The Second Great Contraction

CAMBRIDGE – Why is everyone still referring to the recent financial crisis as the “Great Recession”? The term, after all, is predicated on a dangerous misdiagnosis of the problems that confront the United States and other countries, leading to bad forecasts and bad policy.

The phrase “Great Recession” creates the impression that the economy is following the contours of a typical recession, only more severe – something like a really bad cold. That is why, throughout this downturn, forecasters and analysts who have tried to make analogies to past post-war US recessions have gotten it so wrong. Moreover, too many policymakers have relied on the belief that, at the end of the day, this is just a deep recession that can be subdued by a generous helping of conventional policy tools, whether fiscal policy or massive bailouts.

But the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation.

A more accurate, if less reassuring, term for the ongoing crisis is the “Second Great Contraction.” Carmen Reinhart and I proposed this moniker in our 2009 book This Time is Different, based on our diagnosis of the crisis as a typical deep financial crisis, not a typical deep recession. The first “Great Contraction” of course, was the Great Depression, as emphasized by Anna Schwarz and the late Milton Friedman. The 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.