* The root cause of the economic crisis is excessive consumption accompanied by record low savings rates and huge budget and current account deficits.
* Thawing credit markets alone will not mean a rapid economic recovery in output growth and employment,
* Unemployment will remain high in the near term and only decline slowly over many years as adjustments are made in the skills of the labor force.
* Expect inflation to remain low in the near term. Inflation risks will be present in the long run as the result of monetary stimulus provided by the Federal Reserve.
* The current fiscal stimulus package may not be the best approach since it ignores the need to reduce consumption relative to income.
* Higher tax rates and lower spending will be required once the economy has stabilized.
Many attribute the beginning of the financial crisis to the collapse of the housing market. While the housing bust indeed plays an important role, particularly in the health and stability of the banking sector, the real problem is deeper. The fluctuations observed across real estate markets over the last decade or so simply reflect sizable macroeconomic imbalances. It is the nature of these imbalances that we must fully appreciate to better understand the crisis and to potentially forecast plausible scenarios going forward. At the broadest level, we have witnessed a consumption boom over the last two decades, where U.S. aggregate household consumption grew to represent more than 70% of gross domestic product (GDP), a historically and unsustainably high level (see Exhibit 1).
Excessive consumption was fueled by a loosening of lending standards prompted by government policy to increase homeownership rates, and accompanied by record low savings rates. Cheap credit from both home and abroad and a substantial increase in financial intermediation including new structured derivative products also contributed. In line with the private sector, the U.S. government also ran sizable budget deficits and a huge current account deficit.
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Collectively, the expansion of credit yielded levels of U.S. household indebtedness and corresponding decreases in household savings, as a percentage of disposable income, that were also unprecedented (see Exhibits 2 and 3). In other words, U.S. consumers and policymakers have been financed to a significant degree by borrowing from abroad (and, by default, from future generations). Simply put, the U.S. economy, financed by excess credit, spent more than it earned.
STRUCTURAL CHANGES ARE REQUIRED
The long-term implications of these factors are significant. Perhaps more importantly, a thawing of credit markets will not on its own portend a rapid economic recovery in output growth and employment. It is likely that the economy will not enjoy a healthy recovery until these long-run imbalances are rectified. In fact, given these long-run challenges, a swift recovery could be undesirable. If a rapid recovery merely reflects a temporary return to the levels of excess consumption and debt, we would only have delayed adjustments with a potentially larger economic cost down the road.
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Using IMF data, the table in the next column provides historical evidence that economic contractions associated with financial crises tend to be deeper and last longer than recessions not associated with a financial shock. Accordingly, we conjecture that the outcome with the highest probability is an L-shaped economic pattern, where the economy finds its footing perhaps as early as the second half of 2009, but muddles along for some time with significant excess capacity and unemployment.
We project one measure of excess capacity, the "output gap," reflecting the degree to which actual economic activity diverges from the potential implied by optimal capacity utilization, to significantly expand before narrowing (see Exhibit 4). …