Economics Debrief: Continued Fallout from the Crisis and the Challenges Ahead

Among the abnormalities of the Great Depression in the 1930s were the brutal violence of the economic cycle and the grim persistence of unemployment — which resonates with us today. Of course, mechanistic comparisons to the past can lead to unhelpful caricatures especially if applying contemporary terminologies that don’t work outside of context. This time around very different economic dimensions have emerged, including excessive public debt made worse by bank bailouts, income inequality, and intergenerational warfare.

One study contends that when the Baby Boomers generation liquidate their savings through retirement, asset prices will depreciate, which will be somewhat inconvenient for the savings of the younger generation. Worse still, when the Boomers extract retirement benefits from the state, a large intergenerational wealth transfer will occur compared to what they have actually contributed. Seemingly though, economic growth is spurred when inequality of income distribution in a country is accompanied by equality of opportunity. In such situations, lower-income individuals have an incentive to work harder to improve their quality of life. No need for a revolution just yet then.

A careful new historical analysis by Carmen M. Reinhart, Vincent R. Reinhart, and Kenneth S. Rogoff shows that public debt overhang that has lasted for a minimum of five years is likely to continue for at least 10 years and on average for 23 years. Not exactly good news, but perhaps a silver lining to the crisis is the finding in another paper that abundant bank liquidity levels, as measured by bank deposits, plays a role in credit booms and asset price bubbles. If we know where the puncture is, maybe we can fix it.

Hopefully the quality of the response from today’s regulators is superior to that of the 1930s. A recent study highlights that long-term investors face economic consequences from short-term regulatory horizons, meaning that regulators and investors are working to different and conflicting timescales. Yet another paper suggest that the Dodd–Frank Act will actually make things worse, because the interaction among the act’s various rules will have a chilling effect on credit availability.

Let’s hope banks don’t make the same mistakes over again, especially since they invest so much in financial expertise by employing well qualified staff. Alas, even that happy outcome is not assured. Research shows that overinvestment in financial expertise can have a destabilizing effect. During times of high volatility, financial expertise causes more trades to break down as a result of adverse selection, partly due to asymmetric information. Even firms with the most experts are surprised and mystified along with other firms when financial crises unfold.

Our team of abstractors from CFA Digest takes a look beneath the surface of economic complexities:

• Public Debt Overhangs: Advanced-Economy Episodes since 1800: The authors review history and focus on periods of major public debt overhang in advanced economies since 1800.
• The Seeds of a Crisis: A Theory of Bank Liquidity and Risk Taking over the Business Cycle: When banks experience surges in bank deposits during times of heightened macroeconomic risk, there is incentive to underprice loans, which leads to credit booms and asset price bubbles.
• Why Not to Expect Recovery Anytime Soon: Credit-driven crises tend to result in longer recessions, especially when accompanied by heavy public borrowing.
• Default Risk of Advanced Economies: An Empirical Analysis of Credit Default Swaps during the Financial Crisis: If governments are expected to insure the financial sector during a time of crisis, then after 2008, sovereign CDS spreads should reflect the extra risk of providing this insurance to the private sector.
• Short-Horizon Regulation for Long-Term Investors: The authors examine the optimal portfolio wealth and the economic costs of imposed regulation when the regulatory horizon is as long as the investment horizon and when the regulatory horizon is shorter than the investment horizon.
• The Coming Crisis in Credit Availability: Lending standards and credit availability have tightened significantly since 2008 — and Dodd-Frank will worsen the situation.
• Having Your Cake: Less Inequality Does Not Need to Mean Less Efficiency: Economic growth is spurred when inequality of income distribution in a country is accompanied by equality of opportunity.
• Sponging Boomers: The Economic Legacy Left by the Baby-Boomers Is Leading to a Battle between the Generations: Policies implemented by Baby Boomers will not benefit the generations that follow when the Baby Boomers unwind their positions and receive benefits during retirement.
• No Short Cuts: Short-Term Austerity in the Aftermath of a Severe Crisis May Prove More Painful Than Thought: Several factors suggest that the fiscal multiplier is particularly high in the current economic environment. As a result, fiscal austerity may hurt growth more than initially anticipated.
• Financial Expertise as an Arms Race: The authors illustrate the incentives for firms to overinvest in financial expertise and liken the process to an “arms race.”

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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