Carmen Reinhart and Kenneth Rogoff’s book, “This Time is Different,” has become the bible of the Obama administration. Their claim that recoveries after financial crises are naturally much slower than other recoveries has given President Obama a lot of cover. Their argument may be widely accepted by the media but has not been so readily accepted by economists.
Reinhart and Rogoff lashed out at academic critics a couple of weeks ago with an opinion piece in Bloomberg and again recently on CNN, attacking economists who disagree with them as blinded by support for Mitt Romney.
Our current recovery has been the weakest since at least World War II. Thirty-nine months since the recovery started in June 2009, job growth has been only 2 percent. During the average recovery since 1970, job growth over the first 39 months has averaged over 8 percent. The current recovery has failed to keep up with the growth in the working age population. Unlike past recoveries, much of the drop in the unemployment rate simply reflects people giving up looking for work. And there is no doubt there was a financial crisis.
But the financial crisis is not the explanation for the slow recovery.
The problem for Reinhart and Rogoff is that neither US historical data nor recent international comparisons support their assertion. Indeed, their claim is at odds with two well-known stylized facts:
1) Severe recessions are matched by strong recoveries, known as Zarnowitz’s law (the basis for Milton Friedman “plucking model” introduced in 1964 and supported by direct evidence in 1993).
2) Most severe recessions are accompanied by banking crises. Put these two stylized facts together, and even before looking at the data, you have to be somewhat skeptical about the Reinhart-Rogoff generalization.
When you do look at the data the results are clear. In five of the six financial crises since 1882 – the Great Depression of the 1930s was the sole exception – the strength of the recovery in real Gross National Product greatly exceeds the previous decline, by close to 6 percentage points over the eight quarters following the cyclical trough. This is similar to what we see in the two severe contractions in which there are no financial crises. The recent recession and recovery are more similar to the Great Depression than the other episodes.
Cross-country comparisons tell a similar story. Unemployment actually recovered faster in countries hit by a financial crisis than in those in a recession for other reasons. Of the nine foreign countries for which the Bureau of Labor Statistics has produced comparable unemployment data based on the same definition of unemployment, Reinhart and Rogoff identify four as suffering from a financial crisis (Germany, Japan, the Netherlands and the United Kingdom) and five as not (Australia, Canada, France, Italy and Sweden). From January 2009 to December 2011, the unemployment rates in the countries with financial crises actually increased less than in those that avoided such a crisis (0.66 percentage points versus 0.86 percentage points).
Countries identified as suffering a financial crisis by Reinhart and Rogoff also did not experience slower Gross Domestic Product (GDP) growth during their recoveries. From the third quarter of 2009, when the U.S. recovery started, the difference in GDP growth between the two sets of nations averaged just one-tenth of 1 percent.
The combination of Obama’s stimulus, multiple jobs bills and massive new regulations on everything from financial markets, housing, health care, credit cards and energy is a possible explanation for the difficulties in the U.S. labor market. Resources spent by the government must come out of someone’s pocket. Spending almost $1 trillion on various stimulus projects means moving around a lot of resources and jobs. People don’t instantly move between jobs, temporarily increasing unemployment. All the new regulations are similarly detrimental. And more regulations may be coming, creating substantial uncertainty about the future.
Canada provides a simple comparison. Our unemployment rates increased in lock step from August 2008 until six months later, in February 2009, when the stimulus was passed in the United States. The increased gap when the stimulus was passed is consistent with the stimulus, not something unique about the financial crisis, being the initial development that made things worse. Since the stimulus largely ended by the middle of 2011, the gap has decreased.
Americans have suffered two very slow recoveries – during the Great Depression and now. The most obvious common factor in both has been the Keynesian policies and massive regulations used to “cure” those downturns. Clearly, “financial crisis” can’t explain the current slow recovery.
Jerry Dwyer is the former Vice President and Director of the Center for Financial Innovation and Stability at the Federal Reserve Bank of Atlanta. James Lothian is is distinguished professor of finance at Fordham University and former vice president in charge of financial research at Citibank/Citicorp.