Two significant economic studies indicate that the present slow recovery could drag on for years. Credit-driven crises tend to result in longer recessions, especially when accompanied by heavy public borrowing. The author reminds investors to look through this lens when questioning the current recovery.
Drawing mainly on two economic studies dealing with the recent financial crisis, the author asserts that the current disappointing recovery should come as no surprise and suggests that people have a short collective memory. Recessions driven by private debt along with high public debt have historically meant sluggish GDP growth and late recoveries.
How Is This Article Useful to Practitioners?
Economic forecasters seeking to explain lower-than-expected second-quarter GDP growth in the United States might want to review Taylor’s paper “The Great Leveraging” (NBER Working Paper 18290) and Reinhart and Rogoff’s book This Time It’s Different, which the author believes predict a slow recovery.
The author summarizes certain key findings of Taylor’s study—namely, that over the past 138 years, a financial crisis generally follows private sector leveraging rather than high public debt, money supply growth, or the current account deficit. A normal recession not preceded by private credit growth brings GDP down by only 50–75 bps, with public debt displaying very little impact. But a credit-driven recession subtracts around twice as much, and if public debt also grows significantly, the cost typically reaches 4% of GDP.
Reinhart and Rogoff find that although public debt can be used to finance bailouts and stimulate economic growth, debt service costs increase and policy flexibility evaporates at high levels. The worsening fiscal balance leads to austerity measures that further hinder growth.
If the findings of Reinhart, Rogoff, and Taylor hold, people should expect a long period of continued drag because both the private and public sectors had high debt levels prior to the crisis.
It is useful for practitioners to keep recent history and past economic patterns in mind as they interpret the current recovery or make forecasts. Developed nations have taken on high levels of public debt in recent years, which limits policy options if another recession develops. If the author is correct, people must lower their expectations about recovery. But every situation has its own unique characteristics. For example, whether public debt financing comes from internal or external sources can affect how a crisis plays out. Readers should refer to the author’s sources to better understand the conclusions being reported and to apply the findings responsibly.