by Adam S. Posen, Peterson Institute for International Economics
Submitted to Financial World
© Peterson Institute for International Economics.
Adam Posen is a Senior Fellow at the Peterson Institute for International Economics and a member of the Monetary Policy Committee of the Bank of England. The views expressed here are solely his own and not those of the Bank, the MPC, or any of its staff.
It takes a lot of repeated policy errors to keep a market economy down. For all the talk about Japan in the 1990s being a lost decade, or tracing an “L-shape” (i.e., down and then flat in terms of growth), the actual pattern was that of a sawtooth. Economic recoveries after the initial shock from the bubble bursting were recurrently cut off by macro policy tightening or financial system neglect. Looking at the US and other economies in the Great Depression shows much the same pattern—notably the recovery in the United States once stimulative policy kicked in and the banking panic ended, and a sharp reversal in 1937–38 when policy was prematurely tightened. Absent those kinds of policy mistakes, if you are not Zimbabwe or North Korea—in other words, if you're an economy with rule of law, property rights, basic market structures, and price stability—the nature of things is that the economy tends to bounce back.
You still need to stimulate with macroeconomic policy upfront after a major financial crisis, because if you let a bad downturn of this kind take hold, the deflation and financial fragility can get a momentum of their own. This is primarily about stopping financial panic, which emerged a year ago and which did take aggressive action by economic policymakers to forestall. You also should stimulate upfront so that the cost of this downturn is spread out over our future income and generations to come, rather than imposing all of it on those who happen to become unemployed or bankrupt today. But there is a limit to how far and how long macro stimulus can go, and the good news is that usually the private sector can pick up growth again before too long.
That applies today. On the monetary and fiscal side, the G-20 economies have all pretty much done the right thing in terms of aggressive stimulus policies. The policies are having the desired effect, moving consumption and even some investment from the future to today, and from the private to the public sector, when households are rapidly increasing saving. Unemployment will continue to rise, but that is a lagging indicator in forecasting terms (even though a huge indicator of human and political stress). The financial panic, and with it the potentially self-fulfilling fear of disastrous outcomes, has been largely ruled out. As Milton Friedman said and more recently Michael Mussa has reminded us [pdf], one dependable regularity about business cycles in market economies is the steeper the decline, the sharper the rebound. That is already being seen in residential construction and in stock building to some degree, having been long below replacement levels, and will likely increase over the coming months.
Yet, the path to true recovery is never smooth. Absent major policy mistakes, the sawtooth pattern should not have as many teeth, or teeth as sharp, as those seen in a plot of Japan's GDP—but it will still look a lot more like a string of W's than any other letter or a prolonged upward trend line. We will experience a bumpy ride at best, though thankfully on an average upward trend, for the major economies in the next few years. There are four basic reasons for this:
Compared to where we were a year-ago, the world economy is in much better shape. Macroeconomic policy stimulus has prevented the worst outcomes, and financial panic has receded. The trick will be to sustain that positive overall environment while major adjustments take place within and between economies: from public spending to private demand; from extraordinary policy measures to normal automatic stabilizers and interest rate setting; from booms to lower sustainable growth rates; from previously favorable but now bloated sectors to new sources of employment and growth; from guaranteed banks to boring banking; and from net exporters to net importers (and vice versa). Our market economies and our macroeconomic policies, supported by needed social safety nets, can deliver that outcome. But fasten your seatbelts, it is going to be a bumpy ride for the next few years.
Op-ed: A Dose of Reality for the Dismal Science April 19, 2013
Op-ed: Five Myths about the Euro Crisis September 7, 2012
Article: Why the Euro Will Survive: Completing the Continent's Half-Built House August 22, 2012
Policy Brief 12-18: The Coming Resolution of the European Crisis: An Update June 2012
Policy Brief 12-20: Why a Breakup of the Euro Area Must Be Avoided: Lessons from Previous Breakups August 2012
Book: Sustaining China's Economic Growth after the Global Financial Crisis January 2012
Congressional Testimony: A New Regime for Regulating Large, Complex Financial Institutions December 7, 2011
Op-ed: The Future of Banking: Is More Regulation Needed? April 10, 2011
Working Paper 11-2: Too Big to Fail: The Transatlantic Debate January 2011
Policy Brief 10-24: The Central Banker's Case for Doing More October 2010
Paper: Global Economic Prospects as of September 30, 2010: A Moderating Pace of Global Recovery September 30, 2010
Policy Brief 10-3: Confronting Asset Bubbles, Too Big to Fail, and Beggar-thy-Neighbor Exchange Rate Policies February 2010
Policy Brief 10-7: The Sustainability of China's Recovery from the Global Recession March 2010
Article: The Dollar and the Deficits: How Washington Can Prevent the Next Crisis November 2009
Speech: Rescuing and Rebuilding the US Economy: A Progress Report July 17, 2009
Speech: Global Financial Surveillance and the Quest for Financial Stability June 15, 2009
Congressional Testimony: Needed: A Global Response to the Global Economic and Financial Crisis March 12, 2009
Congressional Testimony: A Proven Framework to End the US Banking Crisis Including Some Temporary Nationalizations February 26, 2009
Speech: Financial Regulation in the Wake of the Crisis June 8, 2009
Speech: Policy Responses to the Global Financial Crisis June 3, 2009
Congressional Testimony: Too Big to Fail or Too Big to Save? Examining the Systemic Threats of Large Financial Institutions April 21, 2009
Speech: The Economic Crisis and the Crisis in Economics January 7, 2009
Paper: World Recession and Recovery: A V or an L? April 7, 2009
Op-ed: Stopping a Global Meltdown November 12, 2008
Book: Banking on Basel: The Future of International Financial Regulation September 2008
Paper: The Subprime and Credit Crisis April 3, 2008
Speech: Addressing the Current Financial Crisis October 7, 2008