In memory of Dr. Andreas Höfert

When do financial crisis end?

Economists agree more often than legend has it. When they debate in front of a broader public or in the media, this usually has more to do with defending specific political positions than having opposing views on scientific content.

However, a debate among economists that occurred during the US presidential campaign had not only a political background but also a rather formidable scientific line of questioning: What was the nature of the financial crisis we faced back in 2007/2008, and how much time would be needed for the US economy to recover?

Major participants in the debate included Carmen Reinhart and Kenneth Rogoff (hereafter R&R), who argued that the financial crisis of the type the US went through five years ago would need a long recovery process. Other contenders were Michael Bordo and Joseph Haubrich, followed at a later stage by John Taylor (hereafter B/H/T), arguing that the usual recovery after a deep recession like the last one should be rapid and vigorous.

One sees the political implications of both standpoints immediately. If R&R are right, then it is justified to defend President Obama by saying that it will be painful, long and tedious to clean up the economic mess he was left with when he took office. However, if B/H/T are right, then Mitt Romney’s claim that President Obama’s policies did more harm than good, delaying and weakening a recovery which should have occurred by now, cannot be dismissed.

There is some political background behind this debate. The exact positions of R&R are not known, though the economics faculty at Harvard, where they teach and research, has traditionally supported state-interventionism. However, both Michael Bordo and John Taylor signed the US economists’ support letter for Mitt Romney. John Taylor had even been considered a possible candidate to succeed Ben Bernanke at the US Federal Reserve in case of a Romney presidency.

All these economists are serious contributors. Reinhart and Rogoff were on many short lists this year for the Nobel Prize in economics. Their book This Time is Different can be considered an economic classic, and also has long been on bestseller lists for a broad public. Rutgers professor Michael Bordo has a well-deserved reputation as a deep thinking economic historian, who has published extensively on the Great Depression. Joseph Haubrich, an economist and a vice president at the Federal Reserve Bank of Cleveland, has an impressive academic publishing record. And Stanford professor John Taylor, also often named on Nobel Prize short lists, has authored numerous academic articles and several standard textbooks in economics. Moreover, he formulated the Taylor rule, which many central banks employ when assessing monetary policy.

So who is right and who is wrong? While the debate is fierce on the political side, the scientific answer after reading both arguments is, in my view, that no one is really wrong. The studies in fact address different types of problems and place their focus differently. This point was actually also stressed by Michael Bordo on Bloomberg: “… comparing their [R&R] finding with ours [B/H/T] is like comparing apples with oranges.”

Indeed, R&R focus on financial crises. To do this, they look not only at the US, but at many other crises all over the world in history, as the subtitle of their opus suggests: Eight Centuries of Financial Folly. They conclude that recessions associated with systemic banking crises tend to be deep and protracted and that this pattern is evident across both history and countries.

Richard Koo in his in-depth study of the Japanese experience after its financial crisis, The Holy Grail of Macroeconomics, delivers a theoretical framework to underpin R&R’s observations, which he defines as balance sheet recessions. But well before that, Irving Fisher, a leading US economist in the early 20th century, wrote his The Debt-Deflation Theory of Great Depressions in 1933. These works all suggest that given the tremendous build-up of the overall (private and public) US debt since the mid 1990s, from 240% to over 360% of GDP at its peak before the financial crisis, there will still be a long way to go before the deleveraging stops weighing on growth.

However, B/H/T also have a point, when looking at all the US recessions, including the 1973 and the 1981 recessions that were not provoked by a financial crisis due to overextended debt build-up: Growth rates from the bottom of the recession tend to be the fastest, the lower the bottom is. And since the bottom of the last recession of 2008/09 was quite low, the recovery should have been stronger. But here again, this is not what R&R are really focusing on: They are not looking only at the bottom of business cycles, but at financial crises overall, which in fact - as we have argued quite often - could reduce trend growth.

Ultimately, the whole debate shows that unresolved economic disputes should not be used as political arguments. I am afraid, though, that this will remain wishful thinking.