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No hope in sight yet for US economy
February 06, 2009
The outlook for the world economy continues to worsen. The majority of experts now believe that the present crisis is likely to be a long-drawn affair. The severity of any crisis is determined in part by its duration. Equally important is the magnitude of the decline in economic activity and its indicators.
History should provide a benchmark against the manner in which the ongoing crisis is likely to unfold. If so, a comparison with the previous episodes of systemic crises could shed some light on the seriousness of the current crisis.
This exactly is the subject matter of a series of recent papers by Reinhart and Rogoff. In their latest paper, the authors update their work on the aftermath of major banking crises to include developing countries as well.*
The paper examines 10 historical episodes of systemic banking crises that the world economy has witnessed over the post-war period. It lists three defining elements of the aftermath of severe financial crises. First, the collapse of the asset markets is indeed deep and prolonged. Second, the aftermath of banking crises is associated with profound decline in output and employment. Third, the real value of government debt tends to explode following a crisis.
Let us first discuss the behaviour of asset markets -- housing and equity � during the historical episodes of crises. On an average, when a banking crisis is precipitated by a house price collapse, real house prices plunge 35 per cent and the distress stretches out over approximately six years. Even after excluding the exceptional experience of Japan, the average house price decline lasts nearly five years. The most severe real house price declines were experienced by Finland, the Philippines, Colombia and Hong Kong where the prices declined by 50 to 60 per cent from their peak.
By comparison, the decline in house price experienced by the US till now during the current episode is just about 28 per cent, according to the Case-Shiller index. Although home prices have already declined more than twice that registered in the US during the Great Depression, it is still moderate compared to what other countries have experienced during the post-war era.
Unlike the real estate market, where prices have declined less than the historical average, equity markets have plummeted by much more in a number of countries. While history suggests that equity prices slump around 55 per cent over roughly three-and-a-half years during a crisis, a number of countries have already experienced a far greater decline and that too in a relatively short time span during the ongoing crisis.
Second, severe contractions in output and employment follow major banking crises. While the unemployment rate shoots up (on an average) 7 percentage points over five years, per capita income records a drop of more than 9 per cent. Recovery, however, is faster in the real sector than in the asset markets, typically in two years or so.
The decline in real GDP is less for advanced economies than for emerging market economies. According to the authors, the reason for this is that developing economies are prone to abrupt reversals in capital flows which happen to be an important source of finance for them. A much more plausible explanation for this is that developed economies are dynamic and much more flexible than developing economies. As a result they tend to recover far more quickly.
Third, and perhaps the most important message from history, is that the fiscal position of the government weakens dramatically in the aftermath of a major banking crisis. The real value of government debt tends to shoot up at an average 86 per cent in the three years following a banking crisis.
The experience of Sweden stands out in this regard. After the 1991 crisis, the fiscal deficit-to-GDP ratio touched 15 per cent of the GDP, compared to a surplus of nearly 4 per cent of the GDP prior to the crisis. Interestingly, what leads to a rapid worsening of the fiscal balance is not, as is commonly believed, the cost of bailing out financial institutions. Rather, it is the drastic decline in tax revenues as a result of output contraction and the ambitious fiscal stimulus package aimed at kick-starting the economy that cause fiscal deficits to explode.
Reinhart and Rogoff contend that their estimates of the rise in government debt are likely to be conservative, as these exclude increases in various forms of government guarantees during a downturn.
Overall, the main conclusion of Reinhart and Rogoff is that, downturns that follow financial crises are typically deep and protracted. The current crisis is unlikely to be an exception.
*Reinhart and Rogoff and Kenneth Rogoff (2009). The Aftermath of Financial Crises, American Economic Review, forthcoming May 2009, available as NBER working Paper 14656, January 2009.
The author is senior economist, CRISIL. She can be contacted at firstname.lastname@example.org
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