<nettime> Struggling with a great contraction

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From.: ft.com (http://tinyurl.com/3nmn75w)


August 30, 2011 8:21 pm
By Martin Wolf


What has the market turmoil of August been telling us? The answer, 
Isuggest, is three big things: first, the debt-encumbered economies of the 
high-income countries remain extremely fragile; second, investors have next 
to no confidence in the ability of policymakers to resolve the 
difficulties; and, third, in a time of high anxiety, investors prefer what 
are seen as the least risky assets, namely, the bonds of the most highly 
rated governments, regardless of their defects, together with gold. Those 
who fear deflation buy bonds; those who fear inflation buy gold; those who 
cannot decide buy both. But few investors or corporate managers wish to 
take on any longer-term investment risks.

Welcome, then, to what Carmen Reinhart, senior fellow at the Peterson 
Institute for International Economics in Washington, and Harvardâs Kenneth 
Rogoff call âthe second great contractionâ (the Great Depression of the 
1930s being the first). Those less apocalyptic might call it the âJapanese 
diseaseâ.

Many ask whether high-income countries are at risk of a âdouble dipâ 
recession. My answer is: no, because the first one did not end. The 
question is, rather, how much deeper and longer this recession or 
âcontractionâ might become. The point is that, by the second quarter of 
2011, none of the six largest high-income economies had surpassed output 
levels reached before the crisis hit, in 2008 (see chart). The US and 
Germany are close to their starting points, with France a little way 
behind. The UK, Italy and Japan are languishing far behind.

The authoritative National Bureau of Economic Research of the US does 
define a recession as âa significant decline in economic activity spread 
across the economy, lasting more than a few monthsâ. This is to focus on 
the change in output, rather than its level. Normally, that makes sense. 
But this recession is not normal. When economies suffer such steep 
collapses, as they did during the worst of the crisis (the peak to trough 
fall in gross domestic product having varied between 3.9 per cent in France 
and 9.9 per cent in Japan), an expansion that fails to return output to the 
starting point will not feel like recovery. This is especially true if 
unemployment remains high, employment low and spare capacity elevated. In 
the US, unemployment is still double its pre-crisis rates.

The depth of the contraction and the weakness of the recovery are both 
result and cause of the ongoing economic fragility. They are a result, 
because excessive private sector debt interacts with weak asset prices, 
particularly of housing, to depress demand. They are a cause, because the 
weaker is the expected growth in demand, the smaller is the desire of 
companies to invest and the more subdued is the impulse to lend. This, 
then, is an economy that fails to achieve âescape velocityâ and so is in 
danger of falling back to earth.

Now consider, against this background of continuing fragility, how people 
view the political scene. In neither the US nor the eurozone, does the 
politician supposedly in charge â Barack Obama, the US president, and 
Angela Merkel, Germanyâs chancellor â appear to be much more than a 
bystander of unfolding events, as my colleague, Philip Stephens, recently 
noted. Both are â and, to a degree, operate as â outsiders. Mr Obama wishes 
to be president of a country that does not exist. In his fantasy US, 
politicians bury differences in bipartisan harmony. In fact, he faces an 
opposition that would prefer their country to fail than their president to 
succeed. Ms Merkel, similarly, seeks a non-existent middle way between the 
German desire for its partners to abide by its disciplines and their 
inability to do any such thing. The realisation that neither the US nor the 
eurozone can create conditions for a speedy restoration of growth â indeed 
the paralysing disagreements over what those conditions might be â is 
scary.

This leads us to the third big point: the dire consequences of soaring risk 
aversion, against the background of such economic fragility. In the long 
journey to becoming ever more like Japan, the yields on 10-year US and 
German government bonds are now down to where Japanâs had fallen in October 
1997, at close to 2 per cent (see chart). Does deflation lie ahead in these 
countries, too? One big recession could surely bring about just that. That 
seems to me to be a more plausible danger than the hyperinflation that 
those fixated on fiscal deficits and central bank balance sheet find so 
terrifying.

A shock caused by a huge fight over fiscal policy â the debate over the 
terms on which to raise the debt ceiling â has caused a run into, not out 
of, US government bonds. This is not surprising for two reasons: first, 
these are always the first port in a storm; second, the result will be a 
sharp tightening of fiscal policy. Investors guess that the outcome will be 
a still weaker economy, given the enfeebled state of the private sector. 
Again, in a still weaker eurozone, investors have run into the safe haven 
of German government bonds.

Meanwhile, stock markets have taken a battering. Yet it is hard to argue 
that they have reached a point of capitulation. According to Yaleâs Robert 
Shiller, the cyclically adjusted price-earnings ratio for the US (based on 
the S&P 500) is almost a quarter above its long-term average. In 1982, the 
valuation was a third of current levels. Will markets avoid such a 
collapse? That must depend on when and how the great contraction ends.

Nouriel Roubini, also known as âDr Doomâ, predicts a downturn. âA stopped 
clockâ, some will mutter. Yet he is surely right that the buffers have 
mostly gone: interest rates are low, fiscal deficits are huge and the 
eurozone is stressed. The risks of a vicious spiral from bad fundamentals 
to policy mistakes, a panic and back to bad fundamentals are large, with 
further economic contraction ahead.

Yet all is not lost. In particular, the US and German governments retain 
substantial fiscal room for manoeuvre â and should use it. But, alas, 
governments that can spend more will not and those who want to spend more 
now cannot. Again, the central banks have not used up their ammunition. 
They too should dare to use it. Much more could also be done to hasten 
deleveraging of the private sector and strengthen the financial system. 
Another downturn now would surely be a disaster. The key, surely, is not to 
approach a situation as dangerous as this one within the boundaries of 
conventional thinking.

What being bolder might mean and what should therefore be done will be the 
topic for next weekâs column.





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