The aftermath of financial crises

In a recent research report titled "The Aftermath of Financial crises", Professor Reinhart from the University of Maryland and Professor Rogoff from the Harvard University investigate how past financial crises affect economies both in the industrial world and in the emerging world.

They gather statistics on house prices, equity prices, employment, output and government debt and adopt a comparative historical methodology to show that, in contrary to what many economists believe, there are a lot in common between the rich world and the emerging markets in the ways their economies are hit by banking crises.

In particular, the study singles out three characteristics. First, assets prices suffer deep and prolong declines. Housing prices fall an average 35 percent while equity prices plunge by 55 percent on average. The average duration of the drop is more then 4 years. Second, unemployment soars by an average 7 percentage points and output goes down by an average 9 percentage points. And notably, job losses in the rich world are in general much more severe than that in the emerging markets. The researchers attribute it to two factors: More flexible downward adjustment of wages and gaps in social safety net which makes job-losers more anxious to find new jobs. Also, the durations of declines in employment and output are also shorter than that of asset prices, below 2 years in general. Third, government debt soars by an average 86 percent in the aftermath of banking crises, mainly because of the inevitable decreases in tax revenues and big spending on counter-cyclical fiscal stimulation instead of the much more minor costs of bailing out financial institutions and recapitalizing them.

The study conclude by discussing how relevant it is to predicting the track of the current global financial crisis. Unfortunately, the geographical extent of the current crisis is rare in history and there are very few examples to learn from. with exception to the Great Depression, the crises covered are regional in nature which affect only a few countries or countries within a continent. In contrast, the crisis we are facing today started in the U.S. and has since then spread to West Europe, East Europe, Asia and Latin America. In a regional crisis, affected countries can grow their way out by exporting more and borrowing more. However, when the world economy take a hit all at the same time and credits are crunching everywhere, that is not feasible. In light of this, what would be more effective is massive fiscal stimulus. Therefore, countries with healthy budget surpluses and current-account surpluses and take the initiative to stimulate their economies will likely be the ones who recover first.