By Steven K. Beckner

JACKSON HOLE, Wyo. (MNI) – The damage which the financial crisis
did to economic output and employment is apt to be long-lasting, and
policymakers should act accordingly, a pair of economists warned
participants in the Kansas City Federal Reserve Bank’s annual symposium
Friday.

One lesson of the crisis and its aftermath is that the Fed should
maintain more of an inflation “buffer” against the zero interest rate
bound, write Carmen and Vincent Reinhart in a paper prepared for
presentation to the symposium on “Macroeconomic Challenges: The Decade
Ahead,” which includes Fed Chairman Ben Bernanke and most members of the
Fed’s policymaking Federal Open Market Committee.

Assuming that losses of output and jobs is just temporary can lead
to policy errors, such as providing insufficient monetary and fiscal
stimulus, they caution.

Carmen Reinhart is a University of Maryland professor. Her husband
Vincent is a fellow at the American Enteprise Institute and former
director of the Federal Reserve Board’s Division of Monetary Affairs.

They examine the economic impact of 15 financial crises, including
the Crash of 1929, the 1970s oil spike, the Asian crisis and the 2007
subprime mortgage crisis, on 66 countries.

Their conclusions seem to support the notion that, in the wake of
the most recent crisis, the economy is doomed to a “new normal” of
historically high unemployment, slow growth and so forth. But the
authors caution that the pre-crisis boom time was “not normal.”

The Reinharts’ analysis finds that:

— “Real per capita GDP growth rates are significantly lower during
the decade following severe financial crises and the synchronous
world-wide shocks. The median post-financial crisis GDP growth decline
in advanced economies is about 1%.”

They note that during the first three years following the 2007 U.S.
subprime crisis (2008-2010), “median real per capita GDP income levels
for all the advanced economies is about 2% lower than it was in 2007;
this is comparable to the median output declines in the first three
years after the 15 severe post World War II financial crises.”

However, they add, “82% of the observations for per capita GDP
during 2008 to 2010 remain below or equal to the 2007 income level. The
comparable figure for the 15 crises episodes is 60%, indicating
that during the current crisis episode recessions have been deeper, more
persistent, and widespread.”

— “In the 10-year window following severe financial crises,
unemployment rates are significantly higher than in the decade that
preceded the crisis. The rise in unemployment is most marked for the
five advanced economies, where the median unemployment rate is about 5
percentage points higher. In 10 of the 15 post-crisis episodes,
unemployment has never fallen back to its pre-crisis level, not in the
decade that followed nor through end-2009.”

— Real housing prices also suffer persistent losses. For 10 of the
15 crises for which data is available, they find that “over an
11-year period (encompassing the crisis year and the decade that
followed), about 90% of the observations show real house prices below
their level the year before the crisis.”

“Median housing prices are 15 to 20 percent lower in this
11-year window, with cumulative declines as large as 55%,” they
write.

— “Another important driver of the cycle is the leverage of the
private sector. In the decade prior to a crisis, domestic credit/GDP
climbs about 38% and external indebtedness soars. Credit/GDP declines by
an amount comparable to the surge (38%) after the crisis.”

“However, deleveraging is often delayed and is a lengthy process
lasting about seven years,” the Reinharts continue. “The decade that
preceded the onset of the 2007 crisis fits the historic pattern.”

“If deleveraging of private debt follows the tracks of previous
crises as well, credit restraint will damp employment and growth for
some time to come,” they warn ominously.

The authors liken the 2007 crisis to those that occurred prior to
World War II. “Like its pre-war predecessors, the recent episode is both
severe in magnitude and global in scope, as reflected by the large share
of countries mired in crises.”

And the damage is apt to be long-lasting, they contend. “As the
effect lingers, it will look more a loss to permanent income and wealth
and those mechanisms may turn out to be counterproductive.”

“The stark difference between the pre- and post-crisis experience
raises the question as to whether the unemployment rate ever returns to
its pre-crisis level,” they write gloomily.

Nor do they offer much hope for a recovery in housing prices,
citing research showing that “about 90 percent of the observations over
an 11-year period show real house prices remaining below their level
on the eve of crisis.”

“Median housing prices are 15% to 20% lower in the 10-year
post-crisis window, with cumulative declines as large as 55%,” they
write. “From 2006 to date, house prices have declined, in varying
degrees in most advanced economies.”

Credit flows will also be slow to return to “normal,” they say, and
“the greater the unwillingness (or inability) to write down
nonperforming debts, the longer the deleveraging process is delayed.”

The Reinhart team finds that the median duration of credit booms
has been about 10 years and that “the unwinding or deleveraging
following a crisis … is of comparable magnitude.”

“The surge in credit does appear to fuel growth in the pre-crisis
decade, while its contraction following the crisis no doubt contributes
to the subpar performance in the macroeconomic aggregates and in real
estate prices in the decade that follows,” they add.

The economists warn that “by the standard of prior crises, the
unwinding of housing prices and domestic and external debt is far from
complete.”

Surprisingly, they find that in the U.S., the UK and elsewhere,
“there is either scant or no evidence of deleveraging through 2010. In
effect, in most countries, credit/GDP and external debt/GDP have
continued to climb since 2007 … . Not unlike the crises episodes
studied here, part of the continued upward march in debt/GDP owes to
marked declines in real and even nominal GDP during the height of the
crisis and part of it to forbearance.”

“If the protracted unraveling of private debt (coupled with a high
public debt burden) unfolds in the same pattern as previous crises, one
can infer that this would exert a dampening influence on employment and
growth, as in the decade following earlier crises,” they add.

Not surprisingly, the Reinharts find that, with the exception of
the 1970s oil spike, crises tend to cause disinflation, though not
outright deflation as in the 1930s.

They conclude with some policy reflections.

While their research shows that “income growth tends to slow and
unemployment remains elevated for a very long time after a severe
shock,” they observe that policymakers tend not to see it that way.

“A ubiquitous pattern in policy pitfalls has been to assume
negative shocks are temporary, when these were, in fact, subsequently
revealed to be permanent (or, at least, very persistent),” they write.
“Misperceptions can be costly when made by fiscal authorities who
overestimate revenue prospects and central bankers who attempt to
restore employment to an unattainably high level.”

This latter observation seems to suggest that the Fed should not
hope or try to bring unemployment down to what were formerly considered
“full employment” levels, lest they cause future financial imbalances
and or inflation. Alternatively, it could mean, as Minneapolis Fed
President Narayana Kocherlakota warned last week, that holding the
federal funds rate near zero for too long can lead to deflation.

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