My Two Cents

There is good reason to be afraid

Chris Farrell Jan 5, 2009

Thanks to Mike Mandel at Business Week, I became aware of this important paper, the “The Aftermath of Financial Crises* by Carmen M. Reinhart of the University of Maryland and Kenneth S. Rogoff of Harvard University. You can read the paper here. (You can read Mike’s comments from the American Economics Association annual meeting where the paper was given here.)

The scholars look at all the major postwar banking crises in the developed world–a total of 18. They emphasize the “the big five” (Spain 1977, Norway 1987, Finland, 1991, Sweden, 1991, and Japan, 1992). They also include a number of famous emerging market episodes, such as the 1997-1998 Asian crisis and Argentina 2001. Finally, they include two earlier historical cases with good housing data, Norway in 1899 and the United States in 1929.

Here is their summary:

Broadly speaking, financial crises are protracted affairs. 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.

The scholars make a sober, carefully reasoned and researched case that the U.S. and the rest of the global economy face much darker days ahead. It’s research like this that is influencing the economists that are now part of Team Obama, and why the size of the fiscal stimulus package has gotten bigger and bolder..

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