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Recovery is Not Resolution

CAMBRIDGE – Earlier this year, the consensus view among economists was that the United States would outstrip its advanced-economy rivals. The expected US growth spurt would be driven by the economic stimulus package described in President Donald Trump’s election campaign. But the most notable positive economic news of 2017 among the developed countries has been coming from Europe.

Last week, the International Monetary Fund revised upward its growth projections for the eurozone, with the more favorable outlook extending broadly across member countries and including the Big Four: Germany, France, Italy, and Spain. IMF Chief Economist Maurice Obstfeld characterized recent developments in the global economy as a “firming recovery.” Growth is also expected to pick up in Asia’s advanced economies, including Japan.

As I noted in a previous commentary, Iceland, where the financial crisis dates to 2007, has already been dealing with a fresh wave of capital inflows for some time, leading to concerns about potential overheating. A few days ago, Greece, the most battered of Europe’s crisis countries, was able to tap global financial markets for the first time in years. With a yield of more than 4.6%, Greece’s bonds were enthusiastically snapped up by institutional investors.

Greek and European officials hailed the bond sale as a milestone for a country that had lost access to global capital markets back in 2010. Greek Prime Minister Alexis Tsipras said the debt issue was a sign that his country is on the path to a definitive end to its prolonged crisis.

In the US, the Federal Reserve’s ongoing exit from ultra-easy post-crisis monetary policy adds to the sense among market participants and other countries’ policymakers that normal times are returning.

But are they? Do recent positive developments in the advanced countries, which were at the epicenter of the global financial crisis of 2008, mean that the brutal aftermath of that crisis is finally over?

Good news notwithstanding, declaring victory at this stage (even a decade later) appears premature. Recovery is not the same as resolution. It may be instructive to recall that in other protracted post-crisis episodes, including the Great Depression of the 1930s, economic recovery without resolution of the fundamental problems of excessive leverage and weak banks usually proved shallow and difficult to sustain.

During the “lost decade” of the Latin American debt crisis in the 1980s, Brazil and Mexico had a significant and promising growth pickup in 1984-1985 – before serious problems in the banking sector, an unresolved external debt overhang, and several ill-advised domestic policy initiatives cut those recoveries short. The post-crisis legacy was finally shaken off only several years later with the restoration of fiscal sustainability, debt write-offs under the so-called Brady Plan, and a variety of domestic structural reforms.

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Since its 1992 banking crisis, Japan has suffered several false starts. There were recoveries in 1995-1996 and again in 2000 and 2010; but they tended to be cut short by the failure to write down bad debt (the so-called zombie loans), several premature policy reversals, and an increasingly unsustainable accumulation of government debt.

The eurozone emerged from the financial crisis in 2008-2009 with some economic momentum. Unlike the Federal Reserve, however, the European Central Bank hiked interest rates in early 2011, which contributed to the region’s descent into a deeper crisis.

History, therefore, suggests caution before concluding that the current recovery has the makings of a more sustainable and broad-based variety. Many of the economic problems created or exacerbated by the crisis remain unresolved.

All of the advanced economies (to varying degrees) have significant legacy debts (public and private) from the excesses that set the stage for the financial crisis, as well as from the prolonged impact of the crisis on the real economy. Low interest rates have eased the burden of those debts (in effect, negative real interest rates are a tax on bondholders), but rates are on the rise.

Political polarization in the US and the United Kingdom is at or near historic highs, depending on the measure used. As a result, many critical but politically sensitive policies to ensure future fiscal sustainability remain unresolved in both countries.

The UK’s withdrawal from the European Union – and Brexit’s medium-term impact on the British economy – is another source of risk that has yet to be tackled. How Japan will resolve its public and private debt overhang is yet to be determined. I have argued elsewhere that inflation will likely be part of that resolution, as it is improbable that an aging population will vote to raise its tax burden and reduce its benefits sufficiently to put Japan’s debt trajectory on a sustainable path.

In Europe, the high level of non-performing loans continues to act as a drag on economic growth, by inhibiting new credit creation. Furthermore, these bad assets pose a substantial contingent liability for some governments. Target2, the euro’s real-time gross settlement system, has emerged as the eurozone’s mechanism for financing the emergence of widening structural balance-of-payments gaps, whereby capital flows out of southern Europe into Germany. For Greece, Italy, Portugal, and Spain, public-sector debt must now also include the central bank’s sharply rising debts.

Perhaps the main lesson is that even more caution is warranted in deciding whether the time is ripe to “normalize” monetary policy. Even in the best of recovery scenarios, policymakers would be ill-advised to kick the can down the road on structural reforms and fiscal measures needed to mitigate risk premia.

Carmen Reinhart is Professor of the International Financial System at Harvard University’s Kennedy School of Government.

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