Second Great Contraction?

There is good reason to think the Global Financial Crisis will last a few years longer.

Listener: 10 July, 2010.

Keywords: Macroeconomics & Money;

We once had a Ford Escort that got stuck crossing fords. (We called it the Ford which wouldn’t.) The first time this happened, I involuntarily switched on the starter motor, which gave just enough power to push us through to dry land.

The economy has been a bit like that. When the Global Financial Crisis stalled the world economy, we got it moving again with a fiscal stimulus. There has been some recovery in the North Atlantic economies, but it’s weak, and some people think there will be a relapse and that unemployment will remain high for some time. In the jargon, it may be a “W” or “double-dipper”, and that may be a precursor of the feared “L”, a long recession or shallow depression

So, the dry land on the other side seems a way off; how much more fiscal stimulus should be applied? The recent New Zealand Budget was more expansionary than expected – the tax cuts were imbalanced – perhaps because the Government thinks the recession following the Global Financial Crisis is going to be more prolonged.

It has good reason to think so. A remarkable book by Carmen Reinhart and Keith Rogoff examines similar crises for the past eight centuries. The title, This Time Is Different, is ironic, for the authors observe similarities.

If they are correct and the patterns continue, two major predictions follow. First, many economies will come out of the crisis on a lower growth track than they went into it; second, the recession will take some time to get over – perhaps five to 10 years.

Increasingly it seems as if something like that is happening. Despite the use of the starter motor, the normal – private sector – engines of growth have yet to take over from the fiscal and monetary stimuli. New Zealand is expected to grow in the next year, but investment remains weaker than a couple of years ago. The North Atlantic economies look weaker.

A ford can be so wide we cannot use the starter motor to power the car through it; the battery eventually runs out. In the economic parallel, eventually, the bouts of fiscal stimulus must stop, as the ability to borrow runs out of juice when a certain limit is reached, something the Greeks found out (and no doubt others will also find out – this time is not so different).

So, the “Club Med” debt crisis may not be over; ultimately we may see quite different arrangements for the European Monetary Union.

The US is having a vigorous debate about the need for a further fiscal stimulus. You might think its “battery” is unlimited, since it provides the world’s reserve currency – issuing it is a form of borrowing. But as American dollars flood the world, they become less wanted, their price goes down and, ultimately, inflation results. All this may soften the long recession in US, but won’t make it go away – just as it won’t go away in Europe.

There is a ray of hope for New Zealand. China has not been as affected by the Global Financial Crisis and is expected to grow strongly. In turn, countries that are major exporters to China – among them Australia – are also expected to grow. So two of our biggest customers have a more optimistic outlook than the North Atlantic economies. With any luck (and a bit of attention), New Zealand will benefit from their good fortune. You might think of us getting through the ford on a couple of cylinders; the car will be going slower and more erratically.

But even if we make it, in five to 10 years the world that comes out of what Reinhart and Rogoff call “the second great contraction” will be very different from the one that entered it, as will the New Zealand economy.

What will our economy look like? I’m not sure. But I am sure that those still thinking rigidly in the framework of the past decade (or even earlier) have little useful to say, and this year’s Budget is hardly engaging with the future, except a very short-term one. The crisis is long term; the policies that got us into it aren’t going to get us through it. They need to be different.