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CARNEGIE

E N D O W M E N T F O R I N T E R N AT I O N A L P E A C E
POLICY
BRIEF
89
NOVEMBER 2010

Five Surprises of the


Great Recession
U r i D a dus h
Senior Associate and Director, Carnegie International Economics Program
V er a E i de l m a n
Managing Editor, Carnegie International Economic Bulletin

S u m mary
ƒƒThe Great Recession included five major surprises: (1) the severity of the global trade
and output collapse, (2) the United States suffered a milder than expected recession,
(3) Europe saw the onset of a severe sovereign debt crisis, (4) China grew at an
extraordinary rate even though it’s greatly dependent on exports, and (5) Latin America
showed remarkable resilience.

ƒƒEach of the five surprises teaches policy makers critical lessons ranging from the need
to rein in unbridled risk-taking in the financial sector, to the importance of a vigorous
response from the private sector to crises, to the importance of quickly re-establishing
sound macroeconomic fundamentals. Beyond the generally applied lessons, the surprises
also hold lessons for specific regions, notably the need for reforms to strengthen the
institutional mechanisms underpinning the Euro area.

ƒƒWhile governments reacted quickly and appropriately with stimulus measures and
bank rescues to prevent a descent into depression, they unfortunately have not acted
forcefully enough on the lessons emerging from the five surprises. In particular, leaders
have failed to enact the structural and regulatory reforms needed to protect the world
against the next crisis.
2 CARNEGIE POLICY BRIEF

about the authors The Great Recession was the mother of all so forth), and the sheer size of government-
Uri Dadush is senior associate surprises. Late in 2008, the “Great Modera- directed housing credit in the United States,
and director of Carnegie’s tion”—the supposed end to economic vola- but most of the failures that were building
International Economics Program. tility worldwide—suddenly morphed into up during the boom had been seen before.
His work currently focuses on the deepest global recession since the 1930s. Households, firms, and governments rapidly
trends in the global economy, the At least four other big surprises followed, accumulated debt, asset and housing prices
global financial crisis, and the which provided a stark demonstration of the boomed and overshot, banks overextended
euro crisis. He is also interested in limitations of our understanding of financial themselves, excessive risks were taken, and
the implications of the increased crises: the United States, despite having been regulatory and macroeconomic policy failed
weight of developing countries at the epicenter of the crisis, experienced a rel- on many fronts (Reinhart and Rogoff).
on the pattern of financial flows, atively shallow recession; Europe, which ini- The real surprise was the speed and global
trade and migration, and the tially appeared to be an innocent bystander, reach of the trade and output collapse. The
associated economic policy and went through a more severe downturn than crisis marked the first contraction in world
governance questions. any region and remains mired in a sover- GDP since the Great Depression, and the
A French citizen, Dadush eign debt crisis; China, despite being heavily shock was global: All countries saw growth
previously served as the World export-dependent, grew at an extraordinary decelerate sharply in 2009, and 91 countries
Bank’s director of international rate throughout the crisis; and Latin America, saw GDP fall (figure 1). World trade went
trade and before that as director which had previously suffered disproportion- into free fall: Its volume decline, 12.8 percent
of economic policy. He also served ately from global recessions, showed remark- in 2009, was about as bad as that of the worst
concurrently as the director of the able resilience. year of the Great Depression.
Bank’s world economy group, Surprises are a terrible thing to waste: We can explain the recession’s depth and
leading the preparation of the examining them can yield valuable policy les- global reach as the result of the interaction of
Bank’s flagship reports on the sons. In this brief we explore the five surprises two forces. First, the credit crunch spread sud-
international economy. of the Great Recession and identify the policy denly and violently from the United States,
Prior to joining the World lessons they teach. We also examine the extent home to the world’s largest financial market
Bank, he was president and CEO to which the reforms enacted to date reflect and reserve currency, through an integrated
of the Economist Intelligence Unit these lessons. While governments reacted global financial system. In October 2008, the
and Business International, part quickly with stimulus and bank rescue mea- TED spread—an indicator of the perceived
of the Economist Group (1986– sures to prevent a descent into depression, credit risk of banks lending to other banks, as
1992); group vice president, they have been much more timid in enact- measured by the difference between the three-
international, for Data Resources, ing the politically tougher structural reforms month London Interbank Overnight Rate
Inc. (1982–1986), now Global needed to protect against the next crisis. and the interest rate for three-month U.S.
Insight; and a consultant with Treasury Bills—spiked at more than 400 basis
McKinsey and Co. in Europe. First Surprise: points, compared to 94 basis points a year ear-
Global Collapse lier. According to the International Monetary
Vera Eidelman is managing With the benefit of hindsight, one can clearly Fund, the United States, the United Kingdom,
editor of the International see that the Great Recession conformed to a and the Euro area saw bank credit contract by
Economic Bulletin. She holds a familiar pattern. Just like the Great Depres- nearly 3 percent on average in the fourth quar-
bachelor’s degree in economics sion and the oil shocks and deep recessions of ter of 2008 from a year before, compared to
and sociology from Stanford the 1970s, the 2008 crisis came on the heels of average growth of more than 8 percent (year
University. a long period of euphoria. The run-up to this on year) in the preceding 20 quarters.
crisis did exhibit several new twists, including The second force was the collapse in the
toxic securities and derivatives (collateralized demand for durable goods—itself a result of
debt obligations, credit default swaps, and tighter credit and vanishing confidence—and
Five Surprises of the Great Recession 3

its multiplier effect on trade. As credit disap- The Great Recession demonstrated exactly
peared and panic spread, any purchase that the opposite of this thinking: The financial and
could be delayed, such as a house, car, or appli- trade linkages that were supposed to contain a
ance, was delayed. The demand for consumer shock originating in one region instead acted
durables fell four to six times more than the as giant conveyor belts that carried the shock
demand for non-durables and services (Bems, worldwide and thus magnified its effects. This
Johnson, and Yi). This had a multiplier effect showed that the major financial centers, and
on global trade, which is largely composed of
the inputs that feed into durable goods and that While governments reacted quickly to
may be re-exported multiple times in the form
the crisis with stimulus and bank rescue
of intermediate products.
Prior to the Great Recession, economists measures, they have been much more timid
had been confident that an outright decline in
in enacting the structural reforms needed to
world GDP could not happen. A more open
and integrated world economy meant, so the protect against the next crisis.
thinking went, that the sources of demand
were diversified such that an adverse shock not just volatile emerging markets, are vulnera-
in any one country or region would be offset ble. It also illustrated how the loss of confidence
by continued demand growth in the others, in a major financial center can have immedi-
and creditworthy countries could borrow ate repercussions on credit and real economic
to finance spending despite the shock. activity worldwide. No country is safe.
Furthermore, with manufactures and com- Fortunately, governments quickly enacted
modities declining in importance relative to stimulus measures and bank rescue, and as
services, demand had supposedly become less confidence began to return the interacting
cyclical, and automatic stabilizers in advanced forces of credit and durable goods worked in
countries would help cushion the shock. reverse. The TED spread fell back to pre-crisis

Figure 1
GDP GROWTH Q2 2008–Q2 2010
0
France

Germany
Canada

-1
United States

-2
Non-Euro Area EU
% Change

Japan
EU

-3
Spain

-4
UK

Italy

-5

-6
Sources: BEA, Eurostat, ESRI, Statistics Canada
4 CARNEGIE POLICY BRIEF

levels by the summer of 2009 and, though Though fiscal stimulus was slightly stron-
credit has still not resumed its prior growth, ger and monetary policy a little looser in the
it has stopped its sharp decline. In 2010, trade United States than they were in other econo-
rose 23 percent (year on year) through May, mies, the policy responses were broadly simi-
and inventory restocking in OECD coun- lar and thus cannot account for such a large
tries has added 1.5 to 2 percentage points to disparity in outcomes. Some of the factors
GDP growth in each of the last three quar- that do help explain the relative mildness of
ters, following a loss of 0.5 percent during the the U.S. downturn are the result of economic
downturn. structure, but others reflect policy choices.
The suddenness and global reach of the Compared to other advanced economies,
Great Recession underscored the need to the United States is much less dependent on
reform the way finance is conducted, not just the sectors that were hit hardest by the cri-
in the less developed periphery, which had sis (figure 2). Manufactures, which suffered
been the focus of scrutiny in the recent past, more than services when consumers and firms
but in the major financial centers as well. They cut back on durable goods and investment,
have prompted a radical rethinking of the account for a much lower share of GDP in
policies and regulations designed to limit risk- the United States than in Germany, Japan, or
taking in financial markets and the banking Italy. Similarly, construction, which contracted
systems of the industrial countries. more than any other sector because of the U.S.
housing bubble, accounts for only a modest
Second Surprise: share of U.S. GDP by international standards.
The United States Suffers Compared to Europe and Japan, the United
a Milder Downturn States is also less dependent on bank lending.
The need for financial reform is clearest in the In April 2010, Euro area monetary financial
United States, home to the world’s largest institution (MFI) assets (including central banks,
capital market and the birthplace of the crisis. resident credit institutions, and other resident
It was in America that the largest housing and financial institutions that receive deposits and
asset price bubbles occurred. There, several grant credit/invest in securities, as well as money
hundred billion dollars were extended in sub- market funds) were nearly 3.5 times as large as
prime mortgages, repackaged into complex Euro area GDP, while the assets of FDIC-
and opaque securities, and insured against. insured institutions amounted to only 90 per-
And there the world’s largest insurance com- cent of U.S. GDP in March 2010. Furthermore,
pany and three of the five largest investment compared to U.S. banks, European banks are
banks collapsed, initiating a string of bank and more dependent on less reliable wholesale
corporate failures. funding than on customer deposits.
Yet the United States saw its own economic Perhaps most important, the private sec-
output decline less during the crisis, and recover tor reacted faster and more aggressively in the
more in the upturn, than did most other United States than it did in other advanced
advanced countries. To be sure, the crisis hit the economies. In the United States, the private
United States hard; the country suffered its lon- sector seized the opportunity to restructure,
gest postwar recession. But from its peak in the shed unneeded workers and capacity, and uti-
second quarter of 2008 to the second quarter lize labor-saving technological innovations.
of 2010, U.S. GDP contracted less than that of For example, in the U.S. auto industry, whose
any other G7 country except Canada. vigorous, government supported restructuring
Five Surprises of the Great Recession 5

was well publicized, capacity utilization rose profits returned to growth (2.2 percent, year on
from 41.5 percent in March 2009 to 52.8 per- year) in the fourth quarter of 2009, while that
cent in February 2010, and, according to the in the Euro area continued to contract (-13.2
Economist, overcapacity will fall from 6 mil- percent, year on year) over the same period.
lion vehicles in 2009 to 3.4 million vehicles in As a result, when demand began to return,
2010, compared to a fall from 10.4 million to U.S. firms were in a better position to invest,
7 million in Europe, where not one carmaker although they remain reluctant to add jobs.
had been shut down or sold as of September In the United States, gross domestic invest-
2009. Similarly, in construction, U.S. employ- ment returned to growth in the third quarter
ers shed 16 percent of workers (quarter on of 2009, while it continued to contract in the
quarter) in the second quarter of 2009—more Euro area until the second quarter of this year.
than two times the cuts in the Euro area. The United States thus remained the safe
Furthermore, banks quickly took repossession haven. Ironically, even though the crisis origi-
of homes whose mortgages were in default, nated in the United States, capital flowed to
and U.S. banks restructured faster and recog- it from abroad, alleviating its credit crunch.
nized (marked-to-market) their losses faster The costs of borrowing in the United States
than European banks (IMF, April GFSR). declined relative to other advanced countries.
This decisive private-sector response meant The safe-haven effect was also visible in the dol-
sharply increased unemployment in the United lar, which appreciated 13.6 percent during the
States, but it also resulted in a quicker reestab- panic from September 2008 to March 2009
lishment of confidence in banks and firms. but returned to pre-crisis levels by November
Overall labor productivity rose by 3.5 percent 2009 as confidence returned.
in the United States in 2009, compared to a The U.S. reliance on services, the country’s
decline of 2.5 percent in the European Union more diversified financial system, the flexibil-
over the same period. Profits also returned ity of its corporate sector and labor markets,
more quickly in the United States: The net and its safe haven status helped it navigate the
value added of U.S. non-financial corporate crisis. But questions about its low household
Figure 2
MANUFACTURES AND CONSTRUCTION
25
Manufactures Construction
20
Share of GDP

15

10

0
Germany Japan Italy Canada Spain United United France
States Kingdom
Sources: OECD, World Bank. Data for Spain, Italy, Germany, and France is for 2008;
2007 for United States, UK, and Japan; 2005 for Canada
6 CARNEGIE POLICY BRIEF

savings and its fiscal sustainability, which had exchange rates are officially tied to the euro,
long predated the crisis, have become increas- such as those in the Baltics and Bulgaria, and
ingly pressing. countries whose ability to devalue is impaired
Observers have paid much attention to by large foreign currency liabilities, such as
the U.S. government’s successful response to Hungary and Romania, were also infected.
the crisis, which may have averted a descent Together, these countries account for about
into depression. However, most of them have one-third of European Union GDP.
neglected the importance of the vigorous pri- The disease manifested itself somewhat dif-
vate sector reaction to the crisis. This is a les- ferently across these countries. In some, such as
son for advanced countries that were hit hard Greece, Spain, and Ireland, the economy grew
by the crisis but whose private-sector response too rapidly on the back of consumer and hous-
was sluggish—a group that includes Japan and ing booms, ample credit, and immigration
many countries in Europe. surges, and ran unsustainable current account
deficits. In others, such as Italy and Portugal,
Third Surprise: the economy depended too much on sluggish
Euro Complacency domestic (non-tradable) activities. In most,
Becomes Euro Funk government spending expanded too rapidly
Though Europe initially appeared to be an amid unsustainable fiscal revenues. The surge
innocent bystander, the Great Recession in government indebtedness was particularly
quickly implicated it, exposing vulnerabilities large in Ireland, mostly due to the massive
similar to—but in many cases worse than— banking crisis and bailout there.
those in the United States. In a few countries The market punished all of these dispa-
such as Ireland and Spain, housing bubbles rate countries in similar ways, however, by
even larger than the one in the United States demanding much higher yields on their gov-
had inflated and burst, and banks were taking ernment debt. Remedies will be painful across
excessive risks. As we argued above, compared the board. To restore competitiveness and put
to the United States, Europe depended more their fiscal accounts in order, they will have
on banks, manufactures, and construction, and to face a deflationary adjustment over many
its private sector was slower to respond, all of years, during which they will remain vulnera-
which help explain the deeper downturn. But ble to a variety of internal and external shocks.
the crisis also exposed a set of vulnerabilities The recent European experience shows that
entirely unique to Europe and to its Euro area the macroeconomic policy and sovereign debt
in particular—namely, a secular loss of com- of the world’s richest countries are now subject
petitiveness and fiscal vulnerability in Greece to just as much market scrutiny as are those of
and other countries that had adopted the single developing countries. No country is exempt.
currency a decade earlier. In hindsight, Europe However, the most important lesson for
had a loaded gun aimed at it from the outset of Europe to draw from its experience is that
the crisis, even if the trigger happened to have even within a monetary union, divergences
been pulled from across the Atlantic. between countries in competitiveness and
The Greek disease affected a significant external balances matter greatly. Even when
number of countries, including large Euro the source of the external imbalance originates
area economies like Italy and Spain, as well in the private sector, the cost of correcting it
as smaller members like Ireland and Portugal. can eventually spill over into the public sector
Newly acceding non-Euro area countries whose and threaten fiscal sustainability. The problems
Five Surprises of the Great Recession 7

such divergences entail are compounded in the China’s ability to respond so quickly
absence of pooled fiscal resources and other and aggressively was due in part to a level
conditions necessary to adapt to shocks within of government control not available—and
a monetary union—most importantly flexible not desired—in other countries. However,
labor markets and international labor mobil- it would not have been possible had China’s
ity. Though labor can move freely within the pre-crisis fundamentals not been so solid.
European Union, in practice intra-European
migration is small. In contrast to the United States, no
Fourth Surprise: sector of the economy in China appears
China’s Gravity-Defying Act to have been overleveraged. As a result,
In contrast to the dismal European expe-
rience, China’s growth rate in 2009—9.1
stimulus spending translated quickly into
percent—came as an enormous favorable increased demand.
surprise. This figure is noteworthy not only
because it occurred in the midst of a global Before the crisis, China’s official government
contraction, but also because China is heavily debt stood at less than 20 percent, and after
dependent on exports, which were hit hard- a decade of reform China’s banking system
est by the crisis, and particularly on exports was also in good shape. And in contrast to the
of manufactures, which, as discussed above, United States, no sector of the economy in
fared the worst. In China, exports account for China appears to have been overleveraged. As
36.6 percent of GDP—more than two times a result, stimulus spending translated quickly
their share in Japan and close to three times into increased demand.
their share in the United States and the Euro Government intervention has not been
area (excluding intra-Euro area trade). without cost, however—far from it. Local gov-
Reflecting the global contraction in trade, ernment debt, which is not included in tabu-
China’s export values fell by nearly 16 percent in lations of the national debt level, amounted
2009, and net exports went from contributing to 20–30 percent of GDP in 2009, imply-
2.5 percentage points to GDP growth in 2007 ing that total debt levels are actually close to
to subtracting 3.8 percentage points in 2009. 40–50 percent of GDP. The ability to repay
Government-engineered credit expansion that debt depends on the health of property
and investment more than compensated for markets—a fact that places local governments
this drag, however. Only seven weeks after the at odds with a national government aiming
Lehman collapse, Beijing announced a four to calm soaring real estate prices (figure 3).
trillion RMB stimulus program. The program Furthermore, just as the government’s decisive
initially took the form of two sets of orders action has enabled China’s remarkable growth
issued by the central government: one to local to continue, a policy misstep in unwinding
authorities to invest in infrastructure and the stimulus carries great risks.
other projects, and another to state-owned China’s unique mix of government control
banks to sharply increase lending. As a result, and market-driven economy and its excep-
investment accounted for more than 90 per- tional balance-sheet strength at the outset
cent of China’s GDP growth in 2009, and of the crisis mean that the applicability of
domestic credit expanded by about 9.6 trillion its experience to other countries is limited.
RMB that year. However, the episode holds an important
8 CARNEGIE POLICY BRIEF

Figure 3

HOUSE PRICES IN 70 MAJOR CITIES IN CHINA


14
12
10

8
% change (y/y)

6
4
2

0
-2
-4
Jan-06
Mar-06
May-06
Jul-06
Sep-06
Nov-06
Jan-07
Mar-07
May-07
Jul-07
Sep-07
Nov-07
Jan-08
Mar-08
May-08
Jul-08
Sep-08
Nov-08
Jan-09
Mar-09
May-09
Jul-09
Sep-09
Nov-09
Jan-10
Mar-10
May-10
Source: Bloomberg

lesson for China: remaining too dependent on Fifth Surprise:


export markets rather than domestic demand Latin America’s Resilience
in a continent-sized economy with a popu- During the Great Recession, Latin America
lation of 1.3 billion people is itself a sign of and the Caribbean (LAC) contracted less than
large imbalances and high intrinsic risk. In the advanced economies during a worldwide
part because China is so dependent on export recession—the first time in three decades that
markets, its policy makers feel compelled to such an outcome has occurred (figure 4). South
stabilize its exchange rate through excessive America did particularly well relative both to
and costly reserve accumulation. And in part other regions and to itself in previous crises.
because China wishes to retain its freedom in As in most other developing regions
domestic macroeconomic policy, its capital (including Sub-Saharan Africa, the poorest
markets remain characterized by interest rate and most vulnerable region), an improved
repression, heavily distorted and isolated from pre-crisis national balance sheet helped Latin
the mainstream. Correcting these distortions America weather the crisis, as did better mac-
and imbalances will require a complex set of roeconomic management. In the past, the
reforms (Dadush). region had to confront global downturns with
Among the needed reforms that will help high initial external debt, current account and
China reorient its economy toward domes- fiscal deficits, modest reserves, pegged or heav-
tic demand is a more flexible and gradually ily managed currencies, vulnerable banks, and
appreciated exchange rate. Pressure to liberal- heavy dependence on foreign debt financing.
ize two-way capital flows will build as China This time, however, the LAC region, helped by
develops and integrates into global markets. a long commodity price boom, had lowered
Eventually, as has been the case in other large its debt from 36.7 percent of GDP in 2000
economies, monetary policy should be dedi- to 20.5 percent in 2008, decreased its reliance
cated largely to stabilizing domestic demand on short-term maturities, and built up foreign
instead of maintaining a currency peg. reserves. The region’s current account turned
Five Surprises of the Great Recession 9

Figure 4

WORLD AND REGIONAL GDP


GROWTH IN RECENT RECESSIONS World
4 Advanced Economies

3 Latin America and


the Caribbean
2

0
1980–1983 1998–1999 2001–2003 2009
-1

-2

-3

-4
Note: Prior to the current recession, the IMF informally defined global recessions as periods when annual
growth fell below 3 percent. This chart covers the four most recent periods that fit that definition.
Source: IMF

to surplus in 2003 for the first time in the last 2008 to June 2009, foreign banks’ outstanding
thirty years and remained positive through claims in the LAC region actually increased
2007. Its banking sectors were more tightly slightly, while their claims in emerging Asia,
regulated and less inclined to take risks: For emerging Europe, and Africa and the Middle
example, they had little or no exposure to U.S. East contracted by nearly 8 percent and more
toxic assets. than 4 percent and 3 percent, respectively.
Better crisis management was also essential According to the IMF, the credit contraction
to the LAC region’s success. Flexible exchange in the LAC region was limited by the fact that
rates worked as a shock absorber and afforded foreign banks conduct much of their lending
more room for expansionary monetary policy. there through local affiliates and in the local
Brazil, Mexico, Colombia, Chile, and Peru currency, which provided added insulation
were able to lower policy rates in 2009 rather from international shocks.
than having to raise them as they had in the Notwithstanding this resilience as com-
past. Excluding Mexico (which contracted pared to past global recessions, the LAC
sharply due to its strong dependence on the region still failed to keep up with other emerg-
United States), GDP in those countries fell ing markets during the crisis. In 2009, it con-
by an average of only 0.2 percent in 2009. In tracted by 1.8 percent, compared to growth of
contrast, the average contraction in Venezuela, 6.9 percent in developing Asia (a region that
Ecuador, and El Salvador, which maintained includes China) and 2.4 percent in the Middle
pegged exchange rates, was about 2 percent. East and North Africa. Of emerging markets,
For the first time, countercyclical fiscal policy only Central and Eastern Europe, which con-
was used by several countries, most notably tracted by 3.6 percent, did worse.
Peru and Chile. The LAC region still suffers from a seri-
In addition, the global credit crunch ous competitiveness deficit. Across the region,
impacted Latin America less directly than it political instability, violence, and limited rule
did other developing regions. From September of law remain notable weaknesses compared to
10 CARNEGIE POLICY BRIEF

other regions, especially after controlling for especially if the shocks originate in the great
the region’s relatively high per capita income. financial centers and are transmitted through
Lack of export diversification in both part- financial channels. Second, decisive policy
ners and goods remains the region’s other action is important in the face of a crisis, but
major weakness. Within the region, coun- so is a decisive private-sector response. Third,
tries with more diversified export structures, external balances and competitiveness mat-
notably Colombia and Brazil, did better than ter, even within a monetary union (the Euro
those that are more heavily concentrated on area)—all the more so when labor markets
the export of primary commodities. The are inflexible. Fourth, large economies (China)
region sends 46 percent of its export goods should nurture their domestic markets so as
not to become excessively dependent on for-
The experience of Latin America shows eign demand. Finally, the benefits of sound
macroeconomic management are, if anything,
that even in the presence of severe greater than we once thought. But are these
structural and competitive handicaps, lessons being heeded?
To limit their vulnerability to future crises,
sound macroeconomic fundamentals can countries must have sound macroeconomic
greatly mitigate the effect of shocks. fundamentals, but a regular feature of financial
crises is a large deterioration in precisely these
to the United States (the numbers are much areas. And in this case the increase of vulner-
higher for Mexico, which was hit badly by the ability and the depletion of arsenals for future
recession). Developing Asia, in contrast, trades crisis response in industrial countries have
increasingly with China and other fast grow- been remarkable: Public debt/GDP ratios are
ing countries in Asia, sending only 20 percent about 20 percent higher than pre-crisis aver-
of its exports to the United States. ages and continue to rise rapidly, central bank
The experience of Latin America shows balance sheets have exploded, and policy inter-
that, even in the presence of severe structural est rates are near zero. In contrast, developing
and competitive handicaps, sound macroeco- countries have been much less affected: Debt
nomic fundamentals can greatly mitigate the levels remain near reasonable, pre-crisis levels;
effect of shocks. Their importance cannot be foreign currency reserves are rising, and with
overstated. output returning to trend levels several central
banks have already tightened monetary policy.
A Timid Response The deterioration of macroeconomic fun-
The fact that the Great Recession delivered so damentals in industrial countries due to the
many surprises underscores the limitations of crisis is not an excuse for inaction, however.
our knowledge of how financial crises arise, Rather, it makes action more urgent. In all the
evolve, and are dealt with. Our ignorance advanced countries, but especially in countries
clearly calls for modesty in forecasting crises, where stimulus policies (rightly) persist, there
caution and flexibility in setting policy to deal is a need for medium-term fiscal consolida-
with them, and further research. tion programs. Thus legislation to reform pen-
The five surprises discussed above teach us sions and healthcare, improve the efficiency
many lessons, but a handful stand out more and targeting of benefit programs, and ratio-
clearly than the others. First, globalization can nalize defense and other spending must pro-
amplify shocks in an extremely violent fashion, ceed, even if it is only implemented once the
Five Surprises of the Great Recession 11

crisis has abated. These measures will have the in better shape than the advanced countries,
added effect of increasing investor confidence. though this is mainly because the crisis had a
Unfortunately, with only a few exceptions there milder and shorter-lived effect on them—not
is no indication that politicians in advanced because of accelerated reforms. Indeed, there is
countries are willing to grasp the nettle. a serious risk that their success during the crisis
The reforms that advanced countries have
taken in the financial sector have been simi- As the world economy recovers,
larly disappointing. Banking systems are slowly
returning to health, but they remain fragile. unemployment declines, and the memories
Steps toward improving capital and liquidity of the disaster fade, the political will
adequacy and tightening regulations have been
taken at both national and international lev-
to bring about change is more likely to
els through the Basel III Accord, but many of subside than grow.
these reforms will be implemented over time
periods as long as a decade. In any event, they will breed complacency. China has announced
are widely viewed as inadequate, partly because greater currency flexibility, but the actual
the banking industry pulls a great deal of appreciation it has allowed has so far been
political weight and partly because of a largely minuscule. The Chinese government appears
unjustified fear of putting additional strain on serious in its declared intent to rebalance the
banks as they restructure and deleverage. Areas economy in favor of domestic demand at the
that still need urgent attention include the “too expense of exports and toward its underdevel-
big to fail” problem and the inclusion of the oped inland regions, but it remains to be seen
non-commercial-bank financial sector in the how far these reforms will go.
regulatory net (IMF, October GFSR). Thus nearly everywhere the lessons of
There has also been only limited progress the financial crisis have yet to be effectively
on narrowing the competitiveness gaps in applied. Governments were quick to react
Europe, which must include increasing the to the crisis with stimulus and bank rescues,
flexibility of labor markets and focusing on but they have been hesitant to undertake the
product markets. Across much of Europe politically tougher, long-term reforms needed
but especially in the countries most vulner- to protect us from future crises.
able to a sovereign debt crisis, the structural Indeed, as the world economy recovers,
reforms envisaged ten years ago by the Lisbon unemployment declines, and the memories
Agenda are all but officially recognized to have of the disaster fade, the political will to bring The Carnegie Endowment does
failed. The sovereign debt crisis is forcing the about change is more likely to subside than not take institutional positions
hardest-hit countries, such as Greece, Ireland, grow. In several large countries—including on public policy issues; the views
and the Baltic states, to enact far-reaching aus- the politically paralyzed trio of the United represented here are the authors’
terity measures and other reforms designed States, Japan, and Italy—big changes appear own and do not necessarily
to reduce the competiveness gap with core especially unlikely. Perhaps the best we can reflect the views of the
European countries. In other large, vulnerable hope for is that partial and incomplete reforms Endowment, its staff, or its
countries in the Euro area, like Italy, and in combined with self-imposed changes in the trustees.
the rest of the continent, reform proposals are behavior of firms, unions, banks, and house-
still far too modest and hesitant. holds will prevent a repeat crisis in the near © 2010 Carnegie Endowment
Judging in light of these lessons, many of future. But history is full of proof that memo- for International Peace.
the largest developing countries appear to be ries are all too often short. n All rights reserved.
www.Carnegieendowment.org
www.CarnegieEndowment.org
www.Carnegieendowment.org

TheThe Carnegie
TheCarnegie
CarnegieEndowment
Endowment
Endowmentfor for Further reAdiNG
reSOUrCeS
WORKS CITED
for International Peace is a
International
International Peace is a private,
Peace isorganiza-
a private,
private, nonprofit
nonprofit organization dedicated Visitwww.Carnegieendowment.org/pubs
Visit
Visit www.CarnegieEndowment.org/pubs
www.Carnegieendowment.org/pubs for
forthese
for these and
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and other
these otherpublications.
publications.
publications.
nonprofit organization
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Stability pastBuilding
and
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This Time
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