If the nearly 900 attendees of the IMCA conference in New York were feeling any better recently about prospects for the economy and investment markets, they got a wakeup call from economist Carmen Reinhart this morning.
“Financial crises cast a long shadow,” said Ms. Reinhart, a former chief economist for the Bear Stearns Cos. Inc. who has worked at the National Bureau of Economic Research, as well as the International Monetary Fund. “The decades after severe financial crises are dominated by deleveraging in the private sector.”
Such periods usually are characterized by weak economic recoveries, frequent so-called double-dip recessions and persistently high unemployment, Ms. Reinhart said. The median GDP growth rates in these periods are typically 2%, versus 3% after less severe recessions. Out of fifteen periods following severe financial crises that Ms. Reinhart studied, seven experienced double dips as sub-par recoveries dwindled back into recession. And in 10 of those 15 post-crisis periods, the unemployment rate never returned to pre-crisis levels—in the case of the U.S., 4% to 5%.
Private and public sector debt is the reason, Ms. Reinhart said. “The leveraged private sector is vulnerable and the usually highly leveraged public sector finds it hard to respond,” she said, noting that the post-crisis deleveraging period typically lasts about as long as the boom that preceded it. That means seven to 10 years for the U.S.
The deleveraging usually doesn't start in earnest until three years after the collapse, Ms. Reinhart said. This year marks the start of the fifth year since the crisis began in the summer of 2007, and household debt levels have fallen from about 100% of GDP to 90%, versus approximately 45% pre-crisis, she explained.
“This is not an environment any of us have experienced,” she told the attendees. “The fiscal debt burden we now have has surpassed what we carried at the end of World War II. The only comparable reference point is the 1930s.”
External shocks usually precipitate a double-dip recession in crisis recovery periods,” Ms. Reinhart said, with Europe is the most likely source this time around. Ms. Reinhart, now a senior fellow at the Peterson Institute for International Economics, recently returned from the World Economic Forum in Davos, Switzerland, where she said there was misplaced optimism about narrowing spreads on Irish, Spanish and Italian debt.
“I don't share that view. I think there will be more restructuring needed beyond Greece,” she said. “Italy and Spain are too big to fail and Europe will go to great lengths to avoid defaults there. However, Portugal is probably next, and I have concerns about Ireland, given the huge amount of their external debt.”
It doesn't take a major event to trigger a shock, Ms. Reinhart said. “Suppose that the Greek restructuring results in further turmoil and some smaller financial firms go belly up in the U.S. There's no way to tell how big a reaction there will be in the market,” Ms. Reinhart said.
In the meantime, governments and central bankers will continue to pursue a coordinated policy of “financial repression.” Not as exotic as it sounds, Ms. Reinhart said, it essentially involves a backlash against laissez-faire economics and financial globalization. “Don't expect a Financial Repression Act of 2012. It happens with piecemeal regulation,” she said.
Central to the policy response is the maintenance of low interest rates — essentially resulting in a transfer of wealth from savers to borrowers. “Low interest rates with a little inflation is the best environment to reduce debt. Financial repression is a subtle type of debt restructuring.”