The Aftermath of Financial Crises

In today’s Barron’s, Alan Abelson discusses a Reinhart & Rogoff paper (The Aftermath of Financial Crises) which (quite oddly) was the subject of the last speaker’s presentation on Thursday’s Cayman Business Outlook.

Note that we have discussed the fine work of R&R previously (here and here)

Abelson quotes broadly from their most recent paper:

They cite three defining elements of the aftermaths of severe financial crises. First, asset markets of just about every kind suffer a bruising and prolonged battering. On average, for instance, real housing prices plunge 35%, and the agony stretches out over six years, while equity prices lose a whopping 55% over roughly 3½ years.

Second, output and jobs take it on the chin: The unemployment rate shoots up (again, on average) 7 percentage points over four years. Meanwhile, gross domestic product suffers losses averaging more than 9%, but — scant consolation — it happens more quickly, typically in two years or so.

Third, the real value of government debt tends to explode, shooting up an average 86% in the major post-war slumps. Reinhart and Rogoff contend that the huge swelling of such debt owes not, as commonly believed, primarily to bank bailouts and handouts (see, the banks aren’t even very good at raiding the Treasury). What really kites government IOUs, they say, is the drastic shrinkage in tax revenues generated by faltering economies and the “often ambitious countercyclical fiscal policies aimed at mitigating the downturn.” (A timely, obvious example is that $825 billion stimulus package the new administration has its heart set on.)”

But for the full effect, you should go read the original — that’s your weekend homnework assignment. Meanwhile, here’s a paragraph

“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. Interestingly, the main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system. Admittedly, bailout costs are difficult to measure, and there is considerable divergence among estimates from competing studies. But even upper-bound estimates pale next to actual measured rises in public debt. 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.”


The Aftermath of Financial Crises
Carmen M. Reinhart
University of Maryland. NBER and CEPR
Kenneth S. Rogoff
Harvard University and NBER
December 19, 2008

Woe Is Us
Barron’s JANUARY 24, 2009

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