Reinhart & Rogoff: Expect a prolonged slump

Terrific piece in the WSJ by Carmen Reinhart and Kenneth Rogoff on the economic situation.

We’ve previously discussed their seminal work, 5 Historical Economic Crises and the U.S., and it has been very instructive as to how we got into — and how we get out of — financial crises

Here is a quick excerpt:

“Financial crises, even very deep ones, do not last forever. Really. In fact, negative growth episodes typically subside in just under two years. If one accepts the NBER’s judgment that the recession began in December 2007, then the U.S. economy should stop contracting toward the end of 2009. Of course, if one dates the start of the real recession from September 2008, as many on Wall Street do, the case for an end in 2009 is less compelling.”

Given the depth of crisis, and the severity of the economic downturn, I care less about starting dates to calculate an end date, than actual measurable economic improvement. The recession will show signs of ending when Housing stabilizes, employment layoffs peak (it will lag the recovery), industrial production improves, and spending begins to normalize. Watch those data points.

Back to R&R:

“On other fronts the news is similarly grim, although perhaps not out of bounds of market expectations. In the typical severe financial crisis, the real (inflation-adjusted) price of housing tends to decline 36%, with the duration of peak to trough lasting five to six years. Given that U.S. housing prices peaked at the end of 2005, this means that the bottom won’t come before the end of 2010, with real housing prices falling perhaps another 8%-10% from current levels.

Equity prices tend to bottom out somewhat more quickly, taking only three and a half years from peak to trough — dropping an average of 55% in real terms, a mark the S&P has already touched. However, given that most stock indices peaked only around mid-2007, equity prices could still take a couple more years for a sustained rebound, at least by historical benchmarks.

Turning to unemployment, where the new administration is concentrating its focus, pain seems likely to worsen for a minimum of two more years. Over past crises, the duration of the period of rising unemployment averaged nearly five years, with a mean increase in the unemployment rate of seven percentage points, which would bring the U.S. to double digits.

Interestingly, unemployment is a category where rich countries, with their high levels of wage insurance and stronger worker protections, tend to experience larger problems after financial crises than do emerging markets. Emerging market economies do have deeper output falls after their banking crises, but the parallels in other areas such as housing prices are quite strong.

Perhaps the most stunning message from crisis history is the simply staggering rise in government debt most countries experience. Central government debt tends to rise over 85% in real terms during the first three years after a banking crisis. This would mean another $8 trillion or $9 trillion in the case of the U.S.

Interestingly, the main reason why debt explodes is not the much ballyhooed cost of bailing out the financial system, painful as that may be. Instead, the real culprit is the inevitable collapse of tax revenues that comes as countries sink into deep and prolonged recession. Aggressive countercyclical fiscal policies also play a role, as we are about to witness in spades here in the U.S. with the passage of a more than $800 billion stimulus bill.”

Good stuff from the guys who correctly identified how other crises end . . .


5 Historical Economic Crises and the U.S. (February 9th, 2008)

5 Historical Economic Crises and the U.S.

The Aftermath of Financial Crises (January 24th, 2009)

The Aftermath of Financial Crises

What Other Financial Crises Tell Us

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