Past Financial Crises
February 3, 2009
A bleak U.S. employment outlook, with a safety net
“U.S. unemployment is only heading up,” Reinhart said. She believes it could rise to 11%-12%, a roughly 7% increase from its low of 4%-4.5%. “If you look closely at the crisis experience, especially in advanced economies, they had a huge impact on unemployment. We’re already starting to see that,” she said. A 7% increase is about average for the systemic financial crises analyzed in her most recent paper. It falls short, however, of the more than 20% increase in unemployment that the U.S. experienced in the Great Depression.
Unemployment tends to rise less in emerging markets than developed markets. But that’s not because the governments of emerging markets have discovered a great solution. Instead, according to Reinhart’s and Rogoff’s paper, “greater (downward) wage flexibility in emerging markets may help cushion employment during periods of severe economic distress. The gaps in the social safety net in emerging market economies, when compared to industrial ones, presumably also make workers more anxious to avoid becoming unemployed.”
Reinhart is skeptical of the Obama administration’s assertion that its stimulus package will create or save more than three million jobs. “It will create jobs, but the exact order of magnitude is a bit optimistic,” she said. Why? Because the government is relying on the private sector to create most of those jobs, and the private sector is feeling the credit crunch. “With credit conditions so out of line with anything normal, you can’t expect maximum bang for your buck,” said Reinhart. Businesses will be reluctant to create new jobs under these circumstances. Another concern: “A lot of the very good stimulus policies in the pipeline don’t have immediate impact,” said Reinhart.
Fix banking first
History doesn’t offer much guidance about the impact of economic stimulus packages. “Being able to employ a ‘big time’ countercyclical policy at a time of crisis is a luxury that few have,” said Reinhart. Japan, which suffered a prolonged economic crisis starting in 1992, is the only historical example. But Japan didn’t recognize and act on its crisis until fairly late in the game, said Reinhart. In that sense, she figures the U.S. is in better shape.
Still, the U.S. isn’t a “poster child” for rapidly recognizing the magnitude of financial crises, Reinhart said. Countries like Sweden have historically done better at recognizing and fixing their banking problems by recapitalizing, encouraging mergers and acquisitions, and even nationalizing banks outright. “When this much of the financial industry is insolvent, you have to be very pragmatic and very broad-minded about how you’re going to approach it,” she said.
Reinhart believes that policymakers need to pay attention to banks and other financial institutions. “What’s most important is to fix what’s broken,” she said. “The core of the problem isn’t infrastructure; it’s the financial sector, which has a huge bad debt overhang.” She’d like to see more emphasis on TARP, the Troubled Asset Relief Program. Fixing the problems of the financial sector is a prerequisite to entering into “full gear recovery mode,” she said.
Recovery and beyond
Current U.S. policy is correct in one important respect: Reinhart does not expect deflation. “That’s a story for the 1930s, when monetary policy was on a completely different planet,” she said. The U.S. money supply may have contracted during the Great Depression, but today the Federal Reserve is committed to using all of the tools at its disposal to help the economy grow.
Reinhart is more concerned about inflation. “We are not there yet, but as public debt piles up, we’ll have to think about inflation,” she said. High levels of public debt tempt the government to use inflation to reduce the cost of paying off that debt. But inflation is probably a couple years in the future.
Looking forward, Reinhart is reluctant to forecast rates of U.S. economic growth and she doesn’t see the U.S. recovering until well into 2010. As for the future of the dollar, “over the very long haul, I do think the imbalances in the U.S. economy, like the big current account deficit, will come back to haunt us,” she said. But, she noted, that’s not a one-year forecast or even a three-year forecast.
Susan Weiner, CFA, is a writer specializing in investment and wealth management. Contact her through http://InvestmentWriting.com.
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