The green shoots are weeds growing through the rubble in the ruins of the global economy, by Willem Buiter

from an article by Willem Buiter, Professor of European Political Economy, London School of Economics. The full article, dated yesterday, 8 April, titled "The green shoots are weeds growing through the rubble of the ruins of the global economy", may be found on Professor Buiter's Financial Times blogsite at ft.com/maverecon.


April 8, 2009

The Great Contraction will last a while longer This financial crisis will end. The Great Contraction of the Noughties also will come to an end. But neither the financial crisis nor the contraction of the global real economy are over yet. As regards the financial sector, we are not too far - probably less than a year - from the beginning of the end. The impact of the collapse of real economic activity and of the associated dramatic increase in defaults and insolvencies by non-financial enterprises and households on the loan book of what is left of the banking sector will begin to show up in the banks' financial reports at the end of the summer and in the autumn. By the end of the year - early 2010 at the latest - we will know which banks will survive and which ones are headed for the scrap heap. With the resolution of the current pervasive uncertainty about the true state of the banks' balance sheets and about their off-balance-sheet exposures, normal financial intermediation will be able to resume later in 2010.

Governments everywhere are doing the best they can to delay or prevent the lifting of the veil of uncertainty and disinformation that most banks have cast over their battered balance sheets. The banking establishment and the financial establishment representing the beneficial owners of the institutions exposed to the banks as unsecured creditors - pension funds, insurance companies, other banks, foreign investors including sovereign wealth funds - have captured the key governments, their central banks, their regulators, supervisors and accounting standard setters to a degree never seen before.

I used to believe this state capture took the form of cognitive capture, rather than financial capture. I still believe this to be the case for many, perhaps even most of the policy makers and officials involved, but it is becoming increasingly hard to deny the possibility that the extraordinary reluctance of our governments to force the unsecured creditors (and any remaining non-government shareholders) of the zombie banks to absorb the losses made by these banks, may be due to rather more primal forms of state capture.

History teaches us that systemic financial crises are protracted affairs. A most interesting paper by Carmen M. Reinhart and Kenneth S. Rogoff, "The Aftermath of Financial Crises", using data on 10 systemic banking crises (the "big five" developed economy crises (Spain 1977, Norway 1987, Finland, 1991, Sweden, 1991, and Japan, 1992), three famous emerging market crises (the 1997-1998 Asian crisis (Hong Kong, Indonesia, Malaysia, the Philippines, and Thailand); Colombia, 1998; and Argentina 2001)), and two earlier crises (Norway 1899 and the United States 1929) reaches the following conclusions (the next paragraph paraphrases Reinhart and Rogoff).

First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent over six years; real equity price declines average 55 percent over a downturn of about 3.5 years. Second, the aftermath of banking crises is associated with large declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, but the duration of the downturn averages around 2 years. . . . . .

Conclusion

There are signs that the rate of contraction of real global economic activity may be slowing down. Straws in the wind in China, the UK and the US hint that things may be getting worse at a slower rate. An inflection point for real activity (the second derivative turns positive) is not the same as a turning point (the first derivative turns positive), however. And even if decline were to end, there is no guarantee that whatever growth we get will be enough to keep up with the growth of potential. We could have a growing economy with rising unemployment and growing excess capacity for quite a while.

The reason to fear a U-shaped recovery with a long, flat segment is that the financial system was effectively destroyed even before the Great Contraction started. By the time the negative feedback loops from declining activity to the balance sheet strength of what's left of the financial sector will have made themselves felt in full, financial intermediation is likely to be severely impaired.
All contractions and recoveries are primarily investment-driven. High-frequency inventory decumulation causes activity to collapse rapidly. Since inventories cannot become negative, there is a strong self-correcting mechanism in an inventory disinvestment cycle. We may be getting to the stage in the UK and the US (possibly also in Japan) that inventories stop falling an begin to build up again.
An end to inventory decumulation is a necessary but not a sufficient condition for sustained economic recovery. That requires fixed investment to pick up. This includes household fixed investment - residential construction, spending on home improvement and purchases of new automobiles and other consumer durables. It also includes public sector capital formation. Given the likely duration of the contraction and the subsequent period of excess capacity, even public sector infrastructure spending subject to long implementation lags is likely to come in handy. A healthy, sustained recovery also requires business fixed investment to pick up.

At the moment, I can see not a single country where business fixed investment is likely to rise anytime soon. When the inventory investment accelerator goes into reverse and starts contributing to demand growth, and when the fiscal stimuli kick in, businesses wanting to invest will need access to external financing, since retained profits are, after a couple of years of declining output, likely to be few and far between. But with the banking system on its uppers and many key financial markets still dysfunctional and out of commission, external financing will be scarce and costly. This is why sorting out the banks, or rather sorting out the substantive economic activities of new bank lending and funding, that is, sorting out banking , must be a top priority and a top claimant on scarce public resources.

Until the authorities are ready to draw a clear line between the existing banks in western Europe and the USA, - many or even most of which are surplus to requirements and have become parasitic entities feeding off the tax payer - and the substantive economic activity of bank lending to non-financial enterprises and households, there will not be a robust, sustained recovery.