Academic journal article Journal of Economics and Economic Education Research

A Long Hard Slog: Debt and Economic Recovery

Academic journal article Journal of Economics and Economic Education Research

A Long Hard Slog: Debt and Economic Recovery

Article excerpt

INTRODUCTION

Over the last several years, the United States economy has faced the deepest reduction in real GDP and the slowest recovery since the Great Depression. Though the economy has experienced twenty five consecutive months of net job growth, economic growth has been sluggish and unemployment remains stubbornly high. Why was the drop off in economic activity so steep? What accounts for the slow pace of recovery?

In their ambitious book This Time is Different, economists Kenneth Rogoff and Carmen Reinhart have empirically investigated a wide variety of financial crises endured by sixty-six countries over the last eight centuries (Reinhart and Rogoff, 2009). Their research indicates that economic downturns that follow financial crises are more severe and persist much longer than typical recessions. It "typically takes an economy more than four years just to reach the same per-capita income level that it had attained at the pre-crisis peak" (Rogoff, 2011). They argue that our current economic miseries are largely the result of the recent housing crisis and the large fiscal imbalances that have built up over the last decade. While many economists have portrayed the economic crisis as "The Great Recession," Rogoff and Reinhart have called it the "Second Great Contraction" (with the Great Depression being the First Great Contraction). The authors contend that this "contraction applies not only to output and employment, as in a normal recession, but to debt and credit, and the deleveraging that typically takes many years to complete" (Rogoff, 2011). Deleveraging refers to the process of paying down of private and public debt by households, businesses, and taxpayers. The housing crisis which precipitated our current economic woes was preceded by dramatic increases in both private and public debt. The painful process of deleveraging that has followed this crisis has both inhibited and delayed a return to robust economic expansion. This report explores the impact of debt on economic activity and the implications for our current situation.

We begin by taking a historical perspective, looking back at the period that preceded the "First Great Contraction," a time of rapidly expanding household debt. Next, our report reviews several theoretical explanations that describe how debt contributes to the depth and duration of economic slumps. Then, we analyze the effects of the debt build up during the 2000s on the recent recession and on current economic recovery. Lastly, our paper discusses economic strategies that United States can take in addressing the enduring consequences of the financial crisis.

A TALE OF TWO CONTRACTIONS

The Armistice that brought World War I to a close in 1918 triggered a rapid demobilization from the war effort in the United States. The abrupt cancellation of military contracts, the cessation of war production, and the return of hundreds of thousands of soldiers to the labor force precipitated a brief downturn in the economy during the first half of the following year. Despite this hiccup, the economy roared back by the second half of the year. The robust economic rebound combined with the maintenance of low discount rates by the Federal Reserve, however, fueled inflationary pressures. In response, the Federal Reserve in late 1919 initiated a series of discount rate increases such that, by June 1920, rates had climbed from 4.75% to 7.0%, a 47% increase (Walton and Rockoff, 2010, 390-1)!

These rate increases set off a sharp but relatively short economic downturn, a classic V-shaped recession. From 1920-21, nominal net national product declined by 18% leading to a jump of 7.9% in the unemployment rate. The same period witnessed a dramatic deflation in the overall price level with the wholesale price index falling by 37%. The simultaneous reduction in both nominal output and the overall price level accounted for a relatively modest 4% decline in the real net national product (Walton and Rockoff, 2010, 391; Hughes, 1990, 448). …

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