It's Worse Than You Think: Halftime Between Two Lost Decades [View all]

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http://www.theatlantic.com/business/archive/2012/06/its-worse-than-you-think-halftime-between-two-lost-decades/258260/

The global economy is in a synchronized swoon. Brazil's economy practically stalled out in the first quarter, all of China's manufacturing figures indicate much lower growth than last year, Britain remains in recession, Spain's banking system needs a rescue and may collapse, and the U.S. -- which had been the last remaining bright spot in the global economy -- suddenly has started sputtering. The number of jobs created in May was not just half as many as expected; the figures for the previous two months were sharply revised lower as well. And for good measure, GDP growth for the first quarter was revised downward too.

Many observers were surprised or disappointed, because they still do not understand the nature of this recession, which is neither exclusively cyclical, nor exclusively structural, but rather a rare collision of crises -- a financial recession, in the middle of a global slow-down, at the edge of a demographic time bomb.

THE FIRST HALF


First, this is not a normal demand-damp cyclical recession. In such a recession, demand has been driven upward by rising population and rising wages, faster than production can keep pace, and the result is inflation. To rein in that inflation, monetary authorities raise interest rates and/or governments reduce spending to reduce demand. The result is a dampening of demand that usually drops unemployment and spending and ends inflation. However, as soon as inflation is under control, interest rates can be lowered and government spending can resume; hiring then usually picks up as does overall demand and the economy again grows. The whole process is a bit like hitting the pause button, then the forward button, for the economy as a whole. In such a cycle, the basic relationship between economic growth and job and wage growth remains unchanged, hence the recession is only cyclical, not structural.

However, the current slump is a different kind of cyclical recession; it is a financial overleveraging recession brought on by an excess of debt rather than just demand. In such recessions, deregulation and unusually easy credit lead to enormous borrowing to invest in 'sure things' -- in this case, private residential housing (in other cases it has been sovereign debt, or property, or new technologies). People view this asset as so safe that they develop all kinds of ways to boost their leverage (e.g. debt to asset ratios) or get out risky loans to purchase those assets. This huge influx of buying power raises the price of the 'safe' asset to unsustainable, unrealistic levels; then when people start to realize that the risky loans will fail and the underlying asset is losing value, you get a collapse of the market and a financial bust. Both borrowers and firms that managed the debt are critically hit.