It's been almost four years since the start of the financial crisis that brought on the deepest recession since the Great Depression. While many experts hoped the recovery would be robust, it's proven disappointingly slow and shallow -- even slower lately. That's no surprise to Carmen Reinhart, senior fellow at the Peterson Institute for International Economics. Along with Harvard economist Kenneth Rogoff, she's written a book, This Time is Different: Eight Centuries of Financial Folly, which looks at boom-and-bust economic cycles over time.
Reinhart and Rogoff show that when real estate bubbles burst, financial crises often follow. They, in turn, lead to large losses in the financial sector, which are frequently addressed by government-funded bailouts that, in the end, compromise the fiscal health of the nation in question. Recovery is slow and protracted.
We checked in with Reinhart to see whether the U.S. is facing a long period of anemic growth. Here is an edited transcript of our conversation.
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KIPLINGER: What’s in store for the U.S. economy?
REINHART: The U.S. is facing a slow-growth problem for essentially the next five to six years. My husband, Vincent Reinhart, and I wrote a paper, titled “After the Fall,” that examines economic growth following a negative economic or financial event. In a developed economy, economic growth is about 1% lower in the decade following a severe financial crisis than in the decade prior to the crisis, and unemployment rates remain stubbornly high. In half of the 15 most-severe post-World War II financial crises that we studied, unemployment does not return to the pre-crisis low in the decade after a financial crisis.
Why is this the case? These recoveries are so protracted and so anemic because of high levels of indebtedness and the slow process of paying that debt off. Prior to the financial crisis, the worst recession since World War II had been the 1981-82 recession. However, in 1982 household debt was 45% of gross domestic product, and when interest rates began to come down markedly, people paid down debt, allowing them to begin spending again. The economy came roaring back. Today household debt is more than 90% of GDP, and interest rates are already low. People will be paying off debt for a lot longer instead of spending in ways that make the economy grow. As a result, for the next five to six years the economy will only grow around 2% a year after inflation, and unemployment will remain high.
How does our situation compare with Japan’s lost decade? We should be worried about a Japan-like scenario. That’s one in which the private sector was highly indebted -- especially the financial industry. Lenders delayed writing down bad debt, and the government stepped in to guarantee bank deposits. Japan kept interest rates low, but that failed to get its economy jump-started. Instead, the country experienced a prolonged period of slow growth and deflation, with prices falling because of waning demand. We have a similar situation here in terms of debt and how we’re dealing with it. We should be worried about those strong similarities.
Your outlook is decidedly more grim than the U.S. government’s. Have our policy prescriptions been the right ones? The federal stimulus coupled with aggressive action by the Federal Reserve was needed to put a floor under the free-fall situation in the fall of 2008. But we should not have allowed foreclosures to be delayed, and mortgage loans, as well as mortgage-backed securities, should have been made to reflect the decreased value of real estate. How do we reconcile the fact that real estate prices in the U.S. have fallen by almost 40% in inflation-adjusted terms, but we have mortgage securities that are sitting on the books at the purchase price?
Banks should have been forced to recognize billions in losses in those securities instead of putting the losses off. Those loans are like albatrosses, weighing down lenders and households. Kicking the can down the road instead of acknowledging losses and taking the hit is not healthy for recovery. Anything that causes the public and private sectors to pay down debt and to free households to spend in ways that are healthy to the economy will help bring us out of this situation faster.
What do falling home prices mean for banks that are still grappling with bad mortgages? We have loans that are tied to real estate prices that have not shown any sign of important recovery. These loans are zombie loans -- they should be in default but have not yet been written down. Just as happened in Japan, real estate prices looked as if they were stabilizing last year, but now they have softened again. As unpleasant as it is, taking write-offs and ridding the balance sheet of that debt is constructive for both financial institutions and households.
What should Uncle Sam be doing now? We need something constructive to signal that the budget mess will be addressed and that we will deal with our debt. We’re still generating big deficits. Our public debt is building up. We have serious liabilities with Social Security and Medicare. The government may still need to rescue the nation’s largest banks should the real estate market, the economy or both continue to deteriorate.
Is the U.S. facing a fiscal crisis? A fiscal crisis is not around the corner because the dollar is held in significant quantities by governments around the world and because the U.S., Europe and Japan all have problems. And, frankly, our problems are not as bad as those of the rest. So as we muddle through, crisis is not around the corner, but neither is recovery.
Any thoughts on the European debt crisis? The European Union has been kicking the can down the road by bailing out member countries with debt problems. That approach is a Band-Aid and can only go on for so long. Greece, Portugal and Ireland need to restructure their debt -- and that will happen at some point. If the restructuring is done in a favorable environment with the support of the European Union, instead of in a disorderly fashion, I don’t foresee it posing a risk to the global financial system because the market and the authorities are already attuned to the situation.
For a bonus question and answer from Reinhart on the similarities between the economic situations in the U.S. and in Ireland, become a fan of Jennifer Schonberger on Facebook.
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