Thoughts on Reinhart and Rogoff’s “Second Great Contraction”

I am spurred to discuss macroeconomic matters due a couple of recent articles.  One was written by Drs. Kenneth Rogoff and Carmen Reinhart, of whom I have written many times.  They argue that the economy of the past several years was not just a larger or ‘great’ recession but something worse, in contrast to the view of the Federal Reserve and many others that this was just worse than other recessions but not qualitatively different.

From the body of their article :

We … have consistently argued that the popular term “Great Recession” is something of a misnomer for the current episode, which we have argued would be better thought of as “the Second Great Contraction” (after Milton Friedman and Anna Schwartz’s characterization of the Great Depression as the Great Contraction)…

Figure 1 (attached) compares the still unfolding (2007) financial crisis with U.S. systemic financial crises of 1873, 1893, 1907 and 1929. As the figure illustrates, the initial contraction in per-capita GDP is smaller for the recent crisis than in the earlier ones (even when the Great Depression of the 1930s is excluded). Five years later, the current level of per-capita GDP, relative to baseline, is higher than the corresponding five-crisis average that includes the 1930s. The recovery of per-capita GDP after 2007 is also slightly stronger than the average for the systemic crises of 1873, 1893 and 1907. Although not as famous as the Great Depression, the depression of the 1890s was dismal; in 1896, real per-capita GDP was still 6 percent below its pre-crisis level of 1892.

There is much more in this article.

It is difficult to see how Rogoff and Reinhart cannot be correct.  Even in the 1929-33 period, very little depositor’s money was lost.  Many banks closed, many of them very small ones, but often the losses were absorbed at the shareholder or director level.  In contrast, the largest financial institutions in the U.S. went bust or would have without extensive intervention.  Sheila Bair has written a book that now reveals what presumably we all knew, which is that Citigroup was insolvent in the crisis.  Fannie Mae, Freddie Mac, AIG, Wachovia, Lehman, Countrywide, on and on.  What this implies is absolutely massive mismarking of assets to liabilities, and an unimaginably large amount of bad investments.

The mis-matching of assets and liabilities for the above to have occurred must have been massive.  How can that not be reflected in the real economy for some time to come?

Last year, I analogized the remedy the authorities have prescribed in a post titled On Treating Economic Crises the Way We Treat Heart Failure.  To summarize, it argues that our modern economic doctors have made the same mistake as doctors of not long ago when they treated the syndrome of congestive heart failure.  We were taught that if the heart was weak, well then, it should be stimulated.  It turns out that doing so made the patient feel better for a while, but when one or two drug candidates were put to the test, they ended up overstimulating the heart.

Against prevailing wisdom, it turned out that the two best remedies to heal weak hearts were A) beta blockers, which temporarily weaken the heart in a manner that allows it to gradually gain strength over the intermediate and long run, with better duration and quality of life, and B) ACE inhibitors and their relatives, which neither stimulate nor weaken the heart but do help the heart and the entire body recover from the heart failure syndrome.  (Stimulants that strengthened the heart and led patients to feel better also shortened their lives.  The analogy with what might go wrong with over-stimulating post-Lehman is clear.)

While the authorities did their best when faced with the terrible circumstances in 2008-9 they did not anticipate, they followed a prescription for prior recessions.  This involved pulling future demand forward by lowering short term rates to near zero and keeping them there.  Innumerable speeches and comments from the Fed and the administration’s best economists show that they anticipated that economic growth would come to trend quickly.   They did not anticipate a sluggish recovery and now find themselves trapped in the emergency remedies of zero short term interest rates and money-printing, now called quantitative easing.

And despite all the support for the economy from Washington, the sales and profits cycle for public corporations may be pointing downward before anything like a full recovery has occurred.  From Reuters (LINK):

Sales stumbles raise fresh worry for corporate America

* Most companies that reported earnings missed sales expectations

* Slump showing limits of margin expansion

* ‘Crack in the armor’ of profit growth story

Here are some quotes:

A majority – 54.3 percent – of the 70 companies in the widely watched Standard & Poor’s 500 Index that have reported results so far have missed analysts’ revenue forecasts, according to Thomson Reuters I/B/E/S.

The list of companies’ reasons for weak performance has expanded, with some citing a decline in demand in the United States – until recently a more reliable source of growth – as well as in Europe, which is mired in a debt crisis.

American Express warned that its cardmembers’ spending was starting to wane…

International Business Machines Corp, the world’s largest technology services company, missed analysts’ sales forecasts for a fifth consecutive time with a 5 percent drop in the third quarter, as corporate customers in the United States and Canada cut their spending on equipment and services.

What, you ask, about earnings?  The article goes on:

Of the S&P 500 companies that have reported so far, 64.3 percent have beaten Wall Street’s lowered expectations. At the start of the third quarter on July 1, analysts expected those 500 companies to collectively increase profits by 3.1 percent, a forecast that was cut to a drop of 2.1 percent by Oct 1.

I don’t know whether the U.S. is in a fresh recession, but falling corporate profits are a warning sign.  So is seeing so many companies ”miss” on sales.  So is the following from Business Insider (LINK):

Morgan  Stanley just published its October read on its proprietary Business  Conditions Index and it collapsed to 41% from 55% in September…

Despite the stronger than expected employment report for October, both hiring  indices fell to multi-year lows. The hiring index dropped 10 points to 44%, low  since December 2009, and the hiring plans index sunk 13 points to 44%, low since  August 2009.

Long term, continuation of the money printing as promised by the Fed almost guarantees higher stock and commodity prices over time.  In the short run, though, anything can happen.  Federal Reserve interest rate manipulation and direct purchase of securities from governmental or quasi-governmental mortgage agencies are meeting a cyclical business slowdown in the setting of a global economic down cycle. 

What will happen next (besides an election)?

I guess my only insight for the present is that corporate sales and earnings, and companies’ comments about the months ahead, provide an unfiltered view of economic trends.  While it’s somewhat early in earnings season, for the second quarter in a row corporations are not reporting much if any earnings growth.  In that setting, their averred concern about the issues that are referred to as the “fiscal cliff” makes it sound as though the current slowdown in earnings growth (or actual decline, especially in inflation-adjusted terms) might continue for a while. 



7 comments to Thoughts on Reinhart and Rogoff’s “Second Great Contraction”

  • David Pristash

    DoctoRx There is little doubt that what you and Drs. Kenneth Rogoff and Carmen Reinhart are saying is not true and also I concur with the reference to Milton Friedman and Anna Schwartz’s seminal work, which I have read. However there is another factor here that makes a purely economic review misleading.

    Those in power today have other agendas in mind then just getting us moving again. They see that they can remake the country into something different — a place that redistributes the wealth and income of the nation to those at the bottom. Helping those on the bottom is good but giving them things they have not earned has never worked.

    The Affordable health Care Act; Dodd-Frank financial reform act, Agenda 21 and along with the Cap and Trade legislation that didn’t get past were designed not to achieve the stated purposes but to transform the country in to one that was Central Planned. After reviewing these legislative monsters (and I have) one can not come to any other conclusion. Further to fix the problems that existed could have been done much quicker and simpler if that was the real goal; the principle of Oaccam Razor.

    The point is that, there is in all this legislation a structural shift being imposed on the country. One example (there are many more) the requirements that anyone that works 30 hours is now a full time employee and that companies over 50 employes must pay for health care.

    The results of this is that smaller companies will not go over 49 employees and in fact that they may split themselves up in to under 50 employes corporations to avoid that. And they will hire two people each working 24 hours a week instead of 1 working 40.

    The impact of the legislation now in the pipe line and that is about to hit starting next year is what is now holding back any growth. So we have the great contraction being amplified by the great legislation bubble that is about to sweep over us.

    • “Those in power today have other agendas in mind then just getting us moving again. They see that they can remake the country into something different — a place that redistributes the wealth and income of the nation to those at the bottom.”, quote D.P.
      This statement requires a challenge, a clarification, even a correction.
      “Those in power today” are the private for-profit banks and financial institutions who have taken control of the currency and are now using that currency as funding for their own governing. It is only a matter of time for when they will “govern” away most “entitlements” if not all.
      Perhaps we should listen to history:

      ““The banks — commercial banks and the Federal Reserve — create all the money of this nation and its people pay interest on every dollar of that newly created money. Which means that private banks exercise unconstitutionally, immorally, and ridiculously the power to tax the people. ”Jerry Voorhis (five terms US House)
      “All the perplexities, confusion and distress in America arises not from deficits in the Constitution or Confederation , nor from want of honor and virtue, so much as downright ignorance of the nature of coin, credit, and circulation, “wrote Adams in the very early 19th century America.”

      Even more pointedly, Adams charged that “Banks have done more injury to religion, morality, tranquillity, prosperity, and even wealth of the nation than they have done or ever will do good.”
      As Thomas Jefferson said,(12/26/11 N.B. Great quote, except that it’s not an exact quote-see notes))”‘I believe that banking institutions are more dangerous to our liberties than standing armies.If the American people ever allow private banks to control the issue of their currency, will deprive the people of all property… The issuing power (of currency) should be taken from the banks and restored to the people,to whom it properly belongs,’
      It is to be noted that it is perhaps someone else’s opinion of an interpertation of Thomas Jefferson’s fellings and beliefs about private banks
      “‘The system of banking [is] a blot left in all our Constitutions,
      which, if not covered, will end in their destruction…
      I sincerely believe that banking institutions are more dangerous
      than standing armies…’(Letter to Taylor 1816)
      “‘… the circulating medium must be restored to the nation to whom it belongs.’ (Letter to Eppes 1813)

      AS FOR AMERICA;””The Wealth of a Nation is in How it Redistributes Its Wealth”

    • John

      “Those in power today have other agendas in mind then just getting us moving again.”

      When has this not been true? Don’t be naive.

  • chris goodwin

    To David Pristash; line one: – “are saying is not true and also I concur”…

    Really ?

  • Perhaps a re examination of the 2001 and 2008 financial crises could possibly lead to a different solution.

    In 2001 the Fed had a choice between two solutions: 100% reserve or credit expansion.

    The Feds (Greenspan) choose “credit expansion”. It appeared to have worked.But in reality

    it only postponed the solution and in 2008 visible signs were shown that an even greater financial crisis was created. As von Mises stated,”There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

    Yet in 2008 the Feds (Bernanke) had as a choice between two solutions- 100% reserves or credit expansion; they choose “credit expansion”.

    Here is the flaw.

    Credit expansion is temporary.

    100% reserves is permanent.

    There is no other way to become solvent.

    The Fed has to power to mandate 100% reserves. To do so without a safeguard to prevent massive default (“systemic failure”) that must get the “deposits” from somewhere, someway other than credit expanstion.

    But as Keynes, Minsky, von Mises, Desoto, and many others (in particular Frederick Soddy , “The Role Of Money”) contend; there must be a separation between private for-profit banks and government.

    With this separation done , the Fed has the power to lend the “free banking system” all the currency needed to make them whole. Yes, even if $100′s of trillions is required. The Office of the Comptroller of the Currency reported US financial institutions have just in derivatives in excess of $230 trillion.

    Please challenge, clarify,correct.

    The unintended consequences from the lending of $200 trillion at 2% for 36 years to private for-profit banks could mean;

    the end of FICA,

    the end of federal income taxes,

    the end of the federal debt,

    the beginning of “The Redistribution of the Wealth ” for the pursuit of happiness”.

  • ***** “Believe nothing merely because you have been told it…But whatsoever, after due examination and analysis,you find to be kind, conducive to the good, the benefit,the welfare of all beings – that doctrine believe and cling to,and take it as your guide.”- Buddha[Gautama Siddharta] (563 – 483 BC), Hindu Prince, founder of Buddhism

  • DoctoRx

    LUCKYFOOL: Great quote from Buddha. You put a lot of thought into your first comment, and your input is welcomed.

    As far as David Pristash’s comments, they too contain a great deal of cogent thinking.