth' -- By: Duncan Currie

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For anyone eager to understand the history of financial meltdowns and the consequences of skyrocketing public debt, the work of economists Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard is simply invaluable. Two years ago -- prior to the Bear Stearns bailout, at a time when the U.S. unemployment rate was hovering around 5 percent -- their paper on the origins of banking crises across the developed world made a splash at the American Economic Association’s annual meeting in New Orleans. A year later, Reinhart and Rogoff unveiled a new paper on the aftermath of financial implosions in both rich and poor countries. They expanded on these topics in their widely discussed 2009 book, <a href="http://www.nationalreview.com/redirect/amazon.p?j=0691142165">This Time Is Different: Eight Centuries of Financial Folly</a>. More recently, they made headlines with a study of how government debt can hamper economic growth. Like their earlier research, the debt study is both timely and unnerving, given the ongoing turmoil in Greece, the related troubles in other Eurozone states (Ireland, Italy, Portugal, Spain), and the deteriorating fiscal position of the United States. Reinhart and Rogoff conclude that when public debt surpasses 90 percent of GDP, it is “associated with notably lower growth outcomes.” President Obama’s 2011 budget blueprint projects that the ratio of publicly held federal debt to GDP will reach 77 percent in 2020, up from about 64 percent today. But as the Financial Times reported in early February, Moody’s Investors Service has estimated that when state- and local-government debt is included, America’s overall public-debt-to-GDP ratio could be “well over 100 percent in 2020.” The U.S. debt surge is partly a result of extraordinary pump-priming measures. But a severe financial crisis will always lead to a ballooning debt, Reinhart tells me. Indeed, even absent the $700 billion Troubled Asset Relief Program (TARP) and the $787 billion economic-stimulus package, America’s debt load would have jumped significantly. Reinhart and Rogoff calculate that during the three years after the typical systemic banking crisis, real public debt increases by an average of roughly 86 percent, largely due to plummeting tax revenues and the effects of countercyclical fiscal policy. While Reinhart accepts that major financial shocks inevitably produce soaring debt, she is not sanguine about the consequences. America’s massive debt overhang is harming economic growth, she says, and Washington urgently needs to devise a fiscal “exit strategy.” Reinhart fears it could take “a very rude wakeup call” to catalyze the necessary reforms. She points to Canada’s experience during the mid-1990s. At the time, our northern neighbor was carrying an unsustainable debt burden. Then Mexico’s peso crisis erupted, and its sovereign spreads began acting like those of an emerging-market country. This spurred Canadian lawmakers to tackle their borrowing problem. Federal Reserve chief Ben Bernanke has articulated a monetary “exit strategy,” and Reinhart thinks it will prove successful. (By contrast, Carnegie Mellon economist and Fed historian Allan Meltzer <a href="http://www.aei.org/article/101583">expects</a> the Bernanke strategy to fail.) But there is no comparable plan on the fiscal side; therefore, Reinhart supports establishing a bipartisan debt commission. (She also emphasizes that private debt levels are a serious concern, noting that it would take an enormous amount of deleveraging to bring America’s private-debt-to-GDP ratio closer to the historical average.) To be sure, America’s public-debt-to-GDP ratio is still much lower than that of Japan, whose ratio is easily the highest in the developed world and will soon eclipse 200 percent. When it comes to racking up government debt, Japan and America have more leeway than other countries, because most of Tokyo’s debt is domestically financed and the U.S. dollar remains the global reserve currency. Speaking of Japan, Reinhart laments that U.S. policymakers have failed to embrace a key lesson of the Asian giant’s “lost decade.” By not forcefully addressing the toxic loans polluting bank balance sheets, we are “mimicking what the Japanese did.” This has exacerbated America’s debt overhang and delayed a return to more normal lending practices. Reinhart argues that the Treasury Department should have compelled financial institutions to disclose and write down their bad loans. That was the initial goal of TARP; however, the government quickly got “cold feet,” and wound up relying on the private sector to do the job. Writing in the Wall Street Journal last July, after Treasury secretary Tim Geithner’s vaunted Public-Private Investment Program had been scaled back dramatically, Harvard law professor Lucian Bebchuk warned that the toxic-asset dilemma was being “swept under the carpet.” Policies that facilitate a more rapid cleanup of the nonperforming loans will be greatly helpful to the financial system and the economy, says Reinhart. In 2008 and 2009, “we went overboard on the forbearance,” just as Tokyo did from the early 1990s until the premiership of Junichiro Koizumi (2001-2006). Reinhart cites another lesson from Japan: “Don’t declare victory too soon.” In other words, don’t prematurely adopt policies that might endanger a nascent economic rebound. (In 1997, Tokyo scuttled its fledgling recovery by raising taxes; three years later, the Bank of Japan lifted interest rates before deflation had ended.) She believes that America’s coordinated fiscal-monetary response to the financial crisis “had a very important signaling effect” during a time of global panic. U.S. officials needed to demonstrate that they would do everything possible to prevent the economy from plunging into a freefall, says Reinhart. They couldn’t afford to seem “wishy-washy.” Moving forward, she predicts that “we’re in for a period of subpar growth.” Reinhart and Rogoff have shown that following a severe banking crisis, “The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years.” Indeed, based on past financial calamities and their aftermaths, we should anticipate a sluggish return to economic normalcy. -- Duncan Currie is deputy managing editor of National Review Online. <hr width=100% size=2>

Full post as published by Bench Memos - National Review Online on March 07, 2010 (boomark / email).