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The Slump Goes On: Why?

Nouriel Roubini; drawing by John Springs

In the winter of 2008–2009, the world economy was on the brink. Stock markets plunged, credit markets froze, and banks failed in a mass contagion that spread from the US to Europe and threatened to engulf the rest of the world. During the darkest days of crisis, the United States was losing 700,000 jobs a month, and world trade was shrinking faster than it did during the first year of the Great Depression.

By the summer of 2009, however, as the world economy stabilized, it became clear that there would not be a full replay of the Great Depression. Since around June 2009 many indicators have been pointing up: GDP has been rising in all major economies, world industrial production has been rising, and US corporate profits have recovered to pre-crisis levels.

Yet unemployment has hardly fallen in either the United States or Europe—which means that the plight of the unemployed, especially in America with its minimal safety net, has grown steadily worse as benefits run out and savings are exhausted. And little relief is in sight: unemployment is still rising in the hardest-hit European economies, US economic growth is clearly slowing, and many economic forecasters expect America’s unemployment rate to remain high or even to rise over the course of the next year.

Given this bleak prospect, shouldn’t we expect urgency on the part of policymakers and economists, a scramble to put forward plans for promoting growth and restoring jobs? Apparently not: a casual survey of recent books and articles shows nothing of the kind. Books on the Great Recession are still pouring off the presses—but for the most part they are backward-looking, asking how we got into this mess rather than telling us how to get out. To be fair, many recent books do offer prescriptions about how to avoid the next bubble; but they don’t offer much guidance on the most pressing problem at hand, which is how to deal with the continuing consequences of the last one.

Nor can this odd neglect be entirely explained by the mechanics of the book trade. It’s true that economics books appearing now for the most part went to press before the disappointing nature of our so-called recovery was fully apparent. Even a survey of recent articles, however, shows a notable unwillingness on the part of the dismal science to offer solutions to the problem of persistently high unemployment and a sluggish economy. There has been a furious debate about the effectiveness of the monetary and fiscal measures undertaken at the depths of the crisis; there have also been loud declarations about what we must not do—warnings about the alleged danger of budget deficits or expansionary monetary policy are legion. But proposals for positive action to dig us out of the hole we’re in are few and far between.

In what follows, we’ll provide a relatively brief discussion of a much-belabored but still controversial subject: the origins of the 2008 crisis. We’ll then turn to the ongoing policy debates about the response to the crisis and its aftermath. Not to keep readers in suspense: we believe that the relative absence of proposals to deal with mass unemployment is a case of “self-induced paralysis”—a phrase that Federal Reserve Chairman Ben Bernanke used a decade ago, when he was a researcher criticizing policymakers from the outside. There is room for action, both monetary and fiscal. But politicians, government officials, and economists alike have suffered a failure of nerve—a failure for which millions of workers will pay a heavy price.


Call it the great North Atlantic real estate bubble: in the first decade of the third millennium, prices of both housing and commercial real estate soared in parts of Europe and North America. From 1997 to 2007, housing prices rose 175 percent in the United States, 180 percent in Spain, 210 percent in Britain, and 240 percent in Ireland.

Why did real estate prices rise so much, in so many places? Broadly speaking, there are four popular explanations (which aren’t mutually exclusive): the low interest rate policy of the Federal Reserve after the 2001 recession; the “global savings glut”; financial innovations that disguised risk; and government programs that created moral hazard.

Low Interest Rate Policy of the Federal Reserve

After the technology bubble of the late 1990s burst, central banks sharply cut the short-term interest rates under their direct control in an attempt to contain the resulting slump. The Fed took the most dramatic action, cutting the overnight rate on loans between banks from 6.5 percent at the beginning of 2000 to just 1 percent in 2003, and keeping the rate very low into 2004. And there’s a school of thought—one to which Raghuram Rajan is strongly sympathetic in his book Fault Lines, and that gets more qualified support from Nouriel Roubini and Stephen Mihm in Crisis Economics—that views this prolonged period of low rates as a terrible policy mistake, setting the stage for the housing bubble.

There are, however, some serious problems with this view. For one thing, there were good reasons for the Fed to keep its overnight, or “policy,” rate low. Although the 2001 recession wasn’t especially deep, recovery was very slow—in the United States, employment didn’t recover to pre-recession levels until 2005. And with inflation hitting a thirty-five-year low, a deflationary trap, in which a depressed economy leads to falling wages and prices, which in turn further depress the economy, was a real concern. It’s hard to see, even in retrospect, how the Fed could have justified not keeping rates low for an extended period.

The fact that the housing bubble was a North Atlantic rather than purely American phenomenon also makes it hard to place primary blame for that bubble on interest rate policy. The European Central Bank wasn’t nearly as aggressive as the Fed, reducing the interest rates it controlled only half as much as its American counterpart; yet Europe’s housing bubbles were fully comparable in scale to that in the United States.

These considerations suggest that it would be wrong to attribute the real estate bubble wholly, or even in large part, to misguided monetary policy.

The Global Savings Glut

The term “global savings glut” actually comes from a speech given by Ben Bernanke in early 2005.1 In that speech the future Fed chairman argued that the large US trade deficit—and large deficits in other nations, such as Britain and Spain—didn’t reflect a change in those nations’ behavior as much as a change in the behavior of surplus nations. Historically, developing countries have run trade deficits with advanced countries as they buy machinery and other capital goods in order to raise their level of economic development. In the wake of the financial crisis that struck Asia in 1997–1998, this usual practice was turned on its head: developing economies in Asia and the Middle East ran large trade surpluses with advanced countries in order to accumulate large hoards of foreign assets as insurance against another financial crisis.

Germany also contributed to this global imbalance by running large trade surpluses with the rest of Europe in order to finance reunification and its rapidly aging population. In China, whose trade surplus accounts for most of the US trade deficit, the desire to protect against a possible financial crisis has morphed into a policy in which the currency is kept undervalued, which benefits politically connected export industries, often at the expense of the general working population.

For the trade deficit countries like the United States, Spain, and Britain, the flip side of the trade imbalance is large inflows of capital as countries with surpluses bought vast quantities of American, Spanish, and British bonds and other assets. These capital inflows also drove down interest rates—not the short-term rates set by central bank policy, but longer-term rates, which are the ones that matter for spending and for housing prices and are set by the bond markets. In both the United States and the European nations, long-term interest rates fell dramatically after 2000, and remained low even as the Federal Reserve began raising its short-term policy rate. At the time, Alan Greenspan called this divergence the bond market “conundrum,” but it’s perfectly comprehensible given the international forces at work. And it’s worth noting that while, as we’ve said, the European Central Bank wasn’t nearly as aggressive as the Fed about cutting short-term rates, long-term rates fell as much or more in Spain and Ireland as in the United States—a fact that further undercuts the idea that excessively loose monetary policy caused the housing bubble.

Indeed, in that 2005 speech Bernanke recognized that the impact of the savings glut was falling mainly on housing:

During the past few years, the key asset-price effects of the global saving glut appear to have occurred in the market for residential investment, as low mortgage rates have supported record levels of home construction and strong gains in housing prices.

What he unfortunately failed to realize was that home prices were rising much more than they should have, even given low mortgage rates. In late 2005, just a few months before the US housing bubble began to pop, he declared—implicitly rejecting the arguments of a number of prominent Cassandras2:—that housing prices “largely reflect strong economic fundamentals.”3 And like almost everyone else, Bernanke failed to realize that financial institutions and families alike were taking on risks they didn’t understand, because they took it for granted that housing prices would never fall.

Despite Bernanke’s notable lack of prescience about the coming crisis, however, the global glut story provides one of the best explanations of how so many nations managed to get into such similar trouble.

Out of Control Financial Innovation

Mary had a little lamb,
And when she saw it sicken,
She shipped it off to Packingtown,
And now it’s labeled chicken.

The famous ditty summarizing Upton Sinclair’s The Jungle seems all too appropriate as a description of the financial practices that helped feed the housing bubble, especially in subprime mortgages. By now the litany is familiar: the old model of banking, in which banks held on to the loans they made, was replaced by the new practice of originate-and-distribute. Mortgage originators—which in many cases had no traditional banking business—made loans to buy houses, then quickly sold those loans off to other firms. These firms then repackaged those loans by pooling them, then selling shares of these pools of securities; and rating agencies were willing to label the resulting product chicken—that is, to bestow their seal of approval, the AAA rating, on the more senior of these securities, those that had first claim on interest and principal repayment.

Everyone ignored both the risks posed by a general housing bust and the degradation of underwriting standards as the bubble inflated (that ignorance was no doubt assisted by the huge amounts of money being made). When the bust came, much of that AAA paper turned out to be worth just pennies on the dollar.

  1. 1

    Ben Bernanke, “The Global Savings Glut and the US Current Account Deficit,” March 10, 2005, available at www.federalreserve.gov.

  2. 2

    See, for example, Robert Shiller, Irrational Exuberance, second edition (Princeton University Press, 2005); Paul Krugman, “That Hissing Sound,” The New York Times, August 8, 2005.

  3. 3

    Ben Bernanke, “The Economic Outlook,” Testimony before the Joint Economic Committee, October 20, 2005, available at www.house.gov.

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