“Financial Crises are Protracted Affairs”

The central distinction between the current economic downturn and other periods of weakness since the 1930s is the fact that we are experiencing a financial crisis.  Other downturns were caused by manufacturing slumps or employment imbalances.  The current one has been created by a banking/credit crisis.  In a paper presented January 3rd, 2009 at the American Economic Association, a couple of professors who are also part of the National Bureau of Economic Research provide the following historical insight.  (From today’s Barron’s and The Big Picture.)  Read on, this is worth clicking through…

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.

If this analysis holds true then we are less than half way through the housing  and equity downturns in terms of time.  As I have worried about, we could be “bouncing along the bottom” for a protracted period.  The last point is an interesting one.  While we all like to have tax cuts, this implies they are exactly the wrong thing to do right now.

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