Don Johnson is chief economist for Caterpillar Inc. The views and analyses in this article are those of the author and not of Caterpillar. Caterpillar is not responsible for any statements or omissions herein.
During the past year, the world economy faced its greatest crisis since the Great Depression of the 1930s, with a repeat of that unfortunate experience uncomfortably close. Aggressive actions by governments and central banks prevented such a disaster, and the world economy is growing again.
However, few are optimistic about the prospects for either a strong or lasting recovery. Many worry central bank policies will create more inflation and another financial crisis down the road. Below I would like to share my views on the cause of the severe worldwide recession, the factors driving a recovery and prospects for that recovery.
U.S. Homeowners Shouldn’t Take All the Blame
A common explanation for the financial crisis/recession is that low interest rates earlier this decade triggered a housing boom in the United States. The public used shaky financing to overpay for homes, and financial institutions sold bad mortgage paper throughout the world. When housing collapsed, so did financial institutions and the world economy.
The above is more an outcome than a cause. A careful review of key events suggests the more usual culprits for economic problems—central banks raised interest rates too high:
- The Federal Reserve started in June 2004, and in two years, took the biggest rate increase since the early 1980s recessions. By early 2005, this tightening began reducing liquidity in the banking system. Automobile sales, including imports, peaked in July 2005, and freight movements peaked in February 2005. Commercial property prices began declining in the last half of 2007, despite no signs of overbuilding.
- The European Central Bank started raising interest rates in December 2005 and took its last increase in July 2008, shortly after the start of a severe recession.
- The Bank of Japan started tightening in mid-2006, causing a severe recession in October 2007. Economic output fell more than eight percent.
- Developing countries—star performers in the last upturn—were less aggressive in raising interest rates, and many recovered quickly from setbacks.
Widespread increases in interest rates, coupled with reduced liquidity in the larger economies, were too much for the financial system. The first wake-up call occurred on August 9, 2007, when BNP Paribas suspended three funds heavily invested in subprime mortgages. U.S. commercial paper markets froze, and central banks throughout the world intervened to support financial markets.
The next major crisis occurred on March 16, 2008, when the Federal Reserve backed a takeover of Bear Stearns, saving it from bankruptcy. Tensions simmered until September 2008 when, in quick order, the federal government acquired Freddie Mac and Fannie Mae, Bank of America bought Merrill Lynch, Lehman Brothers filed for bankruptcy, and the Federal Reserve had to prop up AIG. Eurozone governments launched a $2 trillion program to support their banks.
Heading Back to the 1930s
Financial stress and recessions in the world’s three major economies took their toll on the world economy in late 2008. Industrial production plunged at a frightening pace in many countries. Japan saw output drop 37 percent in a year, surpassing its decline during the Great Depression. Production in other large economies, including the United States, the Eurozone, Brazil, Russia and Turkey, dropped 15 to 20 percent in less than a year.
Weak demand and difficulties in obtaining trade financing disrupted world trade. At the worst, world trade volume fell almost 20 percent from a year earlier, the largest decline in at least 50 years. This period was the most perilous for international trade since the 1930s.
Economic turmoil sent already-struggling stock markets spiraling downward. Russia fared the worst, with stock prices bottoming 80 percent below the prior peak. That drop almost matched the 85-percent decline in U.S. stock prices during the early 1930s. Peak-to-trough declines ranged between 50 and 70 percent in the United States, Japan, Australia, Brazil, China and India. These declines hammered personal wealth, turning consumers cautious.
Falling home prices dealt another blow to personal wealth. Home prices dropped in China, Japan, Canada, Australia and many European countries. Prices declined in the United States more than during the Great Depression, contributing to the lowest housing starts since World War II.
The worldwide recession/financial crisis caused extensive personal misery, with an estimated 90 million people in the world falling into poverty. Since the start of the credit crisis, the number of unemployed in 35 countries increased by 18 million, or one-third.
Economic Policies Finally Turned More Aggressive
The world’s central banks and governments initially responded cautiously to the credit crisis and signs of economic weakness. Some evidence: the financial crisis persisted for about 21 months, the U.S. recession was the longest since the 1929–32 depression and the world economy will likely experience its worst postwar decline in 2009.
The economic turmoil in fourth quarter 2008 overcame central bank concerns about inflation and government fears of moral hazard—the belief that aiding failing banks would encourage other banks to take future risks. Economic policies became more aggressive.
Experiences from the 1930s show the following actions helped start recoveries:
- Slash interest rates.
- Significantly increase the money supply to encourage more spending.
- Expand government spending to help offset weakness in private spending.
- Don’t defend currencies if they weaken.
The above measures provide useful benchmarks for judging the likely effectiveness of current policies.
Most central banks cut short-term interest rates to record or near-record lows. Rates in the United States and Canada are lower than they were in the Great Depression, and the United Kingdom has the lowest rates since 1694. Sweden beats all countries, with the lowest rates since 1688.
In the United States, money available for spending, after accounting for inflation, is increasing at the fastest pace since at least the late 1950s. Growth in available money is accelerating in the Eurozone, and China’s 28-percent growth in its money supply helped push third quarter 2009 economic growth to almost nine percent.
In late 2008/early 2009, governments introduced additional spending programs. Collectively, they total about $3.7 trillion and should add about three percent to the world economy in the last half of this year and the first three quarters of 2010.
Budget deficits will soar but should start to shrink as economies improve. The U.S. budget deficit should peak at about 11 percent of the economy’s output—well below the World War II peak. Government spending helped soften the recession and contain human misery.
Since early 2002, the weakening of the U.S. dollar reduced the trade deficit, and further gains from trade this past year offset some weakness in the economy. However, the trade deficit is still large, so further dollar declines are possible, particularly against Asian currencies.
Economic Policies Are Working
Industrial production has improved in 38 countries—one sign of improvement. South Korea has nearly recovered all lost output, and both China and India reached new highs. Output is recovering strongly in both Brazil and Russia. Developing countries will lead this recovery, just like they did in the one earlier this decade.
Financial markets are improving. Credit spreads (differences between higher-risk interest rates and low-risk interest rates, such as Treasury debt) have shrunk significantly from late 2008 peaks. The spread for bank-to-bank lending returned to normal and bond spreads declined sufficiently to encourage more issuances.
U.S. commercial paper outstanding increased during the past 11 weeks, rebounding from the 52 percent decline that started in August 2007. Commercial bank lending is still declining, so some
problems remain.
The Japanese economy grew in the second quarter of 2009, as did many developing economies. Early reports suggest even stronger third-quarter growth. The U.S. economy grew at a 3.5-percent rate in the third quarter, despite another massive inventory drawdown. So the world economy should have grown in the third quarter, ending the world’s worst postwar recession.
Many fear deep declines in production, high unemployment and financial difficulties doom the world economy to a slow recovery. Historical evidence suggests otherwise:
- By early 1933, the U.S. economy was in far worse shape than today. The unemployment rate was over 25 percent, more than 60 percent of corporations were losing money and 45 percent of the banks existing in 1929 had closed. About half of urban home mortgages were delinquent. Improved bank liquidity led to almost 11 percent average yearly economic growth from 1934 through 1936.
- The recovery from the severe 1937-38 recession was also robust. With improved liquidity, the economy grew almost 8.5 percent yearly in 1939-40.
- Severe recessions occurred in the United States in 1957-58, 1973-75 and 1981-82. Within six months after those recessions ended, growth rates soared above six percent.
Another concern is that recovery will quickly give way to another recession. However, recoveries usually persist until economic policies change. The United States had 27 economic recoveries since 1854; the shortest was 10 months and the average was 33 months.
The United States, Europe and Japan are not in positions to tighten economic policies near-term. Consumer prices are declining and unemployment is still rising. Justifying interest rate hikes would be politically difficult.
So the most likely outcome is a good economic recovery, with 2010 growth in many countries better than in 2008. The return to the rapid growth of the best years in the past recovery will likely have to wait until 2011.
Lessons From the Crisis
In looking back, I find it hard not to conclude that the crisis could have been avoided, or at least much diminished. Inflation had not worsened enough to justify the interest rate increases taken, and financial markets sent many distress signals over a long period. The necessary policy corrections came very slowly.
The cost of this crisis has been enormous. Billions of dollars in output were lost, which reduced living standards for the world’s population. Employment data for the United States are dreadful, with the worst employment rates for the youngest workers since at least 1947 and record-high long-term unemployment rates.
Inflation is low, and most economies have considerable idle capacity. So the potential exists for a long period of strong economic growth. Achieving that potential while avoiding an inflation problem will require scaling back, not eliminating, growth-oriented economic policies now in place. iBi
