OECD Insights From Crisis to Recovery The Causes, Course and Consequences of the Great Recession (eBook)

1. Introduction

By way of introduction …

Sometime in the early 2000s, Clarence Nathan took out a loan. He wasn’t in full-time employment but held down three part-time jobs, none of them very secure, and earned about $45 000 a year. Even Mr. Nathan was surprised anyone would give him a loan against his house, especially a sum like $540 000.

“I wouldn’t have loaned me the money,” he later told National Public Radio in the United States. “And nobody that I know would have loaned me the money. I know guys who are criminals who wouldn’t loan me that and they break your knee-caps. I don’t know why the bank did it. I’m serious … $540 000 to a person with bad credit.”

Why did the bank do it? On the face of it, the bank’s decision made no sense. Indeed, if Mr. Nathan had applied for such a loan ten years earlier, he wouldn’t have got it. But in the intervening period, a couple of things changed. The first was that borrowing in the United States and other countries became, and stayed, relatively cheap, buoyed by vast inflows from emerging economies like China. In essence, there was a huge pool of money just waiting to be lent.

The other thing that changed was the banks themselves. They became ever more eager to take big risks, in the expectation of making big returns. Except, as far as the banks were concerned, they weren’t really taking risks. Thanks to clever financial innovations, they were able to slice and dice loans such as Mr. Nathan’s into so many tiny parts that even if he defaulted (which he did) the loss would be spread out so widely that no one would really feel it. Better still for the bank, it would have sold off the loan to someone else long before Mr. Nathan experienced any problems. And if he couldn’t meet his debts, he could always sell his house at a profit – after all, there had been no nationwide decline in house prices in the United States since the 190s.

For a time, it seemed, risk had become so well managed that it just wasn’t as, well, risky as it used to be. It made sense both to lend and to borrow, and so pretty much everyone did. In 2005, homeowners in the US borrowed $750 billion against the value of their homes – about seven times more than a decade earlier. After all, what could go wrong ….

Pop!

By this stage, you either know or have guessed the answer: the bubble burst. Not for the first time, “irrational exuberance” banged up against hard reality, and hard reality won. It usually does.

The resulting financial carnage was exemplified by the collapse of Lehman Brothers in September 200, even though the crisis had been brewing for a long time before then. What started as a financial crisis quickly made its way into the “real economy”, triggering an unprecedented collapse in world trade, widespread job losses and the first contraction in the global economy since the Second World War. No wonder some people called it the “Great Recession”.

This book is about that crisis, the subsequent downturn and the prospects for strong recovery. It examines the roots of the crisis, how it spread into the real economy, and the ways in which the aftershocks of the Great Recession will continue to be felt for years to come.

The recession and its legacies

Economic memories are often short, which is one reason, perhaps, why financial crises and bubbles tend to recur with such frequency. Spotting the factors in advance that may be leading up to such events is not easy (if it were, they wouldn’t occur). But at bottom, one mistaken notion tends to crop up repeatedly: a sense that, for some reason or other, the old rules of economies and financial markets no longer apply. Sometimes the rules do indeed change, but as often as not they do not. As the noted investor and businessman Sir John Templeton once remarked, “The four most dangerous words in investing are, ‘this time it’s different’.”

As it turned out, this time wasn’t different: risk wasn’t nearly as well managed as people thought it was. Indeed, it had only been deepened, both by the huge imbalances that emerged in the global economy in recent decades and by the sea change that swept over financial institutions. And, just as in the past, a financial crisis had a huge impact on the real economy – the world in which most of us earn our living.

What was different was the magnitude of the crisis and how synchronised it was: this wasn’t just a regional event, like the Asian financial downturn of the late 1990s, but a global crisis, at least in its onset. The numbers are striking. According to estimates by the World Bank, the total world economy contracted by 2.1% in 2009 – an unprecedented fall in the post-war era. In the OECD area, there was an economic contraction of 4.7% between the first quarter of 200 and the second quarter of 2009. A plunge in global trade was another sign of the seriousness of the crisis. Worldwide, the volume of world trade in goods and services fell by 12% in 2009, according to the WTO.

Unemployment rose sharply, reaching a post-war record of .7% in the OECD area – that meant an extra 17 million people were out of work by early 2010 compared with two years earlier. The situation became – and remains – especially serious for young people: in the OECD area, the employment rate for young people (15-24 year-olds) fell by more than percentage points. In countries like France and Italy, about one in four young people are unemployed, while in Spain it’s more than two in five. Job creation traditionally lags recovery, so even if economies rebound strongly, high rates of unemployment won’t vanish for some time yet.

Another legacy of the recession is debt. Governments borrowed heavily during the crisis to keep financial institutions afloat and to stimulate activity. By 2011, government debt in OECD countries will typically be equal to about 100% of GDP – in other words, the value of their total output of goods and services.

That action was necessary, but it had the effect of transferring the financial crisis from the private sector to the public sector. In the initial phase of the crisis, financial institutions were “overleveraged” – in effect, they couldn’t meet their debts. Rescuing them, and the wider economy, shifted the problem on to governments, leaving them with high levels of debt. This has already created major challenges for countries like Greece and Spain and put pressure on the euro. In coming years, the need to reduce such borrowings will confront societies across the OECD area with some tough choices on how best to balance taxation with spending, and where best to direct resources in order to generate long-term prosperity.

What this book is about …

Trying to predict where the global economy might go next has proved to be one of the toughest challenges of the crisis. Just as the speed and suddenness of the crisis’s onset caught most people unawares, the subsequent course of the recession and recovery has sprung more surprises than a Hollywood thriller. Predictions of economic collapse in the depths of the crisis were probably overstated. But, equally, forecasts of a rapid recovery look to have been wide of the mark.

What does seem clear is that the synchronised plunge that marked the start of the crisis was not mirrored at the other end by a simultaneous rebound. Countries emerged from recession, but the pace of their recovery varied. Emerging economies, especially in Asia, bounced back strongly, while some low-income countries did much better than many would have expected. Among the developed economies of the OECD area, however, the picture has been more mixed. Recovery looks set to be sluggish for some time yet, which will only add to the challenge of tackling issues like unemployment and mounting deficits and debts.