The US Department of labor announced its monthly job report last week. Economists had hoped that the report would announce 68,000 new jobs had been created in the United States in August. Instead they got zero. Not really a good sign concerning the health of the US economy. It is even worse if you look at the global economy. In a recent report purchasing managers’ indices (PMI) for 17 countries only Japan, Poland and the Czech Republic saw rising new orders. Many of the indices were at 2009 levels.
What has happened to the economies in the developed world? Carmen M. Reinhart, a senior fellow at the Peterson Institute for International Economics, and Kenneth S. Rogoff, a professor of economics at Harvard University, have an answer. According to Ms. Reinhart and Professor Rogoff this recession is different.
Most recessions are part of a normal business cycle. Business cycle recessions are usually short lived. There is a quick contraction followed by rapid growth. This recession is the result of a financial crisis. Financial crises are caused by too much debt. When economies accumulate too much debt during a boom, they have to get rid of the debt during the bust. When you have too much debt, it is impossible for the economy to grow.
Getting rid of the debt is difficult. There are two ways. First, the debt gets restructured, but this is a long a difficult process. In game theory a debtor’s best move is not to pay a creditor back. During a boom it is easier to finance a house at an inflated price, than to foreclose on the property after the bust. It is easier for a consumer to run up a credit card debt, than for the bank to force them to pay the debt back. It is easier for a country to sell sovereign bonds than to force the country to raise taxes on its citizens to pay the money back.
The second way to get rid of a debt is to make money and pay it back. But if there is too much debt hindering growth of an economy or the debtor is unemployed, it is difficult to find the cash to pay off the creditors. The problem becomes acute when the debtor’s failure to pay inevitably leads to revelations about the magnitude of the problem. The result is that recovery from a financial crisis can be long and painful.
The conventional wisdom is that the recent global crisis was caused by developed countries. Many emerging markets were barely touched by the recession. On the contrary, as I pointed out in my column at the beginning of the month that many of these economies were not only expanding, but also overheating. According the The Economist’s emerging markets overheating index the economies of Argentina, Brazil, India, Indonesia, Turkey and Vietnam have real issues. In order to control the inflation created by the rapid growth almost every economy with the notable exception of the US and Japan, have recently raised interest rates to slow the growth.
As I pointed out in my last column, the booms in emerging markets have also resulted in very large debts. The amounts and extents of these debts are just beginning to be realized, but they are substantial throughout the emerging markets and especially in the BRIC economies. So the stage is set for a major contraction and it has happened before.
In the mid 1970s both the US and Europe went into recession. The US problems ended in stagflation and the economy did not achieve sustained growth until 1983. The emerging markets (then known as Less Developed Countries or LDCs) did not immediately feel the stress of the recessions due to a flood of recycled petrodollars from the oil shock. When the investment boom ended like all major investment booms, LDCs suffered the “Lost Decade” of the 1980s. According to Professor Michael Pettis, “Every single case in history that I have been able to find of countries undergoing a decade or more of “miracle” levels of growth driven by investment (and there are many) has ended with long periods of extremely low or even negative growth – often referred to as “lost decades”.
The reason why the aftermath of a financial crisis is worse in an emerging market than in a developed market has to do with the debts. In a developed country liquidating the debts is difficult and time consuming. In emerging markets it is impossible. For the average OECD country a bankruptcy takes 1.7 years and returns 70% of the original amount loaned. In emerging markets the process can take over 4 years and return less than 20%. So when the stench of debt rises it stays around for a long, long time, because the legal plumbing necessary to wash it away doesn’t exist.
