Economists Carmen Reinhart and Kenneth Rogoff have shown in their stunning analysis of financial crises through the ages that downturns coming in the wake of a blowout in a financial system tend to be more protracted than more typical recessions, when economies bounce back to trend relatively quickly.
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There are three common pitfalls in the aftermath of a major financial crisis, the two economists have argued. There is a deep and long drop in asset prices. There are “profound declines” in output and employment. The real value of government debt explodes. Seems familiar?
Their warning should get renewed resonance as the world economy stumbles towards another crisis. The International Monetary Fund has warned that the world economy has entered a dangerous phase. US treasury secretary Timothy Geithner has spoken about the threat from “cascading default, bank runs and catastrophic risk”. Global markets have been in panic.
The immediate cause of worry is the debt crisis in the peripheral European economies such as Greece and Italy, especially the former. The lack of a strong response from European leaders means that the crisis could spread to other countries in case bond investors push up interest rates on sovereign bonds of other countries, turning what is now a liquidity problem into a solvency crisis. French and German banks that hold this debt will then be singed. (Greece is already insolvent, and hence has to accept more bitter medicine.)
But a solution to the Greek crisis may not mark the end of troubles. There could be a very long battle ahead. The recent weeks have shown that the Western economies have not yet recovered from the effects of the North Atlantic financial crisis that broke out in 2008. At a recent conference I attended in Singapore—the Sentosa Roundtable—several top economists and political leaders suggested that Europe and the US are headed for a long stretch of either economic stagnation or anemic growth; some predicted that the return to economic normalcy in these regions is between five years to a decade away.
The fresh troubles come at a time when policymakers are constrained, particularly thanks to a political gridlock on both sides of the Atlantic. The US has to figure out a way to balance the immediate need for a fiscal stimulus with the long-term need to put its shaky public finances in order. Europe is struggling to figure out how to run a rescue programme of the peripheral nations in a way that will not lead to a backlash from voters in Germany and France. The coordinated stimulus of early 2009 is unlikely to be repeated because the developed economies and the emerging economies are fighting different battles right now: a new downturn in the case of the former and high inflation in the latter.
The situation right now does not seem to be as dire as it was in late 2008. Financial markets continue to function because liquidity is more in evidence today. Markets have not seized up, as yet. But the policy bullets used in the last fight have left policymakers with fewer easy options. A big-bang stimulus is unlikely because the public debt in most developed countries has already climbed to worrisome levels. Interest rates are already very low. The second round of quantitative easing was not effective because the extra money either idled in bank balance sheets or chased commodities in an inflationary spiral.
Markets have swung wildly in these past three years, diving with every scare and then leaping with every new infusion of liquidity by central bankers. But investors will at some point have to come around to the conclusion that there are risks that the world economy will grow slower in the next few years, as the rich countries try to deal with their structural problems. In other words, investors may have to recalibrate their expectations in case the West is genuinely headed for another five to 10 years of low growth as well as bouts of uncertainty.
The financial industry has grown on the back of the claim that stocks are the best bet for the long run. Indeed they are, but there have been entire decades when investors would have been better off holding other assets. Countries such as India and China will continue to grow faster than the developed markets, but it is worth asking whether recent valuation assumptions can hold even in our part of the world, given how financial markets are tightly linked across the globe.
The insights of Reinhart and Rogoff are sobering—and the recent troubles show that they are realistic as well. The rich nations need to work out the malign effects of at least a decade of easy credit and high leverage, a process that will take a few years rather than a few quarters. Investors will have to eventually take this harsh reality on board.
Niranjan Rajadhyaksha is executive editor of Mint. Comments are welcome at email@example.com