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70 Finance and economics The Economist December 16th 2017

Free exchange A lost decade

Governments prevented a second Depression, butleftthe world vulnerable
EN years ago this month, America entered the “Great Reces- mulate foreign-exchange reserves, which can be drawn on in cri-
Tsion”. A decade on, the recession occupies a strange space in sis. But these reserves add to a global glut of capital which de-
public memory. Its toll was clearly large. America suffered a cum- presses interest rates and encourages borrowing. Because
ulative loss of output estimated at nearly $4trn, and its labour reserves are so often held in the form of dollar-denominated
markets have yet to recover fully. But the recession was far less bonds, they can destabilise the American economy. They also
bad than it might have been, thanks to the successful application heighten the world’s exposure to American financial stumbles.
oflessonsfromtheDepression.Paradoxically,thatsuccessspared This regime helped turn an American housing bust into a global
governments from enacting bolder reforms ofthe sort that might crisis, and remains in place now. Although dangerous financial
make the Great Recession the once-a-century event economists vulnerabilities in America will take time to build up again, the
thought such calamities should be. present financial peace is likely to be far shorter than the 75 years
Good crisis response treats its symptoms; the symptoms of a that separated the Depression and the Great Recession.
disease, afterall, can kill you. On that score today’s policymakers
did far better than those of the 1930s. Government budgets have Big short memories
become a much larger share ofthe economy, thanks partly to the That would be less troubling had the world made itself more ro-
rise of the modern social safety net. Consequently, public bor- bust to future crises after the last one. In the years after the De-
rowing and spending on benefits did far more to stabilise the pression, sweeping banking and financial reforms created new
economy than they did during the Depression. Policymakers regulatory institutions and placed tight constraints on financial
stepped in to prevent the extraordinary collapse in prices and in- behaviour, which made finance a very boring industry for most
comes experienced in the 1930s. They also kept banking panics of the next half-century. From the 1980s to the 2000s, those re-
from spreading, which would have amplified the pain of the strictions were largely undone: banks were given freer rein over
downturn. Though unpopular, the decision to bail out the finan- theactivitiestheycouldengagein and productstheycould create.
cial system prevented the implosion ofthe global economy. The financial crisis could not have occurred without this liberal-
But the success of those policies, and the relatively bearable isation. Yet in its wake, the financial sector has been treated rela-
recession that resulted, allowed governments to avoid more dra- tively gently. Oversight and disclosure have been improved and
matic interventions of the sort which, after the 1930s, gave the capital-adequacy rules toughened (see previous story). But some
world halfa century of(relative) economic calm. By reducing the of these rules are now being relaxed, at least in America, and the
need for radical innovation, the speed and efficacy of the re- financial industry’s weight in the world economy has scarcely
sponse left the world economy less reformed and so vulnerable changed. As a share of American GDP it has actually increased
to the same forces that made the crisis possible in the first place. somewhat since 2007.
Several shortcomings stand out. In dealing with the Depres- The stabilisation policies used in the Great Recession were
sion, governments ultimately discarded the gold standard, the vastly superior to those of the Depression. But today’s govern-
global currency regime that helped propagate the disaster. Coun- ments have done a worse job of learning from experience than
tries on gold sacrificed monetary-policy independence, and had did their forebears. Franklin Roosevelt did not simply seek to re-
to respond to a lossofmarketconfidence with an economy-bash- store growth. Rather he promised reflation in order to make up
ing increase in interest rates, for instance. The system transmitted the ground lost during the downturn. After the Great Recession,
distress around the world. When one country acted to build up in contrast, most central banks (the BankofJapan being a notable
its gold reserves, others saw a sudden drain on theirs. The sooner exception)werecontenttopreventpricesfalling, and have notac-
a country left gold in the1930s, the soonerits recovery began. tivelyworkedtomakeuplostoutput. Asa result, the recovery has
But the international system that facilitated the more recent fi- been much weakerthan in previouscycles, includingthe Depres-
nancial crisis has been neither abandoned nor reformed. Open sion(seechart),andmonetarypolicyhastaken longerto return to
capital flows can put countries at the mercy of sudden swings in normal, leaving economies poorly prepared for the next reces-
market sentiment. To manage this, many emerging markets accu- sion. Similarly, the Great Recession demonstrated the value of
automatic fiscal stabilisers, but governments failed to seize the
opportunity to link tax and benefits more closely to the business
cycle. Indeed, rules that have recently been adopted, such as Eu-
Not so manic
United States, real GDP per working-age adult, 16- to 64-year-olds rope’s fiscal compact, constrain ratherthan harness fiscal policy.
First year of recession=100 The Depression enabled radical change by discrediting un-
120 trammelled capitalism and the elites who supported it. That had
dangerous side-effects: it also empowered fanatical and danger-
110
ous political outsiders. Though financial and political elites were
The Great Recession 2007
100 not spared a populist backlash after the Great Recession, they
*
have largelykepttheirseatatthe table, blockingthe enactmentof
90
The Depression bolder reforms. The success of the response to the downturn
80
1929 helped avoid some ofthe disasters ofthe 1930s. But it also left the
fundamentals of the system that produced the crisis unchanged.
70 Ten years on, the hopes of radical reform are all but dashed. The
sad upshot is that the global economy may have the opportunity
60
1 2 3 4 5 6 7 8 9 10 11 12 13 to relearn the lessons ofthe past rathersoonerthan hoped. 7
Years after recession
Sources: BEA; US Census data *Forecast from 2017
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