Monday, January 5, 2009

The aftermath of financial crises

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Professors Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard have updated their paper on post war financial crises and their aftermath (Hat tip to John Mauldin of Investors Insight).

It now covers developing and developed countries but the conclusion remains the same - financial crises are protracted affairs. And we are not just talking a couple of years.

From the paper:

More often than not, the aftermath of severe financial crises share three characteristics.

First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years.

Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment.

Third, the real value of government debt tends to explode, rising an average of 86 percent in the major post–World War II episodes. Interestingly, the main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system. In fact, the big drivers of debt increases are the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions, as well as often ambitious countercyclical fiscal policies aimed at mitigating the downturn.

All of which should make sobering reading, particularly for anyone expecting equity markets to bounce back in the second half of the year.

Of course, stock-market bulls will argue that the aggressive actions of central banks and governments mean this crisis is different and the recovery will be swift.
But the professors are not convinced:

The authorities today have arguably more flexible monetary policy frameworks, thanks particularly to a less rigid global exchange rate regime. Some central banks have already shown an aggressiveness to act that was notably absent in the 1930s, or in the latter-day Japanese experience.

On the other hand, one would be wise not to push too far the conceit that we are smarter than our predecessors. A few years back many people would have said that improvements in financial engineering had done much to tame the business cycle and limit the risk of financial contagion.

If anything, they think it could be worse ‘this time’ because the crisis is global.

The analysis of the post-crisis outcomes in this paper for unemployment, output and government debt provide sobering benchmark numbers for how the crisis will continue to unfold. Indeed, these historical comparisons were based on episodes that, with the notable exception of the Great Depression in the United States, were individual or regional in nature.

The global nature of the crisis will make it far more difficult for many countries to grow their way out through higher exports, or to smooth the consumption effects through foreign borrowing. In such circumstances, the recent lull in sovereign defaults is likely to come to an end. As Reinhart and Rogoff (2008b) highlight, defaults in emerging market economies tend to rise sharply when many countries are simultaneously experiencing domestic banking crises.

1 comment:

Edward J. Dodson said...

There is one economist I know who has identified the fundamental causes of business cycles and how to achieve stable economic growth. This is the British economist Fred Harrison. Google on his name and take a look at some of his interviews and several videos he has produced on the global economy.