Academic journal article ABA Banking Journal

Necessary Contraction

Academic journal article ABA Banking Journal

Necessary Contraction

Article excerpt

THE ECONOMY HAS ENTERED into a contractionary phase. How long and how deep will the contraction be before expansion returns?

Historically, recessions have a range of durations and intensities. Post World War II, the average duration is ten months (range, 6 to 16 months) and the average peak-to-trough contraction is 1.6% (worst, 1957, 3.7%). Is it different this time? I doubt it. The U.S. economy isn't some passive system. It responds to its inputs and shocks to return to its growth pattern.

One thing jumps out in reviewing GDP trends. Since the mid-1980s, the growth path has been smoother with only very minor contractions. This predictability of growth and mildness of recessions led to a very natural business and consumer response. They increased leverage to take advantage of this growth. Financially, it makes sense for businesses to increase their return to equity using debt (but only to a certain degree). Likewise, consumers can have more today because they know they'll have more to pay with tomorrow (but only to a certain degree). However, the opposite is true as well.

At the same time, the nominal and real cost of money has been falling since the early 1980s. This also encouraged an increase in leverage and asset values, but with a profound disconnect between the durations of borrowing and lending. Very few people want to lock up investments in CDs and other instruments beyond five years, but many people like to borrow money for 15 and 30 years. This presented a duration mismatch that the market thought it had solved by swapping floating rates for fixed with entities willing to take on that risk. …

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