The Path of True Recovery Is Never Smooth
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.