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History suggests plenty of time for capitulation [ClearOnMoney]
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History suggests plenty of time for capitulation

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Commentary

History suggests plenty of time for capitulation

31 Aug 2010 by Jim Fickett.

History suggests that the economy will require several more years to recover. This in turn suggests that those waiting for better asset prices will not be disappointed.

Carmen Reinhart, a well-known expert on the history of financial crises, gave a joint paper with Vincent Reinhart at the Jackson Hole economics meeting. The Financial Times has published a short piece by the pair, entitled, not very encouragingly, Beware those who think the worst is past. The first main message is that history suggests there is still a long road of painful adjustments ahead:

We have analysed data on numerous severe economic dislocations over the past three-quarters of a century; a record of misfortune including 15 severe post-second world war crises, the Great Depression and the 1973-74 oil shock. The result is a bracing warning that the future is likely to bring only hard choices.

Our research found real per capita gross domestic product growth tends to be much lower during the decade following crises. Unemployment rates are higher, with the most extreme increases in the most advanced economies that experienced a crisis. In 10 of the 15 episodes we studied, unemployment never fell back to its pre-crisis level, not in the following decade nor right up to the end of 2009.

It gets worse. Where house price data are available, 90 per cent of the observations over the decade after a crisis are below their level the year before the crisis. Median prices are 15 to 20 per cent lower too, with cumulative declines as large as 55 per cent. Credit is also a problem. It expands rapidly before crises, but post-crash the ratio of credit to GDP declines by an amount comparable to the pre-crisis surge. However, this deleveraging is often delayed and protracted.

Note that whereas most news commentary is about which of the upcoming months is going to bring relief, Reinhart and Reinhart are speaking in terms of years, or even decades.

They make an interesting observation on policy:

… at Jackson Hole, policymakers debated whether further measures to stimulate demand were needed. …

However, it is also possible that economic contraction and a slow recovery can dent aggregate supply, otherwise known as an economy’s ability to produce efficiently. In this scenario, much less discussed in current debates, a sustained stretch of below-trend investment, alongside the depreciation of human capital that comes from high unemployment, hits the level and growth rate of potential output. That is, the unemployment rate stays high because it has been high.

Importantly, this reduction in supply can also be caused by policy. In adverse economic circumstances, political leaders grasp for quick fixes that impair, not improve, the situation. The list of unfortunate interventions includes not recognising bank losses, as well as restricting trade (both domestically and internationally) and credit. In these cases the effects of crises might be persistent because we make them so.

There are many examples where the US government has damaged the future health of the economy by reaching for a quick fix. The home buyer credit, AIG, GM and Chrysler, and investment bankers come to mind.

Although Bernanke & Co. have spent a good deal of time congratulating themselves, my impression is that the US has so far handled this crisis at about an average level, compared to the historical record of such things. Hence Reinhart and Reinhart are right to warn that it could be several more years before we see the economy really pick up.

What does that mean for investing? One thing it probably means is plenty of time for capitulation. For the last year there has been much talk of the housing market stabilizing. But in fact problems were just being delayed. The high probability that foreclosures will get worse and remain elevated for a time measured in years rather than months suggests that house prices are not just likely to fall further, but to over-correct. The stock market may or may not rise this fall, but if it does, it will come down again as profits later this year and next begin to reflect a very sluggish economy. And so on. I do not think those waiting for better prices will be disappointed.