Professors Carmen Reinhart of the Peterson Institute for International Economics and Kenneth Rogoff of Harvard University pointed out in their book This Time is Different: Eight Centuries of Financial Folly (Princeton University Press, 2009) that countries which plunge into financial and debt crises experience protracted slowdowns in economic growth. Professor Reinhart and Vincent Reinhart, a visiting scholar of the American Enterprise Institute (AEI), also demonstrated empirically in their 2010 paper that economic growth tends to slow down for 10 years post-crisis. According to these findings, the European economy is likely to face protracted sluggish growth in the coming years. In this column, I assemble recent research on protracted recessions.
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Macroeconomic analyses of protracted recessions based on the neoclassical framework started with the research paper "The Great Depression in the United States from a Neoclassical Perspective" (Federal Reserve Bank of Minneapolis Quarterly Review, Winter 1999) by Professors Harold Cole of the University of Pennsylvania and Lee Ohanian of the University of California, Los Angeles. They argued that the drastic decrease in total factor productivity (TFP; see the "Keywords" below) in the 1930s was the main cause of the Great Depression.
Their research suggesting TFP as the main trigger for the downturn stimulated further research on protracted recessions utilizing neoclassical approaches in the early 2000s. Such research was compiled in the January 2002 issue of the Review of Economic Dynamics edited by Professors Timothy Kehoe of the University of Minnesota and Edward Prescott of Arizona State University, which was subsequently published in 2007 in the book Great Depressions of the Twentieth Century (which has not been translated into Japanese).
In addition to the situations of Japan in the 1990s and the Great Depression in the 1930s, protracted recessions have occurred in many countries since the end of World War II. Kehoe and Prescott defined serious protracted recessions exceeding a certain level as "great depressions" (as a general noun), and studied such situations in New Zealand and Switzerland, for example. The book includes the well-known study of Japan in the 1990s conducted by Professor Fumio Hayashi of Hitotsubashi University and Prescott.
This series of research demonstrated that the neoclassical macroeconomic models are able to explain many of the protracted recessions in various countries without any contradictions. In particular, in most of the cases, TFP was identified as the main cause. It is noteworthy that, while countries and regions in different times have varying labor market systems and capital investment practices, worsening productivity was identified as the common cause of protracted recessions.
The chart of the changes in TFP growth in Japan indicates that the protracted recession in Japan was also largely caused by TFP slowdown. The neoclassical studies including the research by Kehoe and Prescott, however, have not looked into the reason why TFP decreases for an extensive period of time, which have led to different theoretical models.
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Now let me introduce some theories that explain the phenomena of TFP decreases following financial crises.
One such theory is the debt overhang theory (see "Keywords" below). This concept was originally introduced by Professor Stewart Myers of the Massachusetts Institute of Technology (MIT) in his 1977 paper on corporate finance. It emphasized that even when new businesses are profitable and successful, if these companies have excessive debt, most of the revenue must be used to repay the debt to the bank that provided the loan. Other banks would thus be reluctant to provide loans to them. As a result, they cannot obtain additional financing for investing in promising new opportunities, and consequently their businesses remain stagnant and unprofitable.
This theory attracted attention as it explained the debt crisis in Latin America in the 1980s and the negative effects of the bad loan problem in Japan in the late 1990s. According to it, when bad loan problems last for a lengthy period, high-productivity businesses cannot be conducted, causing TFP to remain sluggish.
Another theory is zombie lending. In the midst of Japan's bad loan issue, additional loans to distressed companies became a problem. Professors Ricardo Caballero of MIT, Takeo Hoshi of the University of California, San Diego, and Anil Kashyap of the University of Chicago called in their paper such additional lending as "zombie lending," which has drawn attention. Because zombie companies survive with additional loans and consume resources, other potentially more productive companies cannot enter the market, decreasing the TFP of the overall economy.
These two theories share a commonality in that both focus on the excessive debt of companies, but differ in that the former assumes the potential improvement of companies' productivity while the latter sees low potential for such improvement and instead emphasizes the issue of survival of subsidized companies that otherwise should exit the market.
Among empirical research, a 2008 paper by Adjunct Professor Junichi Nakamura of Hitotsubashi University and Professor Shin-ichi Fukuda of the University of Tokyo indicated that many of the "zombie companies" that were subsidized with additional loans until 2002 have made comebacks through economic recovery, debt reduction, and business restructuring efforts. In particular, it emphasized that downsizing and cutting their losses led to the improvement of their businesses. This result seems to support the debt overhang theory.
Yet some points remain unaccountable. An important assumption of the debt overhang theory is that when companies face difficulty in securing financing, they look for new lending banks other than their existing lenders. In reality, however, banks with existing loans provide additional ones. Thus, additional loans should have been provided without debt reduction, and companies' profitability should have improved. This case contradicts with the assumption that companies recovered through debt reduction and therefore according to the debt overhang theory.
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I consider the banks' concerns that "companies with excessive debt choose bankruptcy" to be key. Even if a loan is provided for promising businesses, their revenue is used to repay excessive debt, and they receive little profit. Therefore, even with new loans, these companies may choose bankruptcy. Banks that anticipate such action become cautious.
In other words, even if companies have similarly promising businesses, those with excessive debt have difficulty obtaining new loans, thus struggling to improve their financing, and finding it impossible to escape the low profitability trap. On the other hand, if their existing debt is reduced, their bankruptcy risk is lowered, making it easier for banks to provide them with new loans. Although this result is similar to the conclusion of the debt overhang theory, banks that provide new loans in this case can be the same as the lenders of the existing loans.
In this case, with the debt reduction, banks provide new loans, making the companies' new businesses feasible and improving their productivity. This result is consistent with the conclusion of the aforementioned argument by Nakamura and Fukuda that emphasized debt reduction as a cause of business recovery.
The other theory that explains stagnant TFP following financial crises focuses on the tightening of companies' borrowing restrictions. Professors Urban Jermann of the University of Pennsylvania and Vincenzo Quadrini of the University of Southern California argued that banks lend money only up to the amount that they can collect if the companies go bankrupt, which becomes the restriction on borrowing. If the collectable amounts decrease due to a crisis, the restriction on the companies' borrowing gets tightened. As a result, they cannot conduct productive business, and the TFP of the overall economy decreases.
Financial crises, through various mechanisms, lower productivity and cause protracted recessions. Studies referred to in this article demonstrate part of such process. Especially, the issue of excessive debts is key. The future of the European and the U.S. economies is closely linked with the changes in the excessive debts in each sector of households, companies, and governments, which calls for further analyses of excessive debts to be conducted.
* Translated by RIETI.
Keywords
- [Total factor productivity (TFP)]
Value added to the economy is generated by capital and labor inputs. Thus, economic growth can be broken down into increased capital input and labor input although an unexplained part remains. This part is considered as growth due to the change in TFP. Specifically, this reflects technological progress and structural changes in the economy. - [Debt overhang]
The situation in which companies or nations with excessive debt are unable to borrow new money to implement new business. Even with successful new business, most of the revenue is used for the repayment of the existing debt. As sufficient returns for the lender of the loans cannot be guaranteed, new money cannot be borrowed. "Overhang" originally refers to the "projection" of a roof or a cliff and to the "excess" of debt, etc.
March 19, 2012 Nihon Keizai Shimbun
