Die Zeit, Germany

The U.S. Recession Will Be Long and Hard

By Fabian Lindner

January 22, 2008

Germany - Die Zeit - Original Article (German)

Or, the recession in the United States will very likely not be a “sugar-lick”. Kenneth Rogoff, former chief economist of the IMF, and the prestigious financial market expert Carmen Reinhardt have dealt for years with such crises. In a recent research paper that compares the US-Subprime crisis, which currently is causing the global economists to hold their breath, ugly parallels are drawn with past crises. Because past financial crises have led regularly to long growth break-downs. It would be unusual luck if the United States were any different.

Probable-sounding arguments, as to why the fast rising US fortune prices were fundamentally justified and not, as in the past, a consequence of irrational over vogue, were short on truth. "This time everything is different," so investors and economists said - no bubbles, but probably solid prospects for steadily rising profits to push prices. Thus, increases in house prices motivated the development by the innovative U.S. financial markets of exciting new financial products, which would allow a higher debt without dealing with higher risk. This financial innovation, making the US financial markets more liquid and more attractive to investors, attracted investment capital, especially from Asia and the oil-exporting countries.

The strong growth in productivity, it has been argued, justifies the expectation of permanently higher yields and hence the sharp rise in stock prices. greater risk of economic discontinuity seemed to be eliminated for the United States.

The economists called it the "The Great Moderation". In this best of all possible worlds, the record current account deficit was fundamentally justified. Internationalized financial markets ensured that foreign investors invest their money in the place with the highest rate of return with low risk - the United States. Asset price bubble? - the fundamentals are in order!

With the fall in real estate prices in the summer of 2007, all of this beautiful economic miracle fairy tale was shattered. And it showed that in the United States, not everything is different. The credit markets are in crisis, and banks have assets in the billions and make loans to businesses as short-term investments. Consumers who, due to rising house prices, had felt richer, and consumed much but had saved little, if any, must now put a break on their consumption. Superior financial markets; mad productivity growth.

Rogoff and Reinhardt show that the emerging crisis follows a pattern. The two scientists investigated 18 financial and banking crises in developed countries. They found that a crisis caused an average drop in the per-capita economic growth of two per cent. A country recovers only after about two years. Hit especially hard were Spain in the late seventies, Norway in the late '80s and Finland, Sweden and Japan in the early 90s. There was economic growth, on average, was impacted by as much as five percent, and a real recovery was still not complete after three years. That was the maximum negative growth, according to Rogoff and Reinhart, that the United States in the next few years can be expected to suffer.

The patterns of all crises are all the same: Houses and stock prices rose strongly on the back of both private and public debt and also because foreign investors wanted to play, creating high current account deficits. If asset prices fall suddenly, then sooner or later, a collapse in growth followed. In the case of the USA, in particular, the rise in houses prices and the current account deficit are more pronounced than in previous crises, which does not bode well. Until recently the stock prices had kept rising.. Rogoff and Reinhart believe that the Fed had to inject large liquidity rapidly. it seems that there is nothing more that can be done to help. In the past week, the major US stock index S & P 500 fell by 5.4 percent.

Even in the causes of the crisis, the two economists see parallels with the past. Rogoff and Reinhart stress that of liberalization of financial markets preceded the majority of crises. Although the United States in recent years saw no legal liberalization, it saw extensive practical liberalization. One has only to think of the many new financial products with abbreviations like the names of robots from Star Wars to understand the bank’s now considerable problems. Or unregulated constructs, such as the so-called "Special Investment Vehicles" (SIV).

How bad the slump in the U.S. economy will actually be - whether nearer minus two percent or minus five percent - can not be said. However that it cannot be easily prevented, seems to have already been taught.

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