In a recession demand falls short of supply, leaving a sorry trail of unemployed workers, shuttered factories and unexploited innovations. But when the recovery arrives, Friedman suggested, it is all the more forceful because these resources have been lying idle, waiting to be brought back into production. The economy can grow faster than normal for a period until it reaches the point where it would have been without the crisis, when it reaches its full potential again (see chart 1, scenario 1).
Friedman’s story is heartening, but it can come unstuck in two ways. If the shortfall in demand persists it can do lasting damage to supply, reducing the level of potential output (scenario 2) or even its rate of growth (scenario 3). If so, the economy will never recoup its losses, even after spending picks up again.
Why should a swing in spending do such lasting harm? In a recession firms shed labour and mothball capital. If workers are left on the shelf too long, their skills will atrophy and their ties to the world of work will weaken. When spending revives, the recovery will leave them behind. Output per worker may get back to normal, but the rate of employment will not.
Something similar can happen to the economy’s assembly lines, computer terminals and office blocks. If demand remains weak, firms will stop adding to this stock of capital and may scrap some of it. Capital will shrink to fit a lower level of activity. Moreover, if the financial system remains in disrepair, savings will flow haltingly to companies and the cost of capital will rise. Firms will therefore use less of it per unit of output.
The result is a lower ceiling on production. In the IMF’s latest World Economic Outlook, its researchers count the cost of 88 banking crises over the past four decades. They find that, on average, seven years after a bust an economy’s level of output was almost 10% below where it would have been without the crisis.
This is an alarming gap. If replicated in the years to come, it would blight the lives of the unemployed, diminish the fortunes of those in work and make the public debt harder to sustain. But even worse scenarios are possible. A financial breakdown could do lasting damage to the growth in potential output as well as to its level. Even when the economy begins to expand, it may not regain the same pace as before.
Financial crises can pose such a threat to national incomes because of the way they erode national wealth. From the start of 2008 to the spring of this year the crisis knocked $30 trillion off the value of global shares and $11 trillion off the value of homes, according to Goldman Sachs, an investment bank. At their worst, these losses amounted to about 75% of world GDP. But despite their enormous scale, it is not immediately obvious why these losses should cause a lasting decline in economic activity. Natural disasters also wipe out wealth by destroying buildings, possessions and infrastructure, but the economy rarely slows in their aftermath. On the contrary, output often picks up during a period of reconstruction. Why should a financial disaster be any different?
The answer lies on the other side of the balance-sheet. Before the crisis the overpriced assets held by banks and households were accompanied by vast debts. After the crisis their assets were shattered but their liabilities remained standing. As Irving Fisher, a scholar of the Depression, pointed out, “overinvestment and overspeculation…would have far less serious results were they not conducted with borrowed money.”
Japan found this out to its cost in the 1990s after the bursting of a spectacular bubble in property and stock prices. For a “lost decade” from 1992 the economy stagnated, never recovering the growth rates posted in the 1980s. Richard Koo of the Nomura Research Institute in Tokyo calls Japan’s ordeal a “balance-sheet recession”.
The typical post-war recession begins when the flow of spending in the economy puts a strain on its resources, forcing prices upwards. Central banks raise interest rates to slow spending to a more sustainable pace. Once inflation has subsided, the authorities are free to turn the taps back on.
But in a “balance-sheet recession”, what must be corrected is not a flow but a stock. After the bubble burst, Japan’s companies were left with liabilities that far exceeded their assets. Rather than file for bankruptcy, they set about paying down their stock of debt to a manageable level. This was a protracted slog which, by Mr Koo’s reckoning, did not finish until 2005. In the meantime Japan’s economy stagnated. By 2002 its output was almost 23% below its pre-crisis trajectory.
Since Pimco’s forum concluded in May, the world economy has palpably improved. In many ways the new normal is beginning to look a lot like the old, vindicating Friedman’s plucking model. China is outpacing expectations. Goldman Sachs is making hay. The premium banks must pay to borrow overnight from each other is now below 0.25%, the level Alan Greenspan, a former chairman of the Federal Reserve, once described as “normal”. Companies in Europe and America are selling bonds at a furious pace. A few months ago financial newspapers were debating the future of capitalism. Now they are merely discussing the future of capital requirements. Shock has given way to relief.