Democrats have a problem talking about the economy. Exit polls from this week’s midterms showed that 70 percent of voters believe economic conditions are poor, and nearly two-thirds think the system favors the wealthy. One of the excuses you hear from party apologists is that it couldn’t really be any better: Severe financial crises, like the one we experienced in 2008, automatically lead to weak economic recoveries. Therefore, the country’s relative improvements over the past six years represent real progress, even if people aren’t feeling it.
President Obama has made this case. So has Bill Clinton. You can find a chart comparing post-Great Recession employment data to other financial crisis; by this metric, the administration’s record looks pretty solid. This theory has an intellectual pedigree, too. It comes from economists Carmen Reinhart and Kenneth Rogoff’s research, compiled in the book This Time is Different. Reinhart and Rogoff survey 300 years of economic history, and argue that during a financial crisis, when the supply of credit diminishes, the average country’s gross domestic product (GDP) plummets, and takes ten years to recover; in their model, political leadership makes little difference. But a new reassessment of Reinhart and Rogoff’s thesis, from a former member of Obama’s inner circle, suggest that they got it wrong.
Christina Romer, former chair of the Council of Economic Advisers, and her husband David, both professors at the University of California-Berkeley, have written a new paper that finds post-financial crisis declines in advanced countries to be “on average only moderate, and often temporary.” More important, they find tremendous variability between the aftermaths of extreme crises, with no pre-determined outcome that holds in every case.
This completely upends the conventional wisdom, and puts the focus back on policymakers’ post-crisis response, rather than the supposedly unchangeable circumstances surrounding them. As Christina Romer told me in an interview, “Once you see that it is not inevitable, it really does lead you to say, ‘I want to be Sweden and not Japan.’”
Romer and Romer believe that previous studies suffered from too broad a survey of global financial crises. For instance, Reinhart and Rogoff’s claims of severe, prolonged downturns rely heavily on crises in emerging markets like East Asia and Argentina in the 1990s, as well as the chaos of the Great Depression. Advanced countries in the post-World War II period tend to have far better tools for handling a crisis, and they shouldn’t be lumped together with other cases. The harshness and stubbornness of financial crises themselves also differ widely, and should be weighted.
Finally, to make their case, Reinhart and Rogoff just measured the fall in GDP coincident with a financial crisis, whether it was attributable to it or not. For example, Reinhart and Rogoff find a big slump in Finland in the early 1990s, and blame financial distress for it. But Christina Romer points out that the dissolution of the Soviet Union, Finland’s main trading partner, produced much of the downturn. “The financial crisis doesn’t happen well over until halfway through fall in output,” Romer said. This significantly alters how we should read the results.
For their paper, Romer and Romer looked at contemporary data from 24 advanced countries from 1967-2007. They ranked the severity of financial crises in these countries, defined as a reduction in the supply of credit amid stressed bank balance sheets and rising loan defaults, on a scale from 0-15. To make this assessment, they consulted accounts of conditions from the Organizations for Economic Co-Operation and Development (OECD), cross-checking with annual central bank reports and Wall Street Journal articles from the time period. Having ranked the crises, from France in 1991 at the low end to Japan in 1998 at the high end, they then investigated their impact on industrial production and GDP.
The results differ greatly from Reinhart and Rogoff. A moderate crisis, ranked 7 on their scale of 0-15, leads to a “quite modest” fall in output, the economists write, and “the effect starts to recede after six months and is completely gone after two years.” When you take the “lost decade” of Japan, which experienced a prolonged drop in GDP in the 1990s, out of the equation, the result is even smaller and more transitory.
“When you do look at those countries, you say, something happens but it’s just not that big,” Christina Romer said. Referring back to her and her husband’s historical work on monetary policy, she explains that on average, “in a financial crisis, industrial production falls about 4 percent, but following a shift to contractionary monetary policy, it falls 12 percent.” In other words, the economic consequences from financial distress pale in comparison to ordinary changes in policy.
Reinhart and Rogoff have disputed the Romers’ methodology, particularly the use of OECD data and the exclusion of emerging economies. But Christina Romer doesn’t see the paper as an attack on Reinhart and Rogoff, but on the conventional wisdom that their research helped spawn, hawked in the media and on Capitol Hill, that financial crises always lead to terrible recessions and very slow recoveries.
This revelation leads Romer and Romer to question our current economic predicament. The 2008 crisis was obviously very severe and global in nature, which they readily acknowledge (Romer and Romer stopped their study at 2007, but the 2008 crisis would certainly have been at the high end of the scale). And central banks had already cut interest rates to near-zero levels, their usual response mechanism to a recession, which limited their tools to address it (although, as the Bank of Japan is trying to demonstrate through its expanded asset purchase program, central banks have options beyond interest rates).
But that doesn’t mean that policymakers had no alternatives but to sit back and endure the hardship. The paper asks whether the failure to reduce debt for underwater homeowners—an argument popularized by economists Atif Mian and Amir Sufi—played a role in the weak recovery. And they cite premature austerity measures in the U.S. and Europe as another possible explanation. “Maybe the policy response was just bad,” Christina Romer said.
This should hit U.S. policymakers like a thunderbolt. Their choices, not the mere existence of the 2008 crisis itself, must bear some blame for our sluggish economy. “It’s destructive to say, ‘it was inevitable, so why even try,’” said Christina Romer.
The paper should lead policymakers to think about optimal policies not only after a crisis develops, but also in advance of the next one. “It does change the policy discussion,” Christine Romer said. “Maybe it becomes important that you have your government budget at a point where you can really run a big expansionary fiscal program. Or maybe our inflation target should be 3 percent instead of 2 percent, so we’re less likely to hit the zero lower bound if we’re hit with a terrible financial crisis.” Invoking Reinhart and Rogoff has become a crutch. It’s important for the Romers’ research to supplant the conventional wisdom, so that the next time policymakers claim that they just can’t help people when the banks screw up the economy, we can respond with the immortal words the great John Vernon said to Senator Lane in The Outlaw Josey Wales: “Don’t piss down my back and tell me it’s raining.”