Many attribute the beginning of the financial crisis to the collapse of the housing market. While the housing bust indeed plays an important role, particularly in the health and stability of the banking sector, the real problem is deeper. The fluctuations observed across real estate markets over the last decade or so simply reflect sizable macroeconomic imbalances. It is the nature of these imbalances that we must fully appreciate to better understand the crisis and to potentially forecast plausible scenarios going forward. At the broadest level, we have witnessed a consumption boom over the last two decades, where U.S. aggregate household consumption grew to represent more than 70% of gross domestic product (GDP), a historically and unsustainably high level (see Exhibit 1).
Excessive consumption was fueled by a loosening of lending standards prompted by government policy to increase homeownership rates, and accompanied by record low savings rates. Cheap credit from both home and abroad and a substantial increase in financial intermediation including new structured derivative products also contributed. In line with the private sector, the U.S. government also ran sizable budget deficits and a huge current account deficit.
Collectively, the expansion of credit yielded levels of U.S. household indebtedness and corresponding decreases in household savings, as a percentage of disposable income, that were also unprecedented (see Exhibits 2 and 3). In other words, U.S. consumers and policymakers have been financed to a significant degree by borrowing from abroad (and, by default, from future generations). Simply put, the U.S. economy, financed by excess credit, spent more than it earned.
STRUCTURAL CHANGES ARE REQUIRED
The long-term implications of these factors are significant. Perhaps more importantly, a thawing of credit markets will not on its own portend a rapid economic recovery in output growth and employment. It is likely that the economy will not enjoy a healthy recovery until these long-run imbalances are rectified. In fact, given these long-run challenges, a swift recovery could be undesirable. If a rapid recovery merely reflects a temporary return to the levels of excess consumption and debt, we would only have delayed adjustments with a potentially larger economic cost down the road.
Using IMF data, the table in the next column provides historical evidence that economic contractions associated with financial crises tend to be deeper and last longer than recessions not associated with a financial shock. Accordingly, we conjecture that the outcome with the highest probability is an L-shaped economic pattern, where the economy finds its footing perhaps as early as the second half of 2009, but muddles along for some time with significant excess capacity and unemployment.
Recession Durations and Amplitudes Across Industrialized Countries
||Average number of quarters
||Percentage change in real GDP|
|Recessions Associated With a Financial Crisis
|All Other Recessions
We project one measure of excess capacity, the “output gap,” reflecting the degree to which actual economic activity diverges from the potential implied by optimal capacity utilization, to significantly expand before narrowing (see Exhibit 4).
Unemployment, clearly among the most important indicators for the general well-being of typical Americans, is a lagging indicator, and the green shoots of good news that are emerging will come well in advance of any turnaround in employment trends. U.S. unemployment is already at a 25-year high, and may exceed and remain above 10% for some time.
We project unemployment will be structurally higher in the near term and only decline slowly over many years as adjustments are made in the skills of the labor force. This prediction stems from the inherent mismatch between skills available in the labor force currently, which are tilted toward a high level of U.S. consumption, and the skills necessary to drive sustainable growth over the next five to 10 years.
To rebuild the economic foundation for sustainable long-term growth, the U.S. economy needs higher levels of financial and real investment. Financial investment means that the savings rate must increase significantly to start generating household wealth sufficient to deal with retiring baby boomers, increased health costs, etc. This transition will hamper near-term growth given the importance of consumption to the U.S. economy.
Real investment is needed to create the infrastructure that will generate wealth and support the future needs of retirees. Specifically, the U.S. economy needs to invest in health care infrastructure, basic R&D, as well as high-margin service and manufacturing sectors because these will meet the needs of the global (and U.S.) economy over the coming decades. Recent investments in consumer discretionary industries and residential construction have been excessive (and returns have been disappointing). Investments in future growth industries are facilitated by capital spending by corporations, but just as importantly through education, job retraining and public infrastructure expansion.
It is important to note that any discussion about real investment is largely about long-term growth. As we discuss below, this presents an inherent challenge to the economy in the short run. Investment requires savings, and savings requires income. However, income growth is likely to be limited in the short run because of the weak economy and the decline in household wealth. Baby boomers, in particular, face increasingly dire circumstances as stocks and real estate have performed poorly in the last decade. In short, the change we see coming will be a long process even though the economic restructuring that will lead to growth is likely to start this year. And, we should not count on the recovery being led by consumer spending. In fact, we should expect consumption growth to be on average below the overall GDP growth rate for some time.
INFLATION OR DEFLATION?
During this difficult transition, the economy is likely to remain below potential output levels for some time. Accordingly, we should expect inflation to remain low (indeed, deflation is the bigger risk for the near term). That said, given the tremendous amount of monetary stimulus provided by the Federal Reserve, long-run inflation risks are present. These risks are less likely to be a major problem as the Fed will be poised to drain liquidity from the system as the economy begins to show signs of growth.
However, a second risk to our forecast that should be clearly acknowledged is an awareness that the Federal Reserve will be required to act swiftly in the early stages of the turnaround. Indeed, the Fed will be forced to initiate monetary tightening while unemployment is still at relatively elevated levels, which will no doubt generate significant ire among elected officials.
WHAT WILL JUMP-START GROWTH?
One likely possibility is that the U.S. current account deficit will turn to a balanced position (or even a surplus). This has already started to happen as a reduction in U.S. consumer demand (as well as falling import prices) have significantly reduced the trade deficit. This is good for the U.S. in the short run but not a sustainable path for long-term U.S. growth. Instead the U.S. will need to foster export growth as opposed to relying on declines in imports as foreign (especially developing) economies rebound.
A second method for combating the significant slowdown in private-sector demand will come from government spending growth that is expected to be above trend in the near term. However, it is important to understand that, after a few years, the government will be forced to rein in spending. This fiscal contraction will retard growth in the intermediate term. The uncertain pace of a retreat in government spending represents a significant risk to our outlook in that this requires restraint by policymakers. Under the president’s proposed budget, the Congressional Budget Office (CBO) forecasts that government debt held by the public, as a percentage of GDP, will increase significantly in the next decade (see Exhibit 5); for historical comparison, these levels were last touched during World War II.
Furthermore, government policy still eventually has to deal with the increasingly impending unfunded liabilities. Social Security, Medicare/Medicaid, and the prescription drug benefit, with their estimated unfunded liabilities of around $40 trillion to $50 trillion, stand in sharp contrast to the current total federal debt of about $11 trillion and the projected $1 trillion to $2 trillion federal deficits for 2009 and 2010. The CBO forecasts that government debt held by the public will exceed 200% of GDP in several decades. There is perhaps no more important issue going forward.
ROLE FOR POLICY
To thaw credit markets, the current wave of financial bailout packages is a necessity. This does not contradict our view on the primacy of the long-run challenges the U.S. economy faces. The financial system is the lifeblood of the U.S. economy, and its smooth functioning is a necessary component of an eventual turnaround. Nonetheless, the policy prescriptions should involve a substantial cost to both equity and bondholders. While equity holders have been penalized, it appears thus far that many bondholders have escaped significant pain. This creates as serious a moral hazard problem as bailing out equity holders.
Going forward, it will be necessary to clean up the financial system and improve the quality of regulation and oversight, but this is not what is restraining economic activity right now. Even if bank credit problems were widely solved, fewer households and businesses would (and should) qualify for credit and those with good credit will likely demand less. Financial market stabilization is a necessary goal, but it does not speak to our long-run challenges.
The current fiscal stimulus package, despite some important components, may not be the best approach. Many current spending proposals would be better dealt with through alternative policy prescriptions. In the face of a significant economic downturn, federal support for unemployment benefits, job retraining, education, and investment tax credits are warranted. However, subsidies (direct or indirect) for additional consumption and residential investment stand in the face of a long-run adjustment on private-sector consumption that needs to happen. The Keynesian injection of public-sector demand is designed to replace—and eventually restimulate—private-sector demand. While economists and policymakers intensively debate the merits of this idea intellectually, it would be a shame to have much of the increase in government spending wasted as part of a turnaround effort that just leaves U.S. households in an even more precarious position.
Finally, we believe that the entire restructuring process will come at a substantial cost to us all. The mind-set that consumption and government expenditures do not carry costs has pervaded the U.S. economy for too long. Steps forward should focus on facilitating a greater balance to the economy, spanning the household, government and external sectors. Greater rates of taxation and lower spending (or, in the worst case, higher inflation) at the end of all this will be required once the economy has stabilized. We can perhaps continue to spend beyond our means for a bit longer, but this will not persist indefinitely. Policies designed to avoid the pain of this transition will only exacerbate the eventual costs for future generations. The legacy of past policies already posts a significant roadblock for economic growth going forward. As the most important example, we need to deal with unfunded liabilities now.
Nothing here is particularly pleasant, but it is necessary. The only other panacea imaginable is an unusually high long-run economic growth rate over the next few generations. Long-run improvements in standards of living are really only achieved with elevated levels of investment and, most importantly, technological advancements that stimulate productivity. The U.S. remains among the most innovative and flexible economies in the world. To maintain that status, the importance of investment in innovative technologies, education, and job training cannot be understated.
The root cause of the economic crisis is excessive consumption accompanied by record low savings rates and huge budget and current account deficits.
Thawing credit markets alone will not mean a rapid economic recovery in output growth and employment.
Unemployment will remain high in the near term and only decline slowly over many years as adjustments are made in the skills of the labor force.
Expect inflation to remain low in the near term. Inflation risks will be present in the long run as the result of monetary stimulus provided by the Federal Reserve.
The current fiscal stimulus package may not be the best approach since it ignores the need to reduce consumption relative to income.
Higher tax rates and lower spending will be required once the economy has stabilized.
Gregory W. Brown (email@example.com) is a professor of finance and the Sarah Graham Kenan Distinguished Scholar, and Christian Lundblad (firstname.lastname@example.org) is the Edward M. O’Herron Distinguished Scholar and associate professor of finance—both at the Kenan-Flagler Business School of the University of North Carolina at Chapel Hill.
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