Carmen Reinhart: Recovery is 'right on track'

Carmen Reinhart By David Futrelle


(MONEY Magazine) -- Why does the nation's current economic malaise seem so prolonged -- and what, if anything, can we do about it? Few people are better equipped to answer that question than Carmen Reinhart.

With Harvard economist Kenneth Rogoff, she wrote the book on the history of debt crises, 2009's This Time Is Different: Eight Centuries of Financial Folly.

Rather than focusing on theory, as many economists do, she concentrates on facts, digging up reams of data on how past recoveries around the world played out and what may have helped (or hurt).

With a résumé that includes Wall Street (she was chief economist at Bear Stearns), policy (the International Monetary Fund), and academia (the University of Maryland), Reinhart is now a senior fellow at the Peterson Institute for International Economics, a nonpartisan think tank.

MONEY recently spoke with her about our current economic situation. Edited excerpts follow.

How did you come to be an expert on economic disaster?

It's a morbid fascination of mine. My debut on Wall Street was in 1982, the year that Mexico defaulted, which threw American banks into disarray. It was riveting to watch. I've been writing about crises ever since.

To understand them, I've learned you have to go beyond the advanced economies and beyond the standard data sources. There's quite a bit of archaeological work.

Many people think it's taking an unusually long time to recover from the recession. Would you disagree?

I would say we're right on track. Yes, the recovery looks long, but that's because we haven't had a financial crisis this severe since World War II.

Historically, the recovery process from a severe financial crisis has been very protracted. The impact on housing and employment in particular tends to be quite long-lived.

What made this crisis and subsequent recession so bad?

A severe financial crisis -- and the recession that follows -- is always preceded by a boom phase during which there is a huge buildup of debt. We are still squarely in the process, which is painful and slow, of deleveraging from [or reducing] that debt.

With the exception of the financial industry, the business sector wasn't leveraged up like crazy, so most businesses are already okay. But the financial industry is still mired in a big stock of nonperforming loans that haven't been written down. And households are still mired in a lot of debt related to the real estate boom. We're in a precarious situation.

How concerned are you about the national deficit?

It's too early to tighten the budget given that the economy is less than robust and employment conditions remain far from desirable. Extending unemployment benefits and extending the stimulus package was something we needed to do, even though both work toward making the deficit bigger. You've gotta do what you've gotta do. But we don't seem to have an exit strategy, and that's really worrisome.

If you look at historic periods where the gross debt of the public sector exceeds 90% of GDP -- which we have surpassed -- economic growth has been subpar.

That sounds like a vicious circle.

There isn't a lot of convincing evidence that you can simply grow your way out of this kind of debt. The answer is usually a combination of fiscal austerity, debt restructuring, or a more subtle type of restructuring like we did after World War II: financial repression.

You clamp down and regulate the financial system so that interest rates remain low. [True, low interest rates helped get us into this mess, but] low rates also let you finance your debts and deficit more cheaply. Whenever there's a lot of debt, there will be a desire to keep debt-servicing costs down.

People forget that most countries -- the U.S. included -- had interest-rate ceilings until the mid-1980s.

What should we expect the economy to look like over the next decade or so?

Downsizing expectations is very much in order. What typically transpires historically after severe financial crises is a period in which there is growth, but not up to the levels of the decade before the crisis.

For the advanced economies, median growth is about one percentage point lower in the following decade. Unemployment remains higher, and companies and the government are still paying down debt for about seven years, on average. We are now past the third-year mark. I think sooner or later we are going to adopt fiscal austerity measures and shift toward heavy-handed regulation.

"Austerity" is not a word any U.S. politician has used for a long time.

Whether you want to use the term "austerity" or not, if you look at the projections of the Congressional Budget Office and other serious institutions about where our debt is going, there's not really much alternative. Belt-tightening has got to come.

That means cutting back on entitlements, raising the retirement age, and ultimately raising taxes. We can hope that we'll grow out of it and that all the bad bank debts are going to resolve themselves. But hope and reasonable expectations are two very different things.

What's down the road for the housing market?

This financial crisis, like most of the severe ones we've looked at, was closely linked to the real estate cycle. Housing peaked at the tail end of 2006, and peak to trough the decline we had was roughly 30% in real terms -- right around the average for other countries that have been in this situation.

It can take a long time for housing values to come back. The real estate market is not like the equity market, where things can move in a very abrupt manner. Median housing prices in the decade after severe crises are typically still about 15% lower than they were before the crash.

What about the stock market?

I think the equity market has had some setbacks because of declaring victory too soon on more than one occasion in 2010. We were ripping along and then, whoops, Greece! Europe has problems!

We began 2010 with Greece and ended it with Ireland. And now we're moving to the Iberian peninsula. I think volatility is going to be the name of the game for a while, for the simple reason that in highly leveraged periods, small shocks have big effects. And all the advanced economies are to varying degrees highly leveraged.

People seem baffled as to why employment hasn't bounced back.

The unemployment rate typically increases by roughly seven percentage points during a severe financial crisis. At our worst moment, it went to about 10%, an increase of about six percentage points.

Look at the history of advanced economies and you see that unemployment in the decade following a crisis is still about five percentage points higher than pre-crisis levels. It's not that you don't get improvements, but you don't see these very clear V-shaped recovery patterns that many people expect to see.

Right now, nonfinancial firms have a lot of cash on hand. But they look at consumers and see that they're not in great shape, so their projections of sales, and therefore their hiring, are going to be adjusted down accordingly.

So we shouldn't expect the consumer to step up and save the day.

Yeah, good luck! In the last two fairly shallow recessions, including the bursting of the tech bubble in 2000, the consumer was the hero. But consumers were enjoying huge increases in their perceived wealth because between 2001 and 2006, housing prices in the U.S. rose by more than they had in the preceding 130 years.

Now households are stretched by their mortgages. Your average person can figure out that we can't continue to accumulate debt without something giving.

Wall Street analyst Meredith Whitney has predicted a wave of defaults on municipal bonds. What's your take?

State and local governments are really hurting. If you have a recovery that is lackluster and you add a depressed real estate market [which hurts property tax revenue], it's not difficult to see why defaults would become more likely.

In the history of the U.S. we've had two waves of state defaults -- in the 1830s and again in the late 1870s -- so they're not unheard of. But I don't think that's a probable scenario.

I think the federal government would fear contagion and would do whatever was required to prevent state defaults from happening. Defaults by cities, on the other hand, are quite probable.

Economies are more intertwined than they once were. Do you worry about defaults in Europe?

I don't think we're going to see big dramas like in Argentina in 2001 and 2002 [when the country defaulted on its debt and people rioted in the streets]. But it's hard for me to envision an outcome in Europe that doesn't involve restructuring of public and private debts -- and restructuring is partial default.

Ireland's gross public and private debt is 10 times GDP. Greece has implemented significant austerity measures, but austerity measures don't yield immediate results, and things often get worse before they get better.

Restructuring will be neither pretty nor painless. It's typically associated with considerable financial market volatility, which could undermine a sustained recovery in the United States.

What is hurting the U.S. economy most right now?

The fact that we are still pretending we do not have the Japanese-style zombie-loan problem [keeping nonperforming mortgage loans at book value on bank balance sheets rather than writing them down].

Compare the swift recovery of the Scandinavian countries after the crash of their housing markets in the late '80s and early '90s with the more protracted malaise in Japan after its debt bubble popped in 1991. The former countries dealt with nonperforming loans and the latter didn't. Here we have "forbearance," which is a technical term for denying the fact that those loans will never resemble book value.

When people hear comparisons to Japan, they get worried. Will we look back on this as a lost decade?

We haven't done the exact same things the Japanese did. We've been a lot more aggressive on monetary and fiscal policy, for example. But on the forbearance issue, well, the subprime crisis hit in 2007, and it's now 2011. The clock is ticking.

Eventually pressure will emerge for write-downs. If you look at Japan, ultimately write-downs did occur -- five years after the crisis. We are delaying the inevitable.  To top of page

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