10-7-2010 Economist special report on the world economy

10-7-2010 Economist special report on the world economy - A...

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A special report on the world economy The cost of repair A battered finance sector means slower growth Oct 7th 2010 ALL recessions are painful, but the hangovers that follow financial crises are particularly long and grim. Growth is substantially lower than it is during “normal” recoveries as households and firms reduce their debt burdens. That is the depressing conclusion from a growing body of research on the aftermath of big financial busts. In one such study, Prakash Kannan, an economist at the IMF, looked at 83 recessions in 21 countries since 1970. He found that in recessions that followed financial crises, growth was a lot slower and credit growth stagnated— whereas after normal recessions it soared (see chart 6). So far the current recovery is following this post-crisis script. Output is sluggish and credit is growing weakly or shrinking across much of the rich world. But is this because over-leveraged households and firms have become less willing to borrow, or because banks have become less willing to lend? In other words, is the credit problem one of demand or supply? The answer will make a difference to the rich world’s growth prospects and to the way policymakers should respond. People’s unwillingness to borrow bodes ill for short-term demand. Firms’ reluctance to invest also risks denting productivity growth. But a broken financial system’s inability to allocate capital efficiently has bigger long-term consequences. In practice, both supply and demand probably play a role. There is plenty of evidence that consumers and firms have become less willing to borrow. A study by Atif Mian of the University of California at Berkeley and Amir Sufi of the University of Chicago, for instance, shows a close correlation between American car sales and the level of household debt. In places where
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households had heavier debt burdens at the start of the recession, subsequent car sales were weaker. Across the rich world, companies, particularly big ones, have been piling up cash. Firms’ cash stockpiles are at, or near, record levels, and bond investors are clamouring for more corporate debt. In August Johnson & Johnson, a top-rated American pharmaceutical, medical device and consumer-products company, issued $1.1 billion in bonds at the lowest yields then on record for ten- and 30-year corporate debt, even though its operating cash flow far exceeds its investment needs. The historical record suggests that the lack of demand for credit is likely to persist. In a recent paper Carmen and Vincent Reinhart estimate that in past crises it took an average of seven years for households and businesses to bring their debts and debt service back to tolerable levels relative to income. In many countries that process has yet to begin. In America, where progress has been fastest, the Reinharts reckon that about half the rise in the ratio of credit to GDP accumulated during the boom era has been unwound. At the same time the supply of credit is clearly constrained. Banks in the euro zone continue to
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10-7-2010 Economist special report on the world economy - A...

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