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Liveblogging World War II: August 21, 1941

Mammoth Failures of Economic Governance

Gavyn Davies:

What went wrong with the global recovery?: As recently as six months ago, mainstream economic forecasters were expecting real GDP growth to be comfortably above trend in 2011, and surveys of business activity were hitting new peaks. Of course, everyone knew that the underlying condition of the western economies was still very weak, but that did not seem to be sufficient to prevent a continuing normalisation of economic activity, with GDP returning slowly towards pre-recession trends.

We now know that these expectations were extremely complacent. Real GDP growth in the US has slumped to around 1 per cent annualised in the first half of the year, and continental Europe has performed no better in Q2. Forecasters like Goldman Sachs and JP Morgan now estimate that the probability of renewed recession in the US is around one third. So what has gone wrong?...

Two adverse factors have been at work on the supply side of the global economy. The natural disasters... global oil supplies....

Now let us turn to factors which relate exclusively to the demand side of the global economy. First, macroeconomic policy has been tightened.... [E]xpenditure cuts by the state and local government sectors.... In the UK, fiscal tightening has been running at about 2 per cent per annum, and in peripheral Europe the austerity programme is now much bigger than that.... [T]he extent of the tightening which has occurred in 2011 has come as a surprise.... Furthermore, self inflicted policy failings in the US and the eurozone in recent weeks have resulted in financial stress and widening credit spreads.... The final factor, which could turn out to be the most enduring, is the process of debt deleveraging in the western economies. This has left households in a much weaker state to cope with oil and policy shocks than is normally the case. Instead of dipping into savings when faced with temporary shocks, households have rapidly reduced their spending, so a weakening in consumption has been one of the main demand side causes of the global slowdown.

Economists like Richard Koo and Ken Rogoff talk of “balance sheet recessions” and a “second great contraction” as if they are entirely unfamiliar developments. They certainly are different from the recessions we have seen outside of Japan in the post-war period, but they could equally be described as a chronic and persistent shortage of demand...

I think that this is wrong. Koo and Rogoff (and Reinhart) make the point that these are not entirely unfamiliar developments: indeed, those of us who knew our economic history, or even what happened in Japan in the 1990s, were familiar with them.

The first real big question is: why have mainstream economic forecasters been so optimistic, at every stage, over the past four years? The second real big question is: why did policy makers believe them to such an extent that they made no plans for what to do if things broke for the worse: The third real big question is: why haven't policymakers reacted to the market's downgrading of prospects by taking steps to stabilize demand?

These are all mysteries to me.