In a column posted on the International Monetary Fund’s (IMF’s) website, Economic Counsellor and Director of the IMF’s Research Department Olivier Blanchard describes why recessions caused by banking crises result in permanent damage to gross domestic product (GDP). In a typical recession (which, by the way, is a natural part of the economic cycle and should not be feared or reviled as much as it is), growth declines as consumers, exhausted from spending during the economic expansion, put their wallets away and concentrate on saving and reducing debt, which generally becomes more expensive as an economic expansion advances. Central banks react by lowering rates, which in turn lowers borrowing costs, to encourage spending. Most consumers and businesses will take advantage of lower borrowing costs to make purchases and investments on big-ticket items. This is why durable goods, such as cars and appliances, and major capital expenditure projects show major leaps as a recession ends. Growth then typically spikes above the previous trend line before settling back to normal and a new economic expansion begins.
A recession caused by a banking crisis is different for many reasons. But let’s begin with what the difference is before looking into the causes. A soon-to-be-released World Economic Outlook from the IMF studies 88 banking crises in various countries over the past four decades. Blanchard summarizes the study, “While there is large variation across countries, the conclusion is that, on average, output does not go back to its old trend path, but remains permanently below it.” However, while output drops permanently, putting a damper on the likelihood of a spike in the growth rate, the good news is that growth rates tend to return to normal eventually.
Among the biggest concerns Blanchard raises with regard to the possible return to the prior economic growth rate are:
- Supply-side: A lack of capital due to the damage done to the banking system and the failure of firms that would generally not have gone insolvent in a typical recession;
- Demand: Fiscal stimulus and inventory rebuilding are driving the recovery, neither of which is sustainable. There is some question as to whether private consumption and business investment return to levels necessary to sustain growth;
- Risk premiums: Higher risk premiums make borrowing and investing more costly, even with the federal funds rate and U.S. Treasury yields at historic lows;
- China: Would the country be willing to reduce is current account surplus, and thus the U.S.’s current account deficit, resulting in more U.S. imports? This would be ideal for both a U.S. and worldwide sustained economic recovery;
- U.S. dollar depreciation: If large fiscal deficits or some other shock causes a disorderly depreciation of the dollar and large capital outflows from the U.S., the resulting uncertainty and instability would almost certainly derail the recovery.
Blanchard’s column raises many key issues and markers concerning the economic recovery. Many, if not all, of these factors will be very important for investors to have an eye on as we continue to navigate a very challenging investment and economic environment for the next several years.
Here is a link to Blanchard’s column: Sustaining a Global Recovery
Gregg D. Killoren
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