On September 15, 2008 Lehman Brothers collapsed in a heap, a bankruptcy that was followed by a recession in most rich countries. As time goes on, the severity of the disruption becomes both more apparent and more puzzling.
When Lehman failed, it was reasonable to expect the pain to be brief and concentrated. While too many houses had been built in the United States, most of the world’s real economy (comprising factories, offices, retail outlets, construction projects) was doing well. The global financial sector was more distorted, even before investors took fright at the decision to let Lehman go under. But by the middle of 2009, governments and central bankers had agreed to provide bankers and brokers with anything needed to keep them healthy.
Optimism was not justified. Although the countermeasures stopped the deterioration, the rich world now seems stuck in a Lesser Depression – many years of poor economic results and a series of financial crises. In the United States, the euro zone, Japan and the UK, real GDP per person is still lower now than it was four years ago. In all of them, GDP growth is currently either slow or non-existent.
The consumption setback shouldn’t cause too much concern – it wasn’t so bad five or six years ago, when real GDP was last at today’s level. But the enduring recession in the labour market is another matter.
In April 2008 the unemployment rates in the United States, euro zone and UK were respectively 5, 7.3 and 5.3 percent. In April 2012, the corresponding percentages were 8.1, 10.9 and 8.4. More refined indicators – youth unemployment, involuntary part time work and disaffected ex-workers – are even more discouraging. The post-Lehman economy is failing a significant number of people in a fundamental way.
Some economists argue that this real suffering is the necessary price to pay to bring order to the financial world. That’s a dubious argument, since people are more important than money and credit. But the ethical debate isn’t necessary. Despite the real economic pain and the official aid, the financial world looks as ill as ever. On the monetary side, policy remains in shock territory – buyers of safe government debt receive negative real returns. Fiscal positions are equally alarming. Deficits everywhere remain at levels more suitable for wartime mobilisation than for a sputtering economy.
The puzzle is why a relatively small problem in the real economy has led to this Lesser Depression, especially when the authorities have followed expert advice throughout. Surely, if the counsel were sound, the depression would have lifted by now.
The experts offer several excuses. One is that the euro zone’s special problems have delayed recovery. That’s probably true, but European politicians and central bankers are following the best advice on how to compensate. Another is that the authorities should have been even more aggressive in their support for the financial system. Maybe, but even larger fiscal deficits and even easier money would create other distortions. Yet another claim is that governments should have cut back their spending faster. Possibly, but that would hit consumption harder and further increased unemployment.
The problem is actually the experts. Recent history provides a good reason to doubt their competence. Five years ago, economic gurus saw no end to the pre-Lehman “Great Moderation” – steady GDP growth, shrinking unemployment and rising asset prices. They were wrong about that, and they are still making two basic mistakes.
The first concerns the real economy, in particular the highly productive modern economy. Economists underestimate the difficulty of keeping unemployment down. It is much easier to destroy jobs, with labour-saving devices and more efficient procedures, than to create them by starting up enterprises, finding customers for new services or creating new bureaucracies. The employment asymmetry accounts for the persistent pain in the labour market. The jobs shed at the beginning of the Lesser Depression are not easily replaced, nor are the jobs currently being cut by governments searching for austerity.
The second mistake is financial. Economists underestimate the danger of debt. Whether the money is owed by companies, households or governments, the disadvantages of debt financing increase as the ratio of liabilities to income rises. Heavily indebted borrowers are less eager to take economic risks and more likely to default. In a highly leveraged and financially interconnected economy, one default often leads to other bigger collapses. In short, massive debts almost invite economic paralysis. It’s hardly surprising that the increase of debt-financed government spending has done so little good.
So what should be done? New ideas are required – and I’ll offer my contributions over the next few weeks. Without a fundamental change in the thinking, the global economy won’t reach its goal of steady growth and low unemployment.